Revisiting the "Decentralization Theorem"--On the role of externalities
The "Decentralization Theorem" [Oates, W.E., 1972. Fiscal Federalism. Harcourt Brace Jovanovich, New York] is central to the discussion of fiscal federalism. We revisit the role of consumption spillovers in evaluating the merits of (de)centralization. Unlike the general prediction, a higher degree of spillovers may reduce the difference in utility of centralization and decentralization. The non-monotonicity result relates to the difference in expenditures on public consumption. Provided decentralized choices yield higher levels of public expenditure, a rise in the amount of spillovers allows residents to enjoy larger gains in public consumption (and thereby utility) under decentralization relative to centralization.
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