Corresponding author: Andrey Yushkov ( a.yushkov90@gmail.com ) © 2015 Non-profit partnership “Voprosy Ekonomiki”.
This is an open access article distributed under the terms of the Creative Commons Attribution License (CC BY-NC-ND 4.0), which permits to copy and distribute the article for non-commercial purposes, provided that the article is not altered or modified and the original author and source are credited.
Citation:
Yushkov A (2015) Fiscal decentralization and regional economic growth: Theory, empirics, and the Russian experience. Russian Journal of Economics 1(4): 404-418. https://doi.org/10.1016/j.ruje.2016.02.004
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The article addresses the theoretical and empirical relation between fiscal decentralization and economic growth. An empirical analysis of Russian regions for 2005–2012 shows that excessive expenditure decentralization within the region, which is not accompanied by the respective level of revenue decentralization, is significantly and negatively related to regional economic growth. In contrast, regional dependence on intergovernmental fiscal transfers from the federal center is positively associated with economic growth.
fiscal decentralization, economic growth, Russian regions
Fiscal decentralization is one of the key concepts in the public finance theory and a commonly used policy measure in public sector reforms. In federal states, fiscal decentralization means that revenue and expenditure responsibilities (the right to impose and collect tax and independently determine the focus areas of expenses) are transferred from the federal to the regional and local levels.
The classical theory of fiscal federalism considers three key goals of the public sector: economic efficiency, macroeconomic stability, and income redistribution (Musgrave,
The key argument in favor of fiscal decentralization is the possibility to increase the allocative and productive efficiency of public goods provision (Martinez-Vacquez and McNab,
In contrast, fiscal decentralization can be dangerous under particular circumstances (
The classical theory of fiscal federalism does not explicitly consider the relationship between fiscal decentralization and economic growth. However, studies in this field became particularly relevant after the beginning of large-scale decentralization reforms in (former) socialist states in the late 1980s — early 1990s (Russia and former republics of the Soviet Union, Eastern Europe, and China). The advocates of these reforms needed a theoretically and empirically justified relationship between the degree of decentralization and economic growth, the most easily measured quantitative indicator of economic development. In their search for such a justification, economists have analyzed and adapted various economic growth models, using them to find a potential link between decentralization and growth and applying various econometric techniques to confirm this link empirically.
Researchers have modified popular economic growth models (Solow model, Barro's endogenous growth model, and Diamond's overlapping generations model) to incorporate a potential relationship between fiscal decentralization and economic growth (Brueckner,
The augmented Solow model (
Summing up the previous research on the theoretical relationship between fiscal decentralization and economic growth,
Thus, a theoretical relationship between fiscal decentralization and economic growth appears to be established and justified. Is there solid empirical evidence of such a relationship?
The results of numerous studies on the relationship between fiscal decentralization and economic growth, both from a cross-country and regional perspective, are very contradictory. Some researchers find a positive relationship (Akai and Sakata,
The most widely used cases in the regional studies are obviously Chinese provinces and American states, because both countries offer sufficient samples (50 American states and 28 Chinese provinces), substantial heterogeneity among regions in terms of economic and fiscal performance, and reliable statistical data for a long period of time. Nevertheless, there is no consensus on the direction and significance of this relationship.
According to some researchers, regional economic growth in China is negatively correlated with expenditure decentralization (
Analyzing the relationship between fiscal decentralization and economic growth in the USA, researchers also obtain contradictory results. For instance, some use the Davoodi-Zou model and analyze ‘long’ time series data (1948–1994) and conclude that there is no strong link between expenditure decentralization and growth, i.e., the exiting degree of decentralization suits the purpose of maximizing economic growth (
The analysis of the decentralization experience in Spain in 1985–2004 reveals a strong positive relationship between revenue decentralization and economic growth and no link between expenditure decentralization and growth (
Summing up the analysis of the empirical literature,
The main lessons that need to be learned from the numerous empirical studies described above are that the multidimensional nature of decentralization (at least its revenue and expenditure dimension) should be considered, and the major determinants of economic growth should necessarily be included in the econometric model to prevent the omitted variable bias.
The development of fiscal federalism in contemporary Russia is similar to a pendulum motion. The highly centralized budget system of the late Soviet Union underwent spontaneous decentralization during a transition period of the early and mid-1990s, formation of fiscal norms and institutions in early 2000s and then gradual fiscal recentralization beginning in the mid-2000s. It should be noted that in contrast to China, where the economic decentralization of the 1990s was accompanied by the preservation of political control over provinces by the central government, fiscal decentralization in post-Soviet Russia was accompanied by political decentralization, whereas the recentralization of the budget system in the mid-2000s was accompanied by political centralization. Thus, the Chinese model proposed for Russia by certain researchers and policy-makers was not attempted in reality.
A detailed description of fiscal federalism development in Russia is beyond the scope of this paper but covered extensively in
The empirical section of this article considers the relationship between fiscal decentralization and regional economic growth at the latest stage of development of fiscal federalism in Russia (from 2005 until now). This stage is characterized by the continuing recentralization of budget revenues and the increased dependence of regions on intergovernmental transfers from the federal center.
For the purposes of the empirical analysis, we collected data on 78 Russian regions over the period from 2005 through 2012.
The growth rate of the gross regional product (GRP) per capita (GRP_GR) is used as the dependent variable in all the specifications. The independent variables that characterize the degree of decentralization include the intraregional revenue decentralization (DEC_1), which is the share of self-generated municipal revenues (without transfers) in total revenues of the consolidated regional budget
The majority of regional studies use similar measures of fiscal decentralization (Akai and Sakata,
Additional independent variables include the share of investments (in fixed assets) in GRP (INV_SHARE); the regional share of total natural resource production (RES_SHARE); the tax burden or tax pressure, measured by the share of tax revenues in GRP (TAX_IN_GRP); the regional population growth (POP_GROWTH); the trade openness ratio of the regional economy, the ratio of exports and imports to GRP (OPENNESS); one of the possible indicators of human capital development, i.e., the share of higher educational institutions graduates in total population of the region (ALUMNI); the inflation index (INFL); and a logarithm of the lagged value of GRP per capita (GRP_PC_LAG) to test the conditional convergence hypothesis.
A few key conclusions should be noted regarding the descriptive statistics. First, the degree of intraregional expenditure decentralization far exceeds the degree of revenue decentralization (average level of DEC_2 over 8 years is 50%; DEC_1 — 28%). That is, there is a significant gap: revenues are concentrated at the regional level, whereas expenditures are equally divided between regions and municipalities. In other words, the municipal tax base does not correspond to its spending authority.
Data for fiscal decentralization and other economic indicators for the 10 best and worst regions in terms of regional economic growth (GRP growth per capita) in 2005–2012.
The following empirical analysis is loosely based on the Davoodi-Zou analytical framework (
where GRP_GRit is a GRP growth per capita in the region i in year t; αi denotes the unobserved regional fixed effects; λt is the vector of time effects (dummy variables)
The panel data model is estimated in the fixed-effects framework (FE).
Model with fixed effects and time dummies.
The intraregional expenditure decentralization (column 2) is negatively and significantly (at 5%) related to regional economic growth, whereas the region's dependence on transfers from the federal budget (column 4) is positively and significantly (at 10%) linked to growth.
These results imply that government expenditures in Russian regions are excessively decentralized, which causes a negative relationship between expenditure decentralization and regional economic growth. At the same time, self-generated revenues of municipalities are only 50% of their total revenues (the second half consists of intergovernmental transfers). Thus, municipalities lack sufficient resources to finance their own spending programs. The majority of their programs are financed through subsidies. Thus, local authorities have no incentives to spend budget resources more efficiently.
The results noted above contrast with the findings of researchers who, studying Russian federalism at its initial stage, find a positive relationship between the intraregional revenue decentralization and the growth of real industrial production (1992–1996) (
At the same time, a high dependence of a region on intergovernmental transfers is positively correlated with economic growth (or, conversely, negatively correlated with economic stagnation). This result confirms the findings of
The majority of independent variables have expected signs, which confirms the adequacy of the model. The GRP per capita logarithm, taken with a threeyear lag, is negatively correlated with economic growth (at 1% significance in all specifications), which confirms the conditional convergence hypothesis. Tax pressure is also significantly negatively (at 1% or 5%) associated with growth. The share of investments in GRP and human capital proxy are positively and significantly related to economic growth, which confirms the findings of previous studies (Barro,
Similar findings are obtained for rentier regions (transfer-dependent regions and regions with a high share of natural resources in GRP; see also Freinkman and Plekhanov,
Returning to the channels of correlation between fiscal decentralization and economic growth described in the theoretical part of the article, we can assume that they do not function efficiently in the modern Russian system of fiscal federalism. Market preservation is not working (and did not work in the 1990s, see
This article illustrates the current situation with fiscal (de)centralization in Russian regions and its potential link to regional economic growth. Identifying a clear causal relationship between decentralization and growth (or, more broadly, development) and solving the issues of dual causality and endogeneity in the model falls beyond the scope of this article, although it is of substantial interest for the future research of Russian fiscal federalism.
Depending on the context, fiscal decentralization can be viewed as a process (transferring budgetary authority) or as a state or result of such a process (scope of authority delegated to lower administrative levels with respect to the total scope of authority of the public sector).
This argument has been challenged in the literature (Thiessen, 2003) because centralization (and a uniform level of public goods provision) may lead to significant economies of scale. Conversely, decentralization may lead to lower production efficiency because lower level officials potentially lack the necessary competences to provide high-quality public goods.
The relationship between decentralization and economic growth is also considered for the case of Turkey (Tosun and Yilmaz, 2008), Australia (Bodman et al., 2009), and India (Zhang and Zou, 2001).
Moscow and St. Petersburg are two federal cities that are excluded from the analysis because their budget structure is incomparable with other regions; Tyumen Oblast includes two Autonomous Okrugs (Yamalo-Nenetsky and Khanty-Mansiysky), and Arkhangelsk Oblast includes Nenetsky Autonomous Okrug.
The consolidated regional budget in Russia consists of the regional budget and consolidated municipal budgets (i.e., budgets of all municipalities present in the respective region).
The formal allocation of revenue and expenditure powers between different levels of the budget system can be found in Ch. 8 and 9 of the Russian Budget Code and Part 2 of the Russian Tax Code (regional and local budget revenues), Ch. 11 of the Russian Budget Code (spending obligations of different levels), Federal Law No. 184-FZ (powers of regions) and Federal Law No. 131-FZ (powers of local authorities).
Including time effects in the regression model is extremely important for the period of interest (2005–2012) because it allows to control for the impact of exogenous macroeconomic shocks and cyclical fluctuations of the economy on economic growth.
Squared specifications have also been tested but showed insignificant results.
Multicollinearity is not an issue here because independent variables in the regression are not highly correlated (only two correlation coefficients exceed 0.3).
The Hausman test results show that the random-effects model (RE) is inconsistent for the model of interest.
To verify the results, separate regressions were run for both periods (the ‘fat years’ and the crisis period with subsequent recovery, see above). The direction of the relationship between decentralization measures and economic growth remained the same. However, the negative correlation between expenditure decentralization and growth is more significant during the ‘fat years’.