Fiscal Decentralization in Developing Countries: The Effects of Local Corruption and Tax Evasion

A movement toward fiscal decentralization is underway in many countries across the world. This movement is partly justified by appeal to the classic argument of Tiebout (1956), who claimed that decentralized provision of public goods allows better fulfillment of diverse individual demands. Many commentators, however, have expressed concern that the conditions justifying Tiebout's argument are not present in many developing countries. This paper analyzes the consequences of altering Tiebout's model to include local corruption and tax evasion, which may exist in many developing countries. The analysis shows that these forces indeed limit the benefits from fiscal decentralization. By raising public-good costs, corruption cancels some of the gains from better demand fulfillment, which arise as Tiebout sorting generates homogeneous local jurisdictions. By creating incentives for mixing, thereby preventing formation of homogeneous communities, tax evasion may block the operation of the Tiebout mechanism, eliminating the gains from fiscal decentralization.