Fiscal decentralization and income inequality in OECD countries: does shadow economy matter?

The impacts of fiscal decentralization on income inequality have been debated, especially they can depend on fiscal tools and other factors. This paper explores whether the allocation of government spending and tax revenue at different levels of government truly alleviates income inequality or inadvertently exacerbates it, considering the presence of the shadow economy – which operates outside formal channels. The study focuses on 23 OECD countries over the period 2002–2020 due to the significant surge in fiscal decentralization, and the growing concerns regarding rising income inequality and the shadow economy within OECD countries. Results show that: (i) tax revenue decentralization increases income inequality; (ii) expenditure decentralization significantly reduces income inequality; (iii) income inequality is positively affected by shadow economy; (iv) the shadow economy intensifies the detrimental effect of tax revenue decentralization on income equality, and it weakens the beneficial effect of expenditure decentralization on income equality; (v) the threshold is 18.53%, meaning that expenditure decentralization abates income inequality as long as the shadow economy is below this threshold, but above this level, expenditure decentralization exacerbates income inequality. These findings suggest that tax revenue decentralization may not be the silver bullet for combating income inequality, whereas expenditure decentralization holds promise when the shadow economy is controlled. These insights call for cautious policymaking in the realm of fiscal decentralization, particularly in the context of the shadow economy, to foster a more equitable future.