Fiscal Decentralization, Political Heterogeneity and Welfare

Working Paper 1903

Theoretical and empirical literature on fiscal decentralization has been thriving, while understanding the welfare implications of fiscal decentralization under political diversity necessitates further investigation. Authors Erkmen G. Aslim and co-author Bilin Neyapti contribute to this literature by formally modeling the interaction between the central government and local governments, where the latter may have varying degrees of political proximity to the former. The model solution reveals that the optimal tax rate is positively associated with fiscal decentralization, political unison, and spillovers across localities, while the local tax collection effort is negatively associated with all of these parameters. The first novel finding of this study is that both the welfare and the central government’s utility peak and income distribution is more equitable at a lower level of fiscal decentralization when spillovers exist than otherwise, which supports the decentralization theorem. The second novel finding is that both the amount of redistributable income and central government utility increases with political unison.