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Is Fiscal Federalism Good for Growth?

Fiscal federalism can be broadly defined as the financial relations between different levels of government – central, regional, municipal level, etc. – and the term was firstly introduced by Musgrave (1959). Under fiscal federalism, provision of public goods is decentralised to subnational governments, allowing better-tailored public goods/services to the preferences of a heterogeneous population. Thus, the main question to ask is which task should be assigned to which governmental level, and how it should be financed.

In the recent decades, we have observed a significant effort from countries in implementing policies towards decentralization due to its arguably beneficial effects in economic performance. In Portugal, the decentralization process started with the new constitution, written in 1976, after the reestablishment of democracy. However, this has been a lengthy process and the country is still considered one of the less decentralized European countries. Several reforms have been put in place in order to increase the level of decentralization, under the main arguments of a higher fiscal efficiency and stronger political accountability.

The theory of fiscal federalism is based on the seminal work of Tiebout (1956), whose basic economic arguments in favour of fiscal decentralization rest on two main assumptions. On the one hand, decentralization increases economic efficiency since local governments are capable of providing better services due to proximity and informational advantages. On the other hand, competition and population mobility across local governments for the delivery of public services ensure the right matching of preferences between local communities and local governments. In summary, subnational fiscal autonomy ensures efficient allocative outcomes, which may eventually lead to higher growth rates.

The relationship between decentralization and growth has been technically formalized by several theoretical models, but its conclusions are not clear-cut regarding the actual transmission mechanism.

Empirically, this relation relationship is also ambiguous. Several studies find a positive relation between fiscal decentralization and economic growth, while other studies fail to find any relationship, and some even identify a negative one. The reason for these discrepancies in results is mainly related with the measures of fiscal decentralization that vary across studies.

Even without a strong empirical evidence to support, the trend for both developed and developing countries has been to fiscally decentralize. In Portugal, the main step towards decentralization was made in 1989 with the introduction of a property tax (Contribuição Autártica), whose revenues were fully managed by local governments, who had also discretion in setting the property tax rate. This measure intended to increase local fiscal autonomy by enhancing their source of fiscal revenues, increasing their political accountability and decreasing the reliance on financial transfers from the central government. However, the process has not been immediate and, currently, it is far from been finished. Even after several reforms, Portuguese local governments are still on the process to be autonomous with the most important source of revenues still being transfers from the central government (more than 20%).

 Catarina Alvarez

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Author: studentnovasbe

Master student in Nova Sbe

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