Fiscal Decentralization and Public R&D Policy: A Country Panel Analysis

This paper examines the impact of fiscal decentralization on both public investment in innovation (measured as the share of research and development - R&D - spending in total government budget) and on the intensity of basic research within the public R&D bundle. We present a theoretical model where a ‘benevolent government’ invests in R&D aiming at maximizing net income available in the country (central government) or in the respective region (subnational government), where states compete to attract capital investment, and where R&D results are subject to interregional knowledge spillovers. The model predicts that decentralization leads to a lower level of public spending on innovation and to a lower share of basic research in government R&D budgets. The implications of the model are empirically tested utilizing country aggregate data. We find evidence that expenditure decentralization leads to lower intensity of basic research within public R&D and that both revenue and expenditure decentralization negatively affect the size of innovation spending. The findings suggest that fiscal decentralization policy, expected to be beneficial in many other dimensions, should be accompanied by measures to compensate for the otherwise decrease in innovation spending and that the assignment of expenditure responsibilities should have central government play a greater role in financing and carrying out basic research.