Regional State Capacity and the Optimal Degree of Fiscal Decentralization

This paper studies the optimal degree of fiscal decentralization in a federation. In our environment, regional governments are characterized by two dimensions of state capacity; namely, administrative and fiscal. These gauge the ability to deliver public goods and to raise tax revenues, respectively. Two regimes are compared: partial and full decentralization. Under partial decentralization, regional governments have no tax powers and rely on central bailouts to refinance incomplete projects. Under full decentralization, regional governments refinance incomplete projects through capital taxes, in a context of tax competition. We provide a normative comparison between partial and full decentralization and show how the optimal degree of fiscal decentralization hinges on the relative magnitudes of each type of capacity. Specifically, for sufficiently low levels of fiscal capacity bailing out regional governments is optimal, regardless of the level of administrative ability. However, a combination of low levels of administrative capacity and high levels of fiscal capacity calls for fully decentralizing tax powers.