Fiscal Decentralization and Macroeconomic Performance

With a view to creating governments that work and serve their people, a large and growing number of countries around the globe are reexamining the roles of various orders of government and their partnerships with the private sector and the civil society (Shah, 2004). This rethinking has led to a resurgence of interest in fiscal federalism principles and practices, as federal systems are seen to provide safeguards against both the threat of centralized exploitation and decentralized opportunistic behavior while bringing decision making closer to the people. In fact, federalism represents either “coming together” or “holding together” of constituent geographic units to take advantage of the greatness and littleness of nations, because in a flat (globalized) world, nation-states are observed to be too large to address small things in life and too small to address large tasks. But federal fiscal systems to accommodate “coming together” or “holding together,” according to some influential writers, pose a threat to macro stability. They argue that decentralized governance structure is incompatible with prudent fiscal management (Prud’homme, 1995; Tanzi, 1995). This chapter investigates the conceptual and empirical bases of these arguments. More specifically, the chapter addresses the following questions: Are there greater risks of macroeconomic mismanagement and instability with decentralized fiscal systems (federal versus unitary countries)?