Time, Decentralization and Development

Time, Decentralization and Development Tobin Im and Seung Jong Lee I. Introduction Timing is an important factor to understand political process (Pierson, 2000). The temporal ordering of events, such as elections, decentralization reform etc., has a significant impact on political outcomes. Despite a reform has its absolute value, a wrong timing or an opposite order of two reform programs in their implementation might turn out harmful to the political or economic system. Decentralization is one of reforms that can significantly affect the resource mobilization and allocation and ultimately macroeconomic stability and economic growth (Iimi, 2005; Lin & Liu, 2000; Litvack & Ahmad & Bird, 1998; Martinez-Vazquez & McNab, 2003). Thus, the World Bank has adopted decentralization as one of the major governance reform agenda (World Bank, 2000a). Decentralization is regarded as a way to make government more responsive and efficient to citizen, so that some developing countries are adopting decentralization as a way of solving problems such as inefficient and ineffective administration, macroeconomic instability, and low level of economic growth (Bird, 1993). Many researchers and practitioners around the world including those of developing countries support the positive effects of decentralization. Free market economists emphasized the aspect of reducing the power of the overextended state through decentralization; postmodernist, multicultural advocates, grassroots environmental activists, and supporter of the cause of indigenous people uphold the assignment of control to local selfgoverning communities (Bardhan, 2002: 186). Even though decentralization is widely believed to promise a range of benefits, and the centralized states seem to have lost a great deal of legitimacy (Bardhan, 2002: 185; Olowu, 2000; Smoke, 1994; Wunsch & Olowu, 1990), it is arguable that this reform will be beneficial to any country regardless its stage of political, economic, and social development process. In fact, the results of the studies on the impact of decentralization are mixed (Zhang & Zou, 1997; Goldsmith, 1999; Fisman & Gatti, 2002a; Treisman, 2000b; Davoodi & Zou, 1998). Decentralization is not a panacea for all maladies that developing countries face. Developing countries are in the very different institutional and economic and social conditions from those of developed countries. These differences may bring about unintended consequences to decentralization reforms (Litvack & Ahmad & Bird, 1998). Indeed decentralization has many versions, so that one can not say a particular type of decentralization reform is the best for each county. Rather, one can say that the best design will vary depending on histories and institutions of the country. This complexity has sometimes been overlooked in the haste to offer policy advice (Litvack & Ahmad & Bird, 1998). One remedy fit to a country will not be good for another country, because the development stages that each

country is passing through are different from one to another. This study questions why there is this difference among countries. II. Theoretical Background: Decentralization and Growth 1. Scope and Concepts Decentralization is a broad concept which can be interpreted in various types. Each type of decentralization has different characteristics, policy implications, and conditions for success. One of the often cited classifications presumes four broad categories of decentralization: administrative, fiscal, political, and market decentralization (Rondinelli & Nellis, 1986; Rondinelli, 1999). Administrative decentralization refers to the transfer of power and responsibility for planning, financing, and managing certain public functions from the central government to local authorities. Fiscal decentralization means broadly to efforts to transfer the distribution and sources of resources available to local governments. Political decentralization signifies to attempts to devolve powers to democratically elected local governments or, in much weaker forms, to attempts to make local governments more accountable to communities through the establishment of oversight boards or the introduction of new forms of citizen participation in development projects and policy-making. Market decentralization involves attempts to transfer substantive control over resource allocation to non-state actors. While distinguishing among the different types of decentralization is useful for highlighting its many dimensions and the need for coordination, these concepts overlap considerably (Rondinelli, 1999). This paper will focus on fiscal and political decentralization. This study questions the relationship between decentralization and growth. Like decentralization, growth is a broad concept having multiple aspects; political, economic, social, cultural, etc. Among these, economic growth is one of the main objectives that all developing countries hope to achieve, because they compete with each other in this globalization era. The question to raise here is whether a country s economy can grow without having achieved the other aspects. In other words, what will be the best strategy of growth for the country regarding the priority to be put among these economic, political, social aspects growth. For example, among components of political development, decentralization was the important issue that scholars and politicians had argued. Increasing GDP per capita and ensuring political liberty, for instance, both are important goals that a developing country wants to achieve within the least delay. This paper will not deal with the ideological argument on which one among these is more important and emergent, because this belongs to the value judgment regarding which one is more important between political emancipation to be achieved through political development such as decentralization and elevation of living standard through economic growth, rather we will focus on empirical dimension about the relationship. Martinez-Vazquez and McNab(2003) and Akai and Sakata(2002) found that the implementation of a multi-tier system of government, i.e. decentralization, can significantly affect overall resource allocation in the economy and hence, economic efficiency, growth, and welfare. Regardless these strategies, some countries economies grow relatively faster than others. There are mixed findings in the effect of decentralization on economic growth. Even though growth is a complex concept for measuring accurately, this study presupposes GDP growth rate, as the indicator for the growth.

2. Positive Relationship There are several empirical studies supportive of a positive relationship between decentralization and growth. Thiessen (2000) finds a positive and direct relationship between decentralization and growth for panels of high-income, Western European and middle-income countries. Akai and Sakata (2002) argued that, providing new evidence, fiscal decentralization contributes to economic growth in the USA. They insisted that their new data regarding the USA state level enable them to estimate the effect of fiscal decentralization more objectively than previously, because the data set exhibits little cultural, historical, and institutional variation. And Lin and Liu (2000) studied the effect of fiscal decentralization reform on the growth rate of GDP per capita which was initiated in the mid-1980s in the mainland China. According to their study, fiscal decentralization has significantly contributed to economic growth in China, which is consistent with the hypothesis that fiscal decentralization can increase economic efficiency. They argued that, based on the data set, fiscal decentralization has raised the growth rate in China mainly by improving the efficiency of resource allocation rather than by inducing more investment. Iimi (2005), using the instrument variables technique with the crosscountry data for the period from 1997 to 2001, found that fiscal decentralization has a significant positive impact on GDP per capita growth. According to this study, as far as the economic situation in the latter 1990s is concerned, decentralization, particularly on the fiscal expenditure, is instrumental in economic growth. 3. Negative Relationship Empirical evidence does not necessarily support the hypothesis of decentralization-growth fit. Davoodi and Zou (1998) provided a simple endogenous growth model showing how the degree of fiscal decentralization affects the growth rate of the economy through a cross-country panel data set of 46 developed and developing countries over the period from 1970 to 1989. They found the negative relationship between fiscal decentralization and growth in developing countries, but none for developed countries. Zhang and Zou(1998) showed, based on annual data on 28 provinces in China from 1986 to 1992, that a higher degree of fiscal decentralization is associated with lower regional economic growth in China. They argued that an increase in sub-national government level expenditure causes a decline in the real growth rate of regional income. The key infrastructure projects, they argue, may have a far more significant impact on economic growth across provinces than their counterparts in each province. Their results reveal that the association between central governments spending on development and economic growth is positive and significant while that of provincial government is negatively associated with economic growth. Xie, Zou, and Davoodi(1999) examined how fiscal decentralization is related to regional growth in the US economy from 1948 to 1994. They interpreted the insignificant coefficients on sub-national government expenditure shares as a policy implication that further decentralization in public spending is harmful to growth in the US context. No matter what the results are in these studies, there are many methodological issues and problems in empirical studies testing the role of the decentralization in economic growth (Martinez-Vazquez & McNab, 2003). Furthermore, little attention is paid to the real decision-making power in local government and it is just assumed that the level of share in expenditure and revenue indicate the level of autonomy in local governments, which cannot be applicable to many countries.

III. Analytic Framework. This study attempts to test the hypothesis of relationship between decentralization and development and discuss its implications. To examine the effect of decentralization on economic growth, the following regression model 1 will be estimated with time-series cross-section data: git = θ1 + θ2fdit + θ3pdit + θ4xit + εit Where g is the growth rate, FD is the degree of fiscal decentralization, PD is the political decentralization, X is the set of control variables identified in the previous studies, i(= 1,, I) and t(=1,, N) refer to country i at time t, I denotes the number of countries and N the number of time periods, and ε is an idiosyncratic error term. IV. Data and Method This study attempts to test the hypothesis of relationship between decentralization and development and discuss its implications especially for the developing countries. Acquiring relevant data and measuring are important issue for this kind of study. The most frequently used are those furnished by the International Monetary Fund, by the World Bank, and by Freedom House which this study used also. Dependent variable is the countries economic growth which is measured by each country s GDP growth rate. GDP growth rate used in this study is from World Development Indicator by the World Bank with time series for 209 countries from 1960 to 2007. Fiscal decentralization was measured as follows. IMF s Government Finance Statistics (GFS) provides financial situation with time series for more than 130 countries from 1970 to 2007 on a basis of three categorization of governments; central government, state or province government, local government. Some countries have three tiers and others have just one local government. This study, considering the latter two governments as local government, sums the total of local government. Thus we calculated the sub-national government sharing of total spending with the ratio of local governments total expenditure over central government s total expenditure. And there was a change in categorization of expenditure in IMF s Government Finance Statistics; from GFSM 1986 to GFSM 2001. To maintain consistency, the data was transformed into one format; According to the data manual, the sum of GFSM2001 Expense and GFSM2001 Net Acquisition of Nonfinancial Assets can be used as a proxy for GFSM1986 Total Expenditure. To measure the political decentralization, we used Freedom House s index of political right and civil liberty with time series for more than 190 countries from 1972 to 2007. Although political right and civil liberty does not perfectly reflect the political decentralization to local government, these indexes are useful to capture the degree of political decentralization which can not be fully measured by existence of local election; if 1 The growth regression models in other studies such as Davoodi and Zou(1998), Andres and Hernando (1997), and Iimi( 2005) were considered in this model.

existence of local election is used as indicator, there is a possibility that the diverse political situation of each country s political decentralization is likely to be overlooked. Average of political right and civil liberty is transformed to a scale 0 to 10. And we imputed values for countries where data is missing by regressing index on the average Freedom House measure. Hadenius and Teorell (2005) show that this average index performs better both in terms of validity and reliability than its constituent parts. Table 1 Summary Statistics Variable Mean Std. dev. Max Min World Developing Countries Semideveloped Countries Developed Countries GDP Growth Rate (%) 3.314984 3.957329 17.7309-21.259 Fiscal Decentralization (%) 19.50391 11.51064 50.86701 1.159843 Political Decentralization 7.97957 2.732153 10 0.5 Population Growth Rate (%) 0.819471 1.057032 6.017009-3.93064 Inflation Rate (%) 36.46089 247.1376 6836.88-8.63783 GDP Growth Rate (%) 3.85672 5.518433 17.7309-21.259 Fiscal Decentralization (%) 14.95623 11.23285 47.76039 1.159843 Political Decentralization 5.710675 2.812094 10 0.5 Population Growth Rate (%) 1.150623 1.354097 3.937506-1.87858 Inflation Rate (%) 83.244 407.178 6836.88-8.63783 GDP Growth Rate (%) 3.437093 3.470074 11.39582-21.1687 Fiscal Decentralization (%) 13.41913 7.258055 32.5993 2.119747 Political Decentralization 8.07712 2.321041 10 2 Population Growth Rate (%) 0.745765 1.188037 6.017009-3.93064 Inflation Rate (%) 23.1955 66.19589 873.6429-0.32697 GDP Growth Rate (%) 2.834369 2.255813 11.6801-7.28317 Fiscal Decentralization (%) 25.68227 10.08884 50.86701 7.727021 Political Decentralization 9.871971 0.258841 10 9.083334 Population Growth Rate (%) 0.584378 0.518176 3.380294-0.92542 Inflation Rate (%) 5.194352 4.371376 27.13229-1.87668 After taking missing data into account, our time-series cross-section data set includes 63 countries with annual observations from 1972 to 2007. Time-series cross-section (TSCS) data has several advantages compared with either purely cross-sectional or purely time-series data such as the ability to study dynamic relationships and to model the differences, or heterogeneity, among subjects (Frees, 2004). We used random effect model. And the Time-Series Cross-Section Regression was run to analyze the relationships. V. Findings and Implication We estimated regression with four different groupings; the world, the developing countries, the semideveloped countries and the developed countries. All these regression results are summarized in Table 2. The results suggest that there are statistically significant relationships between fiscal decentralization and GDP growth rate, or between political decentralization and GDP growth rate in some of the samples.

Table 2 Regression Result of World Sample Dependent Variable: GDP Growth Rate Independent Variable World (full sample) (1) (2) (3) Constant 5.305353*** (0.5537) 4.933672*** (0.6738) 5.095234*** (0.6591) Fiscal Decentralization -0.02129** (0.00962) -0.0148 (0.00990) -0.01589 (0.00969) Political Decentralization -0.16673*** (0.0486) -0.17867*** (0.0642) -0.17635*** (0.0630) Population Growth Rate 0.318736* (0.1683) 0.33236** (0.1645) Inflation Rate -0.00318*** (0.000431) R-Square 0.0155 0.0184 0.0664 Number of Countries 62 62 62 Length of Time Series 38 38 38 Notes: Statistically significant at * the 0.1 level, ** the 0.05 level, *** the 0.01 level. Figures on parenthesis are standard errors. In the full sample (world), the result shows that there is a significant negative relationship both between fiscal decentralization and GDP growth rate and between political decentralization and GDP growth rate; the 0.05 level and the 0.01 level respectively. This result of world sample is in conflict with Iimi s analysis (2005) which showed a positive relationship between fiscal decentralization and economic growth and no relationship between political right and economic growth with data from 1997 to 2001 and Davoodi and Zou s analysis (1998) which showed no relationship between fiscal decentralization and economic growth with data from 1970 to 1989. Table 3 Regression Result of Developing Countries Sample Dependent Variable: GDP Growth Rate Independent Variable Developing Countries (1) (2) (3) Constant 5.708986*** (0.9742) 5.361461*** (1.1355) 5.289647*** (1.0823) Fiscal Decentralization -0.01652 (0.0189) -0.01586 (0.0191) -0.01388 (0.0181)

Political Decentralization -0.26443** (0.1219) -0.23722** (0.1205) -0.19661* (0.1158) Population Growth Rate 0.126838 (0.2939) 0.192694 (0.2783) Inflation Rate -0.00295*** (0.000621) R-Square 0.0133 0.0147 0.0714 Number of Countries 31 31 31 Length of Time Series 38 38 38 Notes: Statistically significant at * the 0.1 level, ** the 0.05 level, *** the 0.01 level. Figures on parenthesis are standard errors. There is a significant negative relationship between political decentralization and GDP growth rate and no relationship between fiscal decentralization and GDP growth rate in the developing countries sample. Table 4 Regression Result of Semi-developed Countries Sample Dependent Variable: GDP Growth Rate Independent Variable Semi-developed Countries (1) (2) (3) Constant 5.871038*** (0.9784) 4.816839*** (1.4611) 4.963386*** (1.0451) Fiscal Decentralization -0.11461*** (0.0355) -0.12569*** (0.0448) -0.04742 (0.0290) Political Decentralization -0.08934 (0.0648) 0.006387 (0.1417) -0.06129 (0.1092) Population Growth Rate 0.560431* (0.3147) 0.341893 (0.2296) Inflation Rate -0.02359*** (0.00298) R-Square 0.0517 0.0674 0.2852 Number of Countries 15 14 14 Length of Time Series 37 37 37 Notes: Statistically significant at * the 0.1 level, ** the 0.05 level, *** the 0.01 level. Figures on parenthesis are standard errors. A significant negative relationship between fiscal decentralization and economic growth is observed in the semi-developed countries sample.

Table 4 Regression Result of Developed Countries Sample Dependent Variable: GDP Growth Rate Independent Variable Developed Countries (1) (2) (3) Constant 3.824684 (4.9326) 2.899341 (4.7255) 3.968302 (4.8321) Fiscal Decentralization -0.00779 (0.00975) -0.00652 (0.00859) -0.00552 (0.00897) Political Decentralization -0.07024 (0.4994) -0.02754 (0.4790) -0.12109 (0.4881) Population Growth Rate 0.803202*** (0.2414) 0.872836*** (0.2518) Inflation Rate -0.04357 (0.0324) R-Square 0.0014 0.0250 0.0272 Number of Countries 17 17 17 Length of Time Series 37 37 37 Notes: Statistically significant at * the 0.1 level, ** the 0.05 level, *** the 0.01 level. Figures on parenthesis are standard errors. In the developed countries sample, fiscal and political decentralization showed no significant impact on economic growth. These results imply that the fiscal and political decentralization which have been very widely adopted in developing countries can have unexpected negative impact on the countries economic growth. We can think of the several reasons why fiscal and political decentralization negatively affect economic growth of the country. First of all, decentralization can promote corruption (Banfield, 1979; Prud homme, 1995) which is likely to have negative impact on the countries economy (Gyimah-Brempong & Camacho, 2006; Mauro, 1995, 1997). Treisman (2000b) showed, through cross-country regressions using several indexes of corruption, that federal states were more corrupt than unitary ones, attributing this to the collective action problem for sub-national officials in deciding how much to extract in bribes from businesses that they have the power to regulate. He insisted that unitary states have more effective hierarchies of control which enable central officials to limit the extraction of sub-national officials to more reasonable levels. Mauro (1995, 1997) investigated the effects of corruption on economic growth using data from a sample of developed and developing countries. He found that corruption has a negative and significant impact on economic growth. Gyimah-Brempong and Camacho(2006) investigated regional differences in the effect of corruption on economic growth using panel data from 61 countries at different stages of economic development over a 20-year period. Using two measures of corruption, they found that there are statistically significant regional differences in the growth impacts of corruption. The

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