Lecture 7: Decentralization. Political economy of decentralization is a hot topic. This is due to a variety of policiy initiatives all over the world

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1 Lecture 7: Decentralization Political economy of decentralization is a hot toic This is due to a variety of oliciy initiatives all over the world There are a number of reasons suggested for referring a more decentralized system of government easier to match reference heterogeneity better control of agency roblems (also di erences in olicy salience)

2 But against this must be set the advantages of centralization internalizing externalities scale economies coordination

3 Contractual Solutions Coasian view Allows jurisdictions to contract with one another But roblems of information/contractability. Also there are issues of distribution which e cient allocation is to be icked? Contractual view does not really give a reference for centralization or decenetralization.

4 Imlicit in most of the literature are failures of the Coase theorem this could be due to imerfect information, or di culties of enforcement.

5 Background I. Tiebout: rimary focus is on the role of exit. sorting across jurisdictions yields otimal allocation But two roblems: theoretical issues not much evidence for mobility based on ublic goods

6 II. Oates Once governance structures are imerfect, heterogeneity becomes a key barrier to solving multi-jurisdictional roblems. This is a key theme in the literature, even going back to Oates (1972), the rst systematic account of issues in scal federalism. But Oates assumes that olicies under centralization must be uniform. This is traded o against sillovers for centralizaed decisions.

7 There is a large literature that has attemted to look at di erent sources of sillovers: obvious examles are: infrastructure rojects taxes/subsidies on mobile goods and factors In ractice, we know little emirically about the magnitudes of these e ects Sources of scale economies include (e.g.) law and order we know very little emirically about this.

8 Recent Literature Exogenous jurisdictions: Centralization versus decentralization: Political economy: Besley/Coate;Lockwood Key issue is how to model centralization and decentralization Commitment: Qian/Weingast/Roland Decentralization makes commitment easier. How does decentralization work? Is there better monitoring? Bardhan/Mookherjee

9 Use of yardstick comarisons Is there more likely to be governmental cature by lobbies and elites?

10 Endogenous jurisdictions Secession: Bolton/Roland Otimal size and shae of nations: Alesina/Soalare

11 Centralization versus Decentralization Secify what would haen in the status quo under non-cooerative behavior. This could either use a olitical economy model or a model of local welfare maximizing governments. Point out the ine ciencies. (Sometimes but not always) Look to see whether a centralized solution will imrove uon things. (Usually the latter is deliberately made imerfect to avoid the trivial Coasian outcome under which centralization is always referred or the benevolent lanner model in which centralization is always referred.)

12 Political economy ought to be a the heart of doing this roerly.

13 Sillovers versus Heterogeneity The economy is divided into two geograhically distinct districts indexed by i 2 f1; 2g. Each district has a continuum of citizens with a mass of unity. There are three goods in the economy; a single rivate good, x, and two local ublic goods, g 1 and g 2, each one associated with a articular district. Preferences: x + [(1 ) ln g i + ln g i ]:

14 where 2 [0; 1=2] indexes the degree of sillovers. Each district has a the range of reference tyes [0; ]. Mean tye in district i is denoted by m i (=median tye) Assume m 1 m 2. In a decentralized system, the level of ublic good in each district is chosen by the government of that district and ublic exenditures are nanced by a uniform head tax on local residents. Thus, if district i chooses a ublic good level g i, each citizen in district i ays a tax of g i.

15 In a centralized system, the levels of both ublic goods are determined by a government that reresents both districts, with sending being nanced by a uniform head tax on all citizens. Thus, ublic goods levels (g 1 ; g 2 ), result in a head tax of 2 (g 1 + g 2 ). Social surlus: S(g 1 ; g 2 ) = [m 1 (1 ) + m 2 ] ln g 1 +[m 2 (1 ) + m 1 ] ln g 2 (g 1 + g 2 ): This is maximized by: (g 1 ; g 2 ) = ( m 1(1 ) + m 2 ; m 2(1 ) + m 1 ):

16 When m 1 exceeds m 2, district 1 s level is higher for all < 1=2.

17 The Standard Aroach (Oates 1972) Decentralization: Exenditures (g1 d; gd 2 ) form a Nash equilibrium. This requires that gi d =: arg max g i fm i [(1 ) ln g i + ln g d i ] g ig; i 2 f1; 2g: Imlies (g d 1 ; gd 2 ) = (m 1(1 ) ; m 2(1 ) ): Centralization: g c = arg max g f[m 1 + m 2 ] ln g 2gg;

18 yielding g c = m 1 + m 2 : 2

19 Proosition 1 Suose that the assumtions of the standard aroach are satis ed. Then (i) If the districts are identical and sillovers are resent ( > 0), a centralized system roduces a higher level of surlus than does decentralization. Absent sillovers ( = 0), the two systems generate the same level of surlus. (ii) If the districts are not identical, there is a critical value of, greater than 0 but less than 1 2, such that a centralized system roduces a higher level of surlus if and only if exceeds this critical level.

20 A Political Economy Aroach Policy makers are elected citizens who follow their olicy references when in o ce. Voters elect candidates whose olicy references yield outcomes they like. Each model has an election stage and a olicy making stage Under centralization olicy making is in a legislature. This requires modeling legslative behavior:

21 Two main choices: Minimum winning coalition view (Riker) Universalistic view (Weingast/Shesle/Johnson)

22 Decentralization: Each district elects a single reresentative from among its members to choose olicy. Reresentatives are characterized by their ublic good references. The olicy determination rocess has two stages. First, elections determine which citizens are selected to reresent the two districts. Second, olicies are chosen simultaneously by the elected reresentative in each district. Working backwards, let the tyes of the reresentatives in districts 1 and 2 be 1 and 2.

23 Then the olicy outcome (g 1 ( 1 ); g 2 ( 2 )) satis es g i ( i ) = arg maxf i [(1 ) ln g i + ln g i ( i )] g i g for i 2 f1; 2g : Solving this yields (g 1 ( 1 ); g 2 ( 2 )) = ( 1(1 ) ; 2(1 ) ): Election stage: If the reresentatives in districts 1 and 2 are of tyes 1 and 2, a citizen of tye in district i will enjoy a ublic goods surlus [(1 ) ln i(1 ) + ln i(1 ) ] i (1 ):

24 These references over tyes determine citizens voting decisions. A air of reresentative tyes ( 1 ; 2 ) is majority referred under decentralization if, in each district i; a majority of citizens refer the tye of their reresentative to any other tye 2 [0; ], given the tye of the other district s reresentative i. Citizens references over tyes are single-eaked imlying that a air of reresentative tyes is majority referred under decentralization if and only if it is a median air; i.e., ( 1 ; 2 ) = (m 1; m 2 ). Thus we have: Lemma 1 Under the assumtions of the olitical economy aroach, the olicy outcome in a decentralized system is (g 1 ; g 2 ) = ( m 1(1 ) ; m 2(1 ) ):

25 Centralization One citizen from each district is elected to a legislature Minimum winning coalition view: each district s reresentative is selected with equal robability. If the reresentatives are of tyes 1 and 2, the olicy outcome will be (g 1 1 ( 1); g 1 2 ( 1)) with robability 1=2 and (g 2 1 ( 2); g 2 2 ( 2)) with robability 1=2 where (g i 1 ( i); g i 2 ( i)) is the otimal choice of district i s reresentative; that is, (g i 1 ( i); g i 2 ( i)) = arg max (g i ;g i ) f i[(1 ) ln g i + ln g i ] 2 (g i + g i )g:

26 It is easily checked that (g i i ( i); g i i ( i)) = ( 2 i(1 ) ; 2 i ); i 2 f1; 2g: If the reresentatives tyes are 1 and 2, a citizen of tye in district i obtains an exected ublic goods surlus of 1 2 f[(1 ) ln 2 i(1 ) +[(1 ) ln 2 i + ln 2 i ] i + ln 2 i(1 ) ] i g: A air of reresentative tyes ( 1 ; 2 ) is majority referred if, in each district a majority of citizens refer the tye of their reresentative to any other tye, given the other district s reresentative tye. As above, we

27 assume that the elected reresentatives in the two districts will be of the majority referred tyes. Thus, if the majority referred reresentative tyes are ( 1 ; 2 ), the olicy (1 ) ; 2 1 ) ) with robability 1=2 and ( 2 2 ; 2 2 outcome will be ( 2 1 with robability 1=2. (1 ) ) Lemma 2 Under the assumtions of the olitical economy aroach, the olicy outcome under a centralized system with a non-cooerative legislature is random, generating (g 1 ; g 2 ) = ( 2m 1(1 ) ; 2m 1 ) with robability 1=2 and (g 1 ; g 2 ) = ( 2m 2 ; 2m 2(1 ) ) with robability 1=2. Two roblems with centralization with a non-cooerative legislature:

28 Uncertainty: each district is unsure of the amount of ublic good that it will receive, re ecting the uncertainty in the identity of the minimum winning coalition. Misallocation: ublic sending across the districts is skewed towards those inside the winning coalition.

29 Decentralization versus centralization Proosition 2 Suose that the assumtions of the olitical economy aroach are satis ed and that the legislature is non-cooerative. Then (i) If the districts are identical, there is a critical value of, strictly greater than 0 but less than 1 2, such that a centralized system roduces a higher level of surlus if and only if exceeds this critical level. (ii) If the districts are not identical, there is a critical value of, strictly greater than 0 but less than 1 2, such that a centralized system roduces a higher level of surlus if and only if exceeds this critical level. This critical level is higher than that in the standard aroach.

30 This model can be used to think about the conditions under which the districts will choose to centralize or decentralize (the formation and dissolution of federations). Following Bolton and Roland, we can identify two main e ects: (they have a third e ect because they assume roortional income taxes) A olitical e ect: how close will olicy making be to the references of the median tye in the district that chooses to join A sillover e ect: to what extent will the new allocation internalize externalities? We can get errors running in both directions welfare reducing centralization (when median exceeds the mean reference)

31 welfare reducing decentralization: mean) (median su ciently below the heterogeneity will also tyically lead to less desire for centralization Transfers are also imortant for this logic. Clearly if one side can commit to a sequence of transfers to the other over time, then this would make centralization desirable if and only the sum of surlus is higher. (again we have a failure of the Coase theorem imlicit in this).

32 How many nations? In a recent article Alesina and Solaore considered what the otimal number of nations should be. Their aroach trades o scale economies and reference heterogeneity. Suose that references are U i = g (1 a`i) t i + y where `i is i s distance from the government. Individuals can live in u to N nations and it costs k to nance government in any nation. Then the aggregate budget constraint for government is Z t i di = Nk.

33 The otimal number of nations is assumed to maximize R U i di subject to this constraint. Assuming equal sized nations this boils down to choosing N such that ga=4n + kn is minimized. (The rst term is the average distance between the government and its citizens in an N nation world.) The otimum is N = (ga=4). They contrast this with what would haen if individuals were allowed to sort themselves endogenously and choose how many nations to form. Suose that a set of N nations is stable if any individual at the border is indi erent between any two nations. Then they show that this imlies that N nations can survive if N < (ga=2). In general there are too many nations! This can be thought of as down to the Coase theorem failing by not allowing individuals to negotiate. All

34 the ower to determine the stable outcome here is held by the indi erent citizen.

35 The Value of Intergovernmental Cometition? The resumtion in a good deal of the recent solution is that the cooerative solution is the valid benchmark. Note that this raises similar issues to those that arise in thinking about markets. Scale economies and sillovers are at the heart of why rms would have an incentive to collude with on another. However, in the rocess they may also choose to collude on rice. Hence, collusion is most often frowned uon and would not be a good social welfare benchmark.

36 So what is di erent about government? Clearly if government is benevolent, then the cooerative benchmark is aealing. However, if there is some agency roblem between government and government, due to agency roblems, then allowing governments to collude can be as questionable as allowing rms to collude. Intergovernmental cometition can be imortant as a form of yardstick cometition used to reveal imerfect information to voters. Besley and Case found evidence for the US that there was some sensitivity of voters to olicy outcomes in neighboring states.

37 if there are otimal locations for economic activity. A good examle here is in allowing state aids to achieve an otimal location of industrial activities when geograhy matters. There is also the ossibility of encouraging olicy innovation where some regions try some articular kind of olicy and others bene t from seeing the results. These issues are at the heart of some of the recent views about tax cometition in Euroe and elsewhere. There is a tendency to focus mainly on the costs and little on the bene ts.

38 Decentralization, Commitment and Cature One ossible di erence between centralized and decentralized decision making is the extent to which governments can commit. Weingast and Qian have recently argued that decentralization limits state ower (they have the examle of China in mind). They argue that the Chinese government has deliberately limited state ower by reventing information ows. This aears to be the oosite of the exerience with municial level regulation of utilities in the United States. (Democratic decentralization may to contend with oulism).

39 In general, decentralization will be exected change government incentives, although I would argue that issue bundling and olitical salience of issues is key to understanding this as well. There has also been some discussion of whether changing the locus of decision making ower changes the likelihood that governments are subject to cature by secial interests - the answer is far from clear-cut theoretically and I am not aware of convincing emirical evidence on this. This goes to the heart of whether we exect more decentralized forms of governance to be resonsive to local needs/tastes.

40 Other Asects of Governmental Architecture Most of the literature on scal federalism takes very simlistic ersectives on the kind of governmental structures that are ermissible. Yet, the world reveals a comlex of overlaing jurisdictional arrangements that overla in comlicated ways. One imortant issue that has received less treatment in the literature, but is closely related to scal federalism is the ossibility of functional searation of tasks. In ractice, this might take the form of articular single issue authorities that chooses olicy in a articular dimension. However, there is no need to make this a regional body. I susect that these issues of disaggregating democracy may become more debated in the next few years.