Fiscal Decentralization with a Redistribution Rule vs. Fiscal Centralization

This paper compares the case of fiscal decentralization (FD) with an intergovernmental transfer rule to the case of fiscal centralization (FC) from a theoretical perspective while focusing on Markov-perfect Nash equilibrium by a continuum of citizens, local governments and a central government, which interact strategically. Simulation analysis shows that both the degree of spillovers and capital mobility play a role in the comparison of these two cases. In the presence of spillovers, the welfare of FD case is higher than the one of FC which is an unexpected result but points out the positive effect of a redistribution rule in FD model in terms of welfare. On the other hand, the growth rate of FD is lower than the FC case when there are spillovers. So, fiscal discipline, provided by the redistribution rule, prevents inefficiently low tax rates which pull down the growth rate. In addition, when spillovers are not allowed, capital mobility determines which case is superior.