Fiscal Decentralization, Intergovernmental Transfer, and Overborrowing

In an infinite horizon dynamic equilibrium model we show how fiscal decentralization in a fiscal federation can affect aggregate government debt. We model borrowing-spending decisions by central and local governments. Distortionary transfers from central government create incentives for local governments to overborrow. Fiscal decentralization changes local government's shares of revenue and spending responsibility, and hence its fiscal gap. A larger local fiscal gap increases the central government's incentive to make transfers ex post, which worsens overborrowing ex ante. As a result, both local and central government debt levels rise. We perform quantitative analysis on Spain and find fiscal decentralization explains 19-40% of changes in general government debt during 1988-2006. We further show that a prudential debt tax can offset the distortion and implement the Pareto optimal allocation, with a 27% reduction in debt and 3.75% welfare gain in 1996.