Macroeconomic Impact

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Contributor: World Bank
Author: Decentralization Thematic Team
Contact: Jennie Litvack

Macroeconomic Impact of Decentralization

The design of decentralization can have a significant influence on how the restructuring of decision-making and responsibility affects a country's macroeconomic conditions. Some countries, including Brazil and China, experienced macroeconomic problems when tax bases were decentralized without clearly assigning expenditures to the level of government that receives the revenues. Others, including Mexico and Argentina, ran into problems, because sub-national governments accrued unsustainable debts and had to be bailed out by the central government. Other decentralization efforts, in which governments solved their fiscal imbalances at the center by decentralizing expenditure responsibilities without the matching revenues, left essential services unperformed and, in some cases gave rise to unsustainable sub-national deficits. The design of intergovernmental fiscal relations needs to take account of these possible negative effects. Most importantly, it must ensure a match between expenditure responsibilities and revenues at each level of government and create institutional mechanisms that will enforce a hard budget constraint between levels of government.

Sub-national Incentives

Compared to central governments, sub-national governments have less incentive to consider the macroeconomic impact of their policies. The macroeconomic impact of sub-national stabilization policies tends to leak away to other jurisdictions, giving macroeconomic stability public goods characteristics. Central governments are therefore usually assigned the task of maintaining stability, and should have the tools to go with it, such as control over monetary policy, and at least some control over fiscal conditions. The latter includes a share of revenues and expenditures sufficiently large and sufficiently flexible to influence aggregate demand in a country. However, whether intended or not, sub-national policies can influence stability: even balanced budget spending increases by sub-national governments can affect macroeconomic stability; and sub-national borrowing can become a major macroeconomic concern. On the other hand, macroeconomic shocks can hit different jurisdictions differently, making some sub-national influence on macroeconomic conditions actually desirable. Finally, centralizing all expenditure and revenues with a potential macroeconomic impact may have excessive efficiency costs.

Structuring Intergovernmental Fiscal Relations to Enhance Stability

Revenue Assignment and Tax Sharing

Sub-national governments should have a fairly stable tax base, for highly income elastic tax bases (such as VAT and progressive income taxes) can induce pro-cyclical government expenditures that aggravate macroeconomic imbalances. Central governments have tended to be more responsible in this respect. Moreover, taxes such as VAT and income tax lend themselves well for macroeconomic policy by increasing rates to cool down an over-heating economy.

Expenditure assignments

Although the discussion on this topic is limited, the public finance literature usually recommends assigning sufficiently stable expenditures to sub-national governments. For instance, many argue that social security is better assigned to the national level because of its pro-cyclical nature. Incentives, however, may moderate this standard conclusion. For instance, while assigning unemployment compensation to central government may create an "automatic stabilizer" it also takes away the incentive for sub-national government to save on unemployment expenditures by, for instance, following a proactive employment policy. Thus the centralization of social security may actually increase macroeconomic imbalances. Making local government responsible for a part of these highly cyclical expenditures may actually lead to better results in terms of stability.


Macroeconomic considerations--but also tax administration and equity considerations--are likely to give central government the larger part of revenues, but not necessarily expenditures. Thus, a system of grants will be needed to fill the vertical imbalances. Although efficiency and equity consideration are likely to dominate the process of grants design, several features could be beneficial to macroeconomic stability.
  • Grants should be designed such that they fill ex ante the gap between sub-national revenues and expenditures. Ex post gap filling could give rise to excessive expenditures at local level, as central government will foot (part of) the bill.
  • The size of the grant pool should be fairly independent from macroeconomic conditions, to avoid the pro-cyclical spending patters noted above. Having a broad revenue base that feeds the grant pool is therefore to be preferred above single-tax based grants.
  • Central government needs some discretion to adjust the amount of grants transferred. Although this is often impossible for general grants mechanisms that are usually based in law, special purpose grants offer more flexibility. Their expenditure effects can even be leveraged, if the grants require sub-national matching.

Sub-national Borrowing

Sub-national borrowing can have a large effect on macroeconomic conditions in a country. Countries such as Brazil and Mexico saw their restrictive central fiscal policies in the early 1990s thwarted by sub-national deficits (either open or hidden) resulting in the end in a bailout by national government. However, intertemporal efficiency speaks strongly for allowing sub-national governments at least some access to borrowing. Countries have therefore taken a number of approaches in allowing sub-national borrowing:
  • Reliance on market discipline for limiting borrowing requires that several strict conditions are fulfilled, among which open capital markets, adequate information, responsiveness of the borrower to market signals, and strict no-bailout policy of central government.
  • Even national governments may not meet these requirements, but especially the latter is particularly binding for sub-national governments. Except for some federal countries (the United States and Canada, for example), few countries solely rely on market discipline.
  • A number of countries (Germany, Switzerland, Spain, Korea) have relied on legally binding rules to restrict borrowing. Some have used the golden rule of allowing borrowing only for investment purposes. Others use rules that restrict borrowing to some indicator of debt servicing capacity.
  • Some countries directly control sub-national borrowing by setting overall limits, approving individual debenture issues, or by allowing borrowing only through a centrally controlled municipal bank. Local governments have ways to circumvent any of these regulations, by reclassifying expenditures from current to capital, running arrears, creating off-budget activities, and using state enterprises for borrowing, or providing guarantees on enterprise borrowing. Thus, any rule should have sufficient incentives and controls to enforce it.

Coordination mechanisms

In recognition of the sub-national influence on stability, several countries have designed intergovernmental macroeconomic coordination mechanisms. Germany, which probably has the most elaborate one, coordinates expenditure and borrowing plans within the context of the Stabilitaetsgesetz (stability law). The 5-year fiscal plan is discussed and coordinated with the states before submission to parliament. In Australia, the Loan Council now coordinates borrowing requirements of national and sub-national public sector, after previously serving as a forum to limit sub-national borrowing. In China, the annual planning and finance conference is used to discuss and coordinate the plans of each level of government. And many countries have informal coordination mechanisms, either through State or provincial representation in a house of parliament, or through special subcommittees of parliament. To what extent coordination without binding rules actually delivers better results is an open question.

Regulating Incentives by Design

In designing intergovernmental fiscal relations, the incentive effects on macroeconomic stability should be explicitly considered. Large vertical imbalances in favor of national governments are likely to lead to ex-post gap filling by national governments, bailouts of sub-national debt, or circumvention of national policies on taxes or debt. Large imbalances in favor of sub-national governments on the other hand could lead to large national debts, and to insufficient fiscal discipline at sub-national levels. Little tax autonomy of sub-national governments reduces the incentive to behave responsibly, because they cannot be required to increase taxes to restore balance on the budget. Thus, other things equal, a broad matching of expenditure and revenue responsibilities, together with explicit responsibility of each level of government to live within its means, and the autonomy to do so is desirable. Rules for budget management for sub-national governments could address many of the detrimental macroeconomic effects of decentralization. As long as sub-national governments are held to responsible management--including limits on deficit spending--and provided the means and incentives to actually do so, the macro impact of their actions can be limited. Having harsh measures for central government to deal with fiscal irresponsibility could help (such as bankruptcy procedures for local governments in New Zealand, and transparent fiscal accounts that are regularly published and audited can add to discipline. Also, in the end, one of the best incentives for responsible behavior is likely to be the pressure from an electorate that would suffer from a fiscal crisis.