Estimating the Income Elasticity of Local Government Revenues and Expenditures under Decentralization

A common feature of the different policy initiatives currently undertaken or considered to improve the decentralization program is a proposal to amend the current formula used in allocating the national government's internal revenues. This formula is known as the Internal Revenue Allotment (IRA) formula, which determines the principal revenue share of local governments in the country's total fiscal resources and as well as the allocation of the total share among the different levels and types of local governments. As an input to policy discussions, this paper seeks to measure the responsiveness of the revenues and expenditures of local government units to changes in the IRA. To measure local fiscal response to IRA changes, the income elasticity of the revenues from local sources and total expenditures of provinces and cities are econometrically estimated using local fiscal data covering the period 1990-96. The results show that revenues from local sources and total expenditures of either the provinces or cities are generally income elastic. That is, the increments in the IRA under decentralization do not seem to substitute for local revenues and have likewise stimulated greater local public spending. The results then suggest that local governments, despite initial apprehensions instigated by their seemingly increased dependence on central transfers, have nonetheless learned to adjust positively to their new roles and responsibilities under the program. However, the results also indicate that current policy reforms must also focus on improving fiscal imbalances, since local governments respond differently, albeit all positively, to the changes in their IRA shares under the decentralization program.