Fiscal decentralization and preference heterogeneity: revisiting the decentralization theorem

Oates’ Decentralization Theorem is the basis of the theory of fiscal federalism. The Decentralization Theorem predicts that the larger (smaller) the heterogeneity in preferences for local public goods across regions, the larger (smaller) the benefits of decentralization. The objective of this study is to examine how the differential between welfares under centralization and under decentralization alters in response to changes in preference heterogeneity. The main findings of this study are as follows. First, if the difference in preferences is small and/or the degree of spillovers in local public goods is large, an increased level of the larger preference parameter is likely to increase the welfare differential between centralization and decentralization. Put another way, an increase in preference heterogeneity may make a centralized regime welfare-preferable. Meanwhile, when the difference in preferences falls through an increase in the smaller preference parameter, a centralized regime becomes welfare-preferable. Second, a mean-preserving spread of preference heterogeneity—a “pure” increase in heterogeneity—makes the decentralized provision of public goods welfare-preferred to the centralized provision. Third, only if a centralized regime is welfare-superior to a decentralized regime can an increase in the larger preference parameter make centralization welfare-preferable.