Decentralization and Intra-Country Transfers in the Great Recession: The Case of the EU

The classic arguments of Musgrave (1959) and Oates (1972) are that the redistribution and stabilization functions should be assigned to the federal level of government. The argument is that redistribution is difficult to achieve at lower levels because the public good nature of redistribution and the mobility of individuals and firms. Likewise, stabilization is difficult to achieve because fiscal stimulus of lower levels of government is likely to be underused due to spillover effects and a limited ability to service debt obligations. These arguments suggest that under-provision of redistributive spending should accompany greater decentralization. They also suggest that subnational policies aimed at macroeconomic stabilization are likely to be less effective than national ones, an important issue in an economic crisis. In this paper I examine data on intra-country social protection transfers in the EU before and after the crisis. The results support the classic federalism assignment. For both reasons of redistribution and stabilization, social protection expenditures are best assigned to the central level of government. Regression results indicate that greater decentralization lowers social protection expenditures and a greater vertical fiscal imbalance and greater subnational deficits result in more spending on things other than social protection.