Central Regulation of Local Authorities

Abstract

Decentralized provision of services allows communities to adapt to local variations in preferences. However, surveys show that central regulation of local sector revenue, spending, and borrowing decisions is pervasive. This article argues that one rationale for central regulations is to prevent local authorities from distorting allocation decisions in order to drive up intergovernmental grants. By limiting the local sector's discretion to act strategically, regulations give the government leeway in setting grants.Fiscal policy making at the local level involves three distinct allocation decisions: setting the mix between private and local public spending, setting the mix between different spending categories, and determining the intertemporal distribution of spending. These will be referred to as the revenue, spending, and borrowing decisions, respectively.According to the &dquo;classical&dquo; theory of fiscal federalism, subcentral authorities have an important part to play in the allocation function of government because decentralized provision of services allows communities to adapt to variations in circumstances and taste (Oates 1972;King 1984). When communities have different preferences for the size, composition, and intertemporal distribution of public spending, there is a strong case for decentralizing revenue, spending, and borrowing decisions to local authorities.However, surveys of central-local relations in Western Europe show that, for all three aspects of local fiscal policy, central regulations are pervasive.' The center controls local revenues by setting intergov-

Intergovernmental Fiscal Transfers: International Lessons for Developing Countries

“…For a more extended review encompassing many other aspects of intergovernmental fiscal relations, see Bird (2001a). Since many of the questions discussed here are far from settled in the literature, readers may also wish to consult two other recent--and very different--discussions of the role and design of transfers in developed countries: Carlsen (1998) and Duncombe and Yinger (1998). The examples used in the paper are for the most part taken from earlier reviews of transfer systems in various countries, both developed and developing--for example, Bird (1986), Shah (1994), Bird, Ebel, and Wallich (1995), Ahmad (1996), Ter-Minassian (1997), and Bird and Vaillancourt (1998)--and may not reflect the current situation in the countries mentioned.…”

Intergovernmental Relations and Fiscal Discipline: Between Common Tax Resources and Soft Budget Constraints

“…The basic question we address in this section is whether it is possible to set a system of incentives such as to induce local governments not to follow the kind of behavior that would elicit a bailout. Tn this spirit, two recent papers, Wildasin (I 997c) and Carlsen (1998), propose formal models of bailouts in fiscal federalism. Both papers model intergovernmental fiscal relations as a game where firstly the central government chooses a bailout policy, i.e., a set of conditions under which it will provide financial assistance to local governments; the possibility of a bailout brings about a nonlinear budget constraint for the local government that will decide whether or not to trigger a bailout, according to its objective function, after taking into account the costs associated with being bailed out, consisting in loss of autonomy and disruption of local activities.…”

“…One way for the central government to avoid this outcome is to "bribe" the local government to abstain from budget distortions by raising the first-period unconditional grant. Indeed, Carlsen (1998) shows that in equilibrium the central government wants to follow exactly this line of conduct, local expenditure will then be higher than what it would be socially efficient but the local government will not distort its budget in order to elicit a bailout.…”

“…The models by Wildasin (1997c) and Carlsen (1998) do not address all the dimensions of the problem of intergovernmental fiscal relations. An ideal model would entail both endogeneity oflocal taxes and divergence between the perceived marginal costs of public funds (the common pool problem) as well as the possibility of a bailout.…”

“…While assigning to local governments enough tax-raising autonomy to finance their expenditure seems an obvious recipe for increasing political accountability and attenuating the common pool problem, it may render more likely the occurrence ofa bailout. In both Wildasin (1997c) and Carlsen (1998), it may be in the interest of the central government to grant a transfer higher than warranted by economic efficiency, in order to incentive the local government not to engage in policies that would force the center to intervene with a bailout. This result has not received much attention, but it seems quite important.…”