Fiscal decentralization, political budget cycles and countercyclicality

Using the IMF Fiscal Decentralization Dataset, we investigate the intricate relationship between fiscal decentralization and discipline. In particular, we analyse how fiscal decentralization affects the conduct of countercyclical fiscal policy and political budget cycles (PBCs). This study reveals that revenue decentralization is associated with a countercyclical fiscal policy stance because local tax autonomy serves as a disciplinary device. In contrast, expenditure decentralization is accompanied by the procyclical behaviours of local governments, probably due to the soft budget constraint stemming from the common pool problem (shared revenue and/or reliance on government transfers rather than their own revenue). Such procyclical effects of fiscal devolution are stronger in developing countries than in advanced countries. Countries should therefore recognize potential downsides before increasing local spending authority and ensure that local governments have adequate taxing powers to maintain fiscal discipline. We also find that the presence of subnational fiscal rules enhances the procyclicality of decentralized spending, particularly during electoral cycles. The unsolicited effects of subnational fiscal rules on fiscal procyclicality and the magnification of PBCs, both at the local government level, should be acknowledged by fiscal authorities.