Decentralization and growth: Do informal institutions and rule of law matter?

We develop a model of the interactions among decentralization, informal institutions and the rule of law. The model sheds light on the ambiguous empirical results reported in the literature regarding the growth effects of the policy of devolving fiscal responsibility to local governments. We find that the distribution of civicness within a country determines the magnitude of the effects of decentralization on its regional convergence, as well as whether decentralization fosters or dampens the country’s national growth. We perform a series of simulated “reforms” using Monte Carlo methods parameterized using OECD countries data set. We then test our findings using a panel data set of 23 OECD countries covering the period 1975–2010. We find that the short and the long run growth effect of decentralization policy depends on the size of the policy reform and can range from extremely negative to positive depending on the rule of law, the level of social capital and its regional dispersion, in line with the model predictions.