Economic Integration and Fiscal Decentralization:
Evidence from OECD Countries†
Dan Stegarescu‡
February 28, 2003
Abstract
Since the 1970s and especially during the last decade several countries experienced a
process of decentralization of the public sector, while at the same time the integration of
the world economy is rapidly progressing. This parallelism becomes even more evident
with regard to European Union countries. Given this background, the paper examines
the impact of economic and political integration on the vertical government structure. By
increasing the market size and the benefits of local provision of public goods and taxes,
economic integration, and particularly integration among European Union countries,
could have triggered the recent process of decentralization. Drawing on recent work on
fiscal federalism, the secession of countries, and new economic geography, the role of
integration is investigated for a panel of OECD countries. The empirical analysis relates
public sector centralization to economic and European integration, controlling for other
determinants, such as inter-regional heterogeneity, economies of scale and institutions,
and including fixed country effects. The results found are in fact consistent with a strong
decentralizing effect of both economic and European integration.
Keywords: public sector decentralization, fiscal federalism, economic integration, European Union
JEL Classification: F15, H72, H77
† I would like to thank the participants in the ZEW department seminar on January, 2003, and especially Thiess
Buettner, and Robert Schwager for helpful comments.
‡ Centre for European Economic Research, L7,1, D-68161 Mannheim, Germany. Phone: +49 (0)621 1235 167. Fax:
+49 (0)621 1235 223. E-mail: stegarescu@zew.de
1
Introduction
Since the 1970s and especially during the last decade several industrial and developing
countries, and, more recently, the East European transformation countries, experienced
a more or less pronounced process of decentralization of the public sector. At the same
time, the globalization and integration of the world economy is rapidly progressing.
This parallelism becomes even more evident with regard to European Union countries.
In the course of economic and political integration, fiscal and political powers have been
transferred from the national governments both to the European Union and to lower
levels of government. This development is often associated with a rise of the regional
level of government – the so-called ”New Regionalism” and the ”Europe of the Regions”
– Spain, Belgium, Italy, France, and, more recently, the United Kingdom, being the most
prominent examples. According to this, the national level of government increasingly
proves to be too small in terms of influence to cope with globalization, and too large to
deal with local or regional necessities, and is thus expected to be further pushed back.
Given this background, this paper adresses the general question whether economic and
political integration fosters the decentralization of the public sector. According to the
traditional literature on fiscal federalism (Oates, 1972, Musgrave, 1959), the optimal
degree of centralization of the public sector is determined by the cost and benefits of
the decentral provision of public goods. On the one hand, decentralization allows for
the differentiation of public goods according to local preferences and conditions. On
the other hand, it implies cost in form of inter-jurisdictional spillovers and foregone
economies of scale. However, recent work on fiscal federalism has shown that political
decision-making processes in democracies and the underlying institutional rules also
have to be taken into account. Against the background of increasing globalization and
secessionist tendencies, new approaches (Alesina and Spolaore, 1997, Bolton and Roland,
1997) investigate the impact of economic integration on the creation and disintegration of
countries. Accordingly, economic integration increases the size of the market and reduces
the cost of independence, thus increasing the benefits of secession or regional autonomy.
However, there is only little empirical evidence on this issue, and, furthermore, the
impact of both economic and political integration on the overall vertical structure of
government has been hardly explored.
Starting with a theoretical framework which combines the traditional cost-benefit approach with institutional rules, this paper tries to develop further these reflections in
order to explore the impact of both economic and political integration on the degree of
centralization of the public sector. According to the new economic geography literature,
economic integration generates agglomeration and specialization effects at the regional
level, thus increasing the scope for economies of scale. Local governments could exploit
these benefits by autonomously choosing local public goods and taxes in order to attract
mobile factors. Political and monetary integration in Europe could even further reduce
the cost of local autonomy, since certain policies are conducted or coordinated at the
European level. However, decentralization could come at a cost, since integration and
factor mobility may enhance the danger of harmful fiscal competition between local governments and increase the exposure to economic shocks. Furthermore, the institutional
framework regulating the devolution of fiscal powers and the participation of lower levels
of government in central decision-making could also play an important role.
These analytical considerations are applied to a panel of OECD countries for the period
1970-2000. The empirical analysis relates public sector centralization to the degree of
economic and European integration and to other explanatory factors, such as interregional heterogeneity, economies of scale, and institutions. In order to focus on the role
of integration, regressions with fixed country effects are performed, however allowing
1
for interactions between time-invariant factors and integration. The results found are
consistent with a strong decentralizing effect of both economic and European integration.
The paper proceeds as follows. The following section briefly surveys the basic theoretical
literature on the determinants of the vertical government structure. Based upon this, the
hypotheses concerning the impact of economic and political integration on the benefits
and cost of decentralization are laid out in the next section. Section 4, then, presents
some descriptive statisticts on OECD countries and provides the regression analysis.
Finally, section 5 draws the conclusions and presents the prospects for future research.
2
Determinants of the vertical government structure
The starting point of the analysis of the division of functions between different layers of
government is the literature on fiscal federalism in the tradition of Musgrave (1959) and
Oates (1972).1 According to the welfare maximizing approach, the optimal allocation of
functions between different layers of government depends upon the trade-off between the
benefits of the decentral provision of public goods, which allows for differentiation according to local preferences and conditions, and the cost implied by inter-jurisdictional
spillovers and foregone economies of scale (Decentralization Theorem). Consequently,
national public goods, like defense, as well as income redistribution and macroeconomic
stabilization should be provided by the central government, whereas local public goods
should be within the competency of local governments. The optimal degree of centralization of the public sector depends both on the degree of inter-jurisdictional heterogeneity
and the characteristics of public goods. Shifts in the allocation of functions are therefore
either due to changes in local preferences and conditions, or in the relative demand for
certain public goods. For example, international conflicts raise the demand for security
and military protection, thus increasing the role of the central government. However,
these considerations hinge on the crucial assumptions of a lack of coordination between
local governments, and the uniform provision of public goods by the central government,
which in general are not met in reality.2
Moreover, the cost-benefit approach neglects the role of elected policymakers, and the
decision-making processes in democracies. As emphasized by the Leviathan literature3 ,
decentralization leads to efficiency enhancing fiscal competition and constrains revenuemaximizing activities of governments. Within this context, Brennan and Buchanan
(1980) refer to the danger of political cartels between local decision-makers in federal
states. The common-pool-problem induced by the involvement of lower levels of government in central decision-making leads in the end to an extensive centralization of the
public sector.4
Without considering the assumption of a Leviathan, recent work on fiscal federalism
tries to integrate the traditional theory with political decision-making processes and the
underlying institutional rules. Besley and Coate (2000) and Gradstein (2000), among
others5 , show that apart from heterogeneity and spillovers, the benefits of centralization
depend upon the involvement of local jurisdictions in national legislation. Without some
constitutionally guaranteed participation in decision-making, especially smaller jurisdictions run the risk of being discriminated against by the national majority or powerful
jurisdictions. According to this, central decision-making proves to be more attractive
in countries with constitutionally guaranteed representation of their constituent juris1 See
Oates (1999) for a recent survey.
work has dismissed the assumption of uniformity, see, e.g., Lockwood (2002), and Schwager (1999).
3 See, among others, Edwards and Keen (1996).
4 See also Weingast et al. (1981), and Wrede (2002). Blankart (1999) provides an application to Germany.
5 See also Persson and Tabellini (1996a, 1996b), Alesina et al. (2001b), and Wrede (2002).
2 Recent
2
dictions.6 Therefore, demands for decentralization or even secession are assumed to be
stronger in countries with relatively high inter-jurisdictional heterogeneity and without
appropriate representation of the subnational level in the legislative process. However,
in contrast to this, inter-jurisdictional bargaining in central decision-making bear the
common-pool-problem described above, thus increasing the inefficiency of centralization.
Another important institutional aspect concerns the way in which the allocation of functions at the different levels of government is determined. This can take place either
through direct consultation of the citizens, simple parliamentary majority or constitutional changes. Crémer and Palfrey (1996) show that federal states, where the decision
on centralization has to be approved by the majority of jurisdictions, are more centralized than unitary states, where national referenda take place. In contrast to this,
Lockwood (2000) concludes that, provided that central provision of public goods allows
for efficiency gains and local differentiation, federal states choose less centralization than
unitary states. Furthermore, Lockwood (2002) shows that the decision on centralization
and the degree of uniformity of public good provision depend on the extent of spillovers.
Finally, Redoano and Scharf (2001) point out that in case of strong heterogeneity regional referenda lead to less centralization, as compared to negotiations between regional
decision-makers in representative democracies.
To sum up, previous theoretical work has shown that preferences and technologies, as
well as political institutions determine the degree of government centralization. Large
inter-jurisdictional differences in preferences and conditions, and less demand for public
goods with spillovers and economies of scale are expected to be associated with a lower
level of overall centralization, whereas the influence of institutions depends on the specific
provisions regulating the participation of local jurisdictions in national decision-making.
3
3.1
The impact of integration
Theoretical considerations
While explaining cross-country differences in the degree of centralization, the literature
on fiscal federalism provides only insufficient interpretation of the recent trend towards
decentralization in several countries. Inspired by increasing regional separatism and
the emergence of new countries, recent papers explore the economic determinants of
the creation and disintegration of countries.7 In the tradition of the Decentralization
Theorem, Alesina and Spolaore (1997), and Bolton and Roland (1997) expound that
a region’s decision of leaving the nation-state or demanding more fiscal autonomy is
driven by the trade-off between the provision of public goods and taxes in accordance
with local preferences, and the cost of reduced coordination with the rest of the nation.
Whereas the benefits of independence are determined by the extent of heterogeneity,
efficiency cost consist in foregone economies of scale in the provision of public goods and
technological and fiscal spillovers due to missing coordination of local policies and taxes.
Majority decisions are shown to prevent the internalization of externalities associated
with secession, the spread of democracy thus resulting in the emergence of an inefficiently
large number of small countries.
However, endogeneous border changes represent an extreme case, which rather applies
to historical ”accidents” or to the local context. According to Bolton and Roland (1997),
6 Several constitutions of federal states, such as USA, Germany, or Switzerland, and even decision-making rules in the
European Union seem to reflect these aspects.
7 A survey on this literature is found in Bolton et al. (1996), and Drazen (2002). See also Ellingsen (1998), Wärneryd
(1998), Alesina et al. (2001a), and Casella and Feinstein (2002), for more recent theoretical contributions.
3
regional autonomy implies less cost than secession, since it partly avoids the efficiency
losses involved. In case of secession, new institutions and rules have to be set up, and
income redistribution and formerly national public goods, such as defence or infrastructure have to be provided at a lower scale and with higher per-capita cost.8 Furthermore,
as Alesina and Perotti (1998) point out, staying within the nation-state provides the advantage of inter-regional risk-sharing and redistribution in case of asymmetric economic
shocks.9 But, with factor mobility, regional autonomy implies also cost in form of fiscal
competition. Moreover, in contrast to the Tiebout world, factor mobility is claimed to
exert a homogenizing effect on the distribution of regional income and preferences, thus
favouring centralization.10
Going a step further, Alesina and Spolaore (1997) analyze the impact of economic integration on the creation of countries.11 Whereas, in general, the degree of integration
in the world economy plays no role for the benefits associated with public good provision according to local preferences, it affects the cost of independence. With significant
barriers to trade and factor mobility, secession would imply high transaction cost in the
economic relations with the rest of the nation and the world. In case of open economies,
however, these cost are reduced, since national borders no longer delimit the size of the
market.12 Expanding market size facilitates economies of scale in the production, thus
fostering economic and productivity growth. Therefore, economic integration is expected
to increase the benefits of secession, or, respectively, fiscal and political autonomy. The
intensification of separatist movements in Québec after creation of the NAFTA, and demands for regional autonomy in certain EU countries seem to illustrate these claims. In
addition to this, Spolaore and Alesina (2001) show that the reduction in international
conflicts and the enforcement of international law raise the benefits of secession. The
end of the cold war could have reduced the necessity of military defence and security,
thus decreasing the role of the central government in the 1990s. Within this context,
regional autonomy movements are also more likely to be tolerated since they are no
longer perceived as a threat to national security and integrity.
In order to assess the relationship between integration and the observed decentralization
of the public sector, these reflections have to be developed further and applied analogously to the overall vertical structure of government. In reality, demands for secession
concern only particular regions, and are often solved by specific agreements, such as
home rules. Decentralization, in contrast, entails the devolution of fiscal competency to
the lower levels of government as a whole.13 Also, certain forms of inter-regional heterogeneity could be dealt with by granting cultural or political autonomy, or through
central government block grants which allow for a differentiated provision of public goods.
Therefore, a closer examination of the fiscal incentives generated by economic integration
seems necessary.
In case of inter-regional heterogeneity of factor endowments, the market size effect of
economic integration is expected to intensify regional specialization according to comparative advantages and to foster the inter-regional divison of labour. This development
is further supported by technical progress which reduces transaction and transport cost
and increases factor mobility and inter-jurisdictional knowledge spillovers. The new economic geography literature in the tradition of Krugman (1991) has shown that economic
8 In case of military defence, however, small countries can behave as free-riders and benefit from the military protection
of large neighbouring countries or alliances. This is, e.g., the case of Austria and the NATO.
9 See also Persson and Tabellini (1996a, 1996b) on the trade-off between risk-sharing, and inter-personal redistribution
and moral hazard.
10 This issue is also presented by Bolton and Roland (1996), and Perroni and Scharf (2001).
11 See also Alesina et al. (2000), Alesina (2002), and Casella and Feinstein (2002), as well as Alesina and Wacziarg
(1999) with regard to the European integration.
12 However, even in an integrated world, high transaction cost can still persist due to cultural or linguistic differences.
13 Spain presents an interesting exception, since the regions have different degrees of autonomy which are negotiated
directly with the central government.
4
integration induces agglomeration effects in the industrial sector and leads to interregional specialization of the production structure.14 Evidence for a causal relationship
is found particularly for regions in the European Union.15 Whereas per capita income
of member countries converged, cross-regional disparities within countries increased.
However, these considerations have not yet become established in the theories on fiscal federalism and secession. Since local public goods which represent complementary
factors of production, as well as taxes influence the location of mobile factors, they
are expected to play an important role in the process of agglomeration and specialization at the regional level. As Krugman and Baldwin (2002) have recently shown,
economic integration creates agglomeration rents for production factors located in the
core which can be taxed away, thus preventing a race to the bottom in taxation. Extending this approach to public spending, Brakman et al. (2002) point out that taxes
stimulate spreading of production factors, whereas public goods foster agglomeration by
enhancing the attractiveness of the location for mobile firms and workers. However, the
resulting implications for the vertical government structure are not taken into account
by these papers. With increasing economic integration local and regional governments
would benefit from extended fiscal autonomy which allows them to implement their own
policies and compete for mobile factors of production. In the end, fiscal decentralization
could trigger a process of repecussions intensifying industrial specialization and agglomeration. Since investors would benefit from fiscal competition and the implementation
of market-conforming policies, economic interest groups are expected to support further
decentralization of the public sector. In addition to this, local autonomy allows investors
to exert more influence on local decision-making and to shape local policies.
On the other side, the benefits of decentralization could be counteracted by increased
economic risk. Since economic opening is associated with higher exposure to exogenous
shocks, the requirement of inter-personal income redistribution and risk-sharing across
regions, and thus the role of the central government, is expected to rise.16 Furthermore,
cross-regional differences in preferences and income are increasing as a consequence of
economic integration, regional specialization and structural change. Whereas well endowed regions could benefit from enlarged autonomy and fiscal competition which permits them to escape from the implicit inter-regional redistribution, poor unproductive
regions would be reluctant to decentralization and demand instead higher central government subsidies and income redistribution.17 Since economic integration strengthens
the credibility of threats of secession, higher central government transfers could even be
necessary to prevent rich regions from leaving.
In line with the fiscal federalism literature, apart from cost-benefit considerations, institutional rules underlying the decision-making processes are expected to influence the
achievement of secession or decentralization. For instance, without the existance of rules
regulating peaceful secessions, the cost of independence could be rather high, at worst
taking the form of armed conflicts.18 Also, the degree of regional involvement in central
decision-making and legal provisions for the transfer of powers affect the implementation of demands for decentralization. Collusive behaviour of regional policy-makers or
the opposition of poor regions in central decision-making could dampen the pressure
for decentralization and fiscal competition induced by integration and increase instead
inter-regional redistribution.
Finally, another important aspect neglected by the previous literature is the possible
14 See
also Krugman (1998), and Krugman and Venables (1996) for recent contributions.
among others, Giannetti (2002), Stirböck (2002), and the survey of Krieger-Boden (2000).
16 See, e.g., Rodrik (1997).
17 See also Bolton and Roland (1997).
18 See, e.g., Bordignon and Brusco (2001), and Jehiel and Scotchmer (2001), with regard to credibility aspects of secession
rules.
15 See,
5
impact of political integration on the vertical government structure. On the one hand,
political integration among countries entails a centralizing effect, since certain government functions are transferred to a higher level of government. On the other side, however, it could intensify the demands for decentralization or secession within the member
countries.19 As illustrates the case of the European Union, the cost of secession would be
further reduced, since certain public goods and policies inherent to the central government are now provided by the supranational level or coordinated among the countries.
This comprises, for example, the common trade and agriculture policies, regulation and
market supervision, the environment policy, and most recently the monetary policy. Furthermore, the European Community is increasingly involved in regional development and
infrastructure projects, and partly takes on certain insurance functions of the national
governments.
In order to take the advantage of political integration, the secessionist regions are required to join the European Union. This case is not yet provided for in the European
treaties, but could be rather questionable when taking into account that admission of
new member countries has to be decided unanimously. In case of rejection, the political
and economic price of staying outside the political union would be considerably higher
as compared to the case of mere economic integration. Also, with increasing majoritarian decision-making in the European Council, small secessionist regions would possibly
exert less influence on European policy-making as compared to forming part of a larger
member country.20 Therefore, regional autonomy and decentralization are expected to
be preferred to secessionism in the context of European integration. Incentives for regionalism are also provided by certain European policies and institutions. Especially the
European structural funds increasingly require regional implementation and planning,
thus augmenting the scope for direct action of regional decision-makers and lobbying
groups. Demands for extended local autonomy could be the consequence. In general,
the European Commission seems to encourage the process of regionalisation in the member countries, probably in order to undermine the power of the national governments.
3.2
Empirical evidence
The theoretical discussion suggests that economic and political integration may contribute to the decentralization of the public sector. However, until now, only little and
unsystematic empirical evidence has been provided with regard to the impact of integration on the vertical government structure. In general, most of the work deals with
the determinants of the degree of centralization as derived from the theory on fiscal
federalism, using cross-sectional analyses of industrial and developing countries.21 In
general, the results support the Decentralization Theorem. For example, Strumpf and
Oberholzer-Gee (2002) demonstrate for the US states liquor policy a decentralizing effect of preference heterogeneity. Little evidence has also been provided for the role of
institutional rules. Democracy and federal constitutions are found to be associated with
less centralization. Schaltegger and Feld (2001) find a negative impact of referenda on
the degree of centralization of Swiss cantons, which is explained by the direct control
exercized by citizens on the government budget. However, these studies focus on the
factors explaining cross-country differences in the degree of centralization, and pay no
attention to the dynamic impact of economic or political integration on the cost and
benefits of centralization.
19 With regard to the European integration, Zimmermann (1990) questions the development associated with the so-called
”Sandwich” hypothesis. See also Lammers (1999), and Alesina (2002) on this topic.
20 This depends, however, on the extent of influence of the regions in question within the nation-state.
21 See, among others, Oates (1972), Pommerehne (1977), Kee (1977), and Panizza (1999). Giertz (1983), and Wallis and
Oates (1988) provide studies for the US states.
6
In line with the literature on secessions, Alesina and Wacziarg (1998) provide evidence
for a negative relationship between the size of the country and the degree of economic
openness, thus confirming the hypothesis that larger countries benefit less from economic
integration. Alesina et al. (2000) find a positive effect of both openness and country
size on the economic development, the growth inducing impact of the market size being
determined by the degree of openness.22 The rising number of countries in the course
of global integration since World War II seems to support this causality. Therefore, according to this view, economic integration increases the benefits of secession and reduces
the advantage of large states.
Whereas this work applies to the extreme case of secession, the particular effect of economic integration on the vertical government structure has been hardly investigated empirically. Rodrik (1998) finds in a cross-sectional as well as in a panel setting of industrial
and developing countries a positive significant effect of the degree of economic openness
on the size of the public sector. However, this result holds especially for countries with
high terms-of-trade risk, and less for OECD countries.23 According to these findings,
increasing exposure to exogenous shocks is mitigated especially by redistributive income
transfers, welfare spending and other measures of macroeconomic stabilisation.24 Since
these functions are in the competency of the central government, one would therefore
expect a centralizing effect of economic integration. Garrett and Rodden (2000) actually
find support for this issue in a panel of industrial and development countries. They show
that, in contrast to the literature on secession, trade integration and capital mobility are
associated with a higher share of central government expenditures and revenues. This is
explained by the demand for inter-regional risk-sharing and higher central government
transfers aimed at preventing the secession of rich regions. In a related study, Hiscox
(2001) shows that globalization changes the regional income distribution, thus affecting
the benefits of decentralization.
The dynamic aspect of integration is partly taken into account by Verdier and Breen
(2001) who provide least squares estimates of the impact of integration on the crosssectional change in the degree of fiscal centralization in 19 OECD countries. An increase
in the degree of financial openness, as measured by the index of Quinn and Inclan (1997),
is found to be positively related to fiscal centralization. The interaction with European
integration, as captured by the EU structural funds receipts, however, yields a negative
effect. This is assumed to be due to the insurance function of the structural policy
which partly substitutes for national income redistribution. However, the progress of
European integration, and other possible determinants of centralization are not taken
into account. Finally, van Houten (2001) provides no clear evidence for a stimulating
effect of economic integration on the demands for regional autonomy in EU countries.
Instead, socio-cultural factors, parties and party systems seem to play a decisive role.
All in all, previous empirical studies on economic integration fail to provide a comprehensive modelling of both cost and benefits of secession or decentralization, such as, e.g.,
heterogeneity, and of existing institutional rules. Moreover, dynamic and interactive
aspects of both economic and political integration are insufficiently taken into account.
Nevertheless, the existing literature provides some important insights and a startingpoint for the analysis of the impact of economic and political integration on the division
of functions among layers of government.
In the following, we test the hypothesis that economic integration, and, even more, the
political unification in Europe have fostered the decentralization of the public sector.
22 See
also Spolaore and Wacziarg (2002), as well as Wacziarg et al. (2002) for a survey of this work.
(1997) even finds a negative sign for OECD countries, indicating that globalization reduces the ability of
governments for welfare spending.
24 See Schulze and Ursprung (1999) for a critical review of the empirical literature on the impact of integration on public
expenditures.
23 Rodrik
7
For that purpose, an empirical investigation is carried out which includes, apart from
integration, also other possible determinants of the vertical government structure, such
as inter-regional heterogeneity, economies of scale, institutions, and other control variables. By this, both differences in the cost and benefits of centralization, and possible
interactions with integration are taken into account.
4
Empirical analysis
The empirical analysis of the impact of economic and political integration on the vertical
division of government functions starts with a comparative-descriptive overview. Then,
the theoretical suggestions are implemented into a simple empirical framework which is
finally estimated.
4.1
Descriptive statistics
The empirical analysis covers 23 OECD countries, thus encompassing, apart from EU
countries, other comparable developed industrial nations with democratic traditions.
This enables us to control for the effect of democracy described in the literature and
for other common features and to separate the specific aspect of political and regional
integration in Europe from the more general aspect of integration in the world economy.
To provide an overall view of the process of fiscal decentralization, Tables 1 to 2 compare
the degree of public sector centralization at the beginning of the 1970s and the end of
the 1990s. The degree of centralization is measured by the share of central government
expenditures (revenues) in total government expenditures (revenues), as reported by the
IMF Government Finance Statistical Yearbook25 , which despite of several shortcomings
constitute simple quantifiable measures and have been used predominantly in previous
empirical studies.26 Social security has been removed from the central government sector in order to focus on government functions which could be decentralized according
to the theory on fiscal federalism27 and to separate the insurance effect of the central
government described by Rodrik (1998). The allocation of inter-governmental transfers
both to the recipient and, alternatively, to the effecting level allows a more detailed
look on the pattern of decentralization. In the first case, only direct central government
spending (revenues) is taken into account, whereas the second case involves total central
government spending net of received transfers.28
The fiscal figures indicate on average a trend towards decentralization in most of the
OECD countries considered here, even if at different paces and with some exceptions.
The most prominent examples are Belgium and Spain, whereas, e.g., the United Kingdom
exhibits a process of centralization of the public sector. However, whereas in only half of
the countries the share of direct expenditures of the central government has diminished,
net expenditure figures indicate decentralization in 14 out of 20 countries. This means
that, in general, central government transfers to lower levels of government probably tend
to be substituted by expanded own financial resources. Indeed, a look at the revenue
side confirms an even more pronounced process of decentralization. At the same time,
all countries exhibit a higher degree of centralization of public revenues as compared to
the expenditure side, which indicates that net vertical grants are positive. Furthermore,
25 OECD National Accounts also provide long time series, which, however, suffer from certain difficulties of calculation
and missing current data.
26 For a critical discussion of the measurement of centralization see, e.g., Oates (1972), Levin (1990), and OECD (1999).
27 Analogously, defence expenditures could be excluded, too. However, for the moment, we leave this to future research.
28 Note that, in both cases double countings are thus eliminated.
8
Table 1: Degree of centralization of OECD countries (excl. Soc.Sec.), 1970-2000
Country
AUS
AUT
BEL
CAN
DEN
FIN
FRA
GER
GRE
ICL
IRL
ITA
JAP
LUX
NED
NEZ
NOR
POR
SPA
SWE
SWI
UK
USA
Direct expenditures (1)
1970-75
1995-00
50.8
51.9
51.8
53.2
79.2
47.8
41.5
36.8
35.9a
40.7
57.1
56.0
71.0
67.8
34.1
35.3
94.6
78.3
67.8
66.0
71.7
73.8
64.9
34.7
37.5
73.3
72.5
46.3
53.4
87.5a
89.3
52.0
91.2
86.9
84.5
37.8
51.9
58.7
25.8
21.7
62.9
73.7
46.6
40.6
Net expenditures (2)
1970-75
1995-00
72.3
68.7
62.2
65.0
90.1
83.4
50.3
44.1
67.3a
64.6
69.1
67.1
82.4
78.5
40.7
39.9
94.8
78.2
71.1
81.8
92.7
88.3
84.2
72.0
72.4
86.0
82.5
87.8
85.7
89.6a
90.2
58.0
93.9
91.0
91.5
70.1
64.1
65.8
36.9
37.4
77.0
57.0
50.8
Direct revenues (3)
1970-75 1995-00
75.8
67.1
65.4
66.1
89.8
82.2
50.7
44.0
70.3
66.2
70.3
64.7
87.1
77.7
45.8
45.1
94.7
80.7
74.9
84.5
92.2
90.9
84.7
65.8
62.2
88.1
86.4
93.8
84.1
88.6a
90.0
59.5
93.1
91.3
91.8
74.4
63.9
65.3
38.4
36.1
82.1
53.6
48.2
Note: total expenditure and lending minus repayments (total revenue and grants) of the central government, without social
security and EU payments in % of total public expenditure (revenue); for JAP only current expenditures (revenues); period
averages; a 1975-80. (1) intergovernmental transfers allocated to the recipient level; (2) net intergovernmental transfers
allocated to the effecting level; (3) intergovernmental transfers allocated to the effecting level. Source: IMF, Government
Finance Statistical Yearbook (except for: BEL – Banque Nationale de Belgique, JAP – OECD, National Accounts); own
calculations.
European Union countries are on average more centralized than other OECD countries.
The process of decentralization is, even if to a lesser extent, confirmed when adding
social security to the central government sector. According to the figures, the relative
share of social security expenditures and revenues has increased considerably in most of
the OECD countries.
To contrast the development of the public sector both to economic and European integration, Table 3 reports some figures on the degree of trade and financial openness, and
on the share of trade with EU countries. Both the share of exports and imports in GDP,
and the Quinn/Inclan-Index which reflects the degree of financial openness according to
currency, capital and current account restrictions, have clearly increased in all OECD
countries during the period of observation. Due to the establishment of the common
market, economic opening has been on average more pronounced in EU member countries. In line with this, EU trade figures also indicate increasing integration among EU
countries, the opposite being true with regard to the other countries. This shows at the
same time that especially regionally deeply integrated countries have joined the EU.29
Finally, Table 4 depicts the dynamics of political integration in Europe. The share of EU
expenditures as % of total GDP or as % of total expenditures of the member countries
29 The
correlation coefficient between the share of trade with EU countries and EU membership amount, however, only
to 0.507.
9
Table 2: Degree of centralization of OECD countries (incl. Soc.Sec.), 1970-2000
Country
AUS
AUT
BEL
CAN
DEN
FIN
FRA
GER
GRE
ICL
IRL
ITA
JAP
LUX
NED
NEZ
NOR
POR
SPA
SWE
SWI
UK
USA
Direct expenditures (1)
1970-75
1995-00
50.8
51.9
64.9
67.6
85.5
66.5
42.3
40.4
39.9a
45.0
63.0
62.8
82.4
81.8
55.5
63.4
95.9
82.5
73.0
69.2
74.4
82.2
75.6
51.4
64.2
83.6
84.5
66.5
71.4
87.5a
89.3
63.6
65.3
93.6
90.3
90.2
64.8
56.6
64.4
41.7
50.5
67.7
73.7
55.2
53.2
Net expenditures (2)
1970-75
1995-00
72.3
68.7
72.5
75.7
92.4
88.0
51.6
47.3
69.3a
67.3
73.2
72.2
89.3
87.9
60.0
66.2
96.0
82.5
75.8
83.4
93.5
92.1
89.1
77.4
81.5
91.4
90.0
92.1
91.4
89.6a
90.2
67.5
78.0
95.6
93.4
94.7
83.1
67.5
70.6
49.9
56.1
79.8
92.7
64.0
61.1
Direct revenues (3)
1970-75 1995-00
75.8
67.1
73.0
74.7
92.5
87.5
52.2
47.3
71.1
67.6
73.5
68.8
91.6
86.6
62.6
66.9
96.2
81.5
76.6
85.7
93.0
94.5
89.0
74.2
76.8
91.5
89.8
96.1
90.0
88.6a
90.0
68.1
78.9
95.2
93.6
94.9
82.6
68.0
70.1
52.9
56.3
84.2
92.0
60.8
58.3
Note: total expenditure and lending minus repayments (total revenue and grants) of the central government, without EU
payments in % of total public expenditure (revenue); see Table 1 for further details.
has doubled since the beginning of the 1970s. Hence, these findings seem to endorse the
”Sandwich” theory of a diminishing role of national governments in the EU, at least in
terms of expenditure and revenue figures.
4.2
Empirical implementation
The hypothesis of a decentralizing effect of economic and political integration is tested
for the panel of 23 OECD countries within the period 1970-2000. The regression analysis
relates public sector centralization to the degree of economic and European integration,
and controls for further variables which explain the vertical division of government functions and the relative demand for certain public services. In general, reported changes
in the share of central government expenditures (revenues) in total government expenditures (revenues) are either due to changes in the allocation of functions, or in the budget
share of certain expenditure (revenue) categories.
In order to focus on the role of integration, the model is estimated with fixed country effects, which absorbe all time-invariant country-specific factors, such as area, institutions,
traditions, or regional diversity. In doing so, we concentrate on the determinants which
are assumed to change the cost and benefits of decentralization over time. Contrary to
pooled estimations, by conditioning on the cross-section the fixed effects approach focuses on the time variation in the data. Moreover, it controls for characteristics which are
10
Table 3: Degree of openness, and trade with EU countries, 1970-2001
Country
AUS
AUT
BEL
CAN
DEN
FIN
FRA
GER
GRE
ICL
IRL
ITA
JAP
LUX
NED
NEZ
NOR
POR
SPA
SWE
SWI
UK
USA
OECD
Non-EU15
EU15
Trade openness (1)
1970-75 1995-01
27.8
41.5
62.1
90.0
90.9
149.1
44.8
78.7
57.8
72.7
52.6
69.7
34.8
49.3
45.4
57.5
35.6
49.3
81.0
74.3
84.8
158.5
34.9
50.6
22.2
19.2
171.2
235.0
93.8
109.0
48.8
62.4
75.7
73.8
57.2
68.1
29.7
55.7
52.8
80.3
63.9
73.5
48.3
56.6
13.1
24.1
57.8
78.2
47.2
55.9
63.5
90.1
Quinn/Inclan-Index (2)
1970-75
1995-01
0.55
0.82
0.71
0.93
0.70
0.97
0.88
1.00
0.65
1.00
0.63
1.00
0.79
0.93
0.99
1.00
0.32
0.93
0.60
0.75
0.55
0.70a
0.86
0.44
0.54
0.32
0.43
0.74
0.88
0.59
0.90
0.66
0.68
0.65
0.99
1.00
0.79
0.97a
1.00
0.96
0.96
0.96
0.93
0.93
0.93
1.00
1.00
0.95
0.92
0.97
EU trade (3)
1970-75 1995-00
27.0
17.9
63.3
66.5
75.0
73.4
13.3
7.4
66.7
67.8
62.0
55.9
59.6
63.5
58.7
55.9
56.0
63.1
55.4
60.2
76.5
61.9
53.6
58.1
11.1
15.3
75.0
77.8
71.3
69.3
22.4a
17.3
71.0
73.2
53.9
78.0
46.9
68.0
62.8
61.4
70.1
69.2
41.8
55.0
26.0
19.6
53.0
54.6
37.0
35.0
61.5
65.0
Note: (1) sum of exports and imports in % of GDP; (2) index for the financial openness, re-adjusted on a scale of 0-1, a
corresponds to BEL; (3) sum of exports and imports to/from EU15 countries in % of total foreign trade, a 1987; period
averages. Source: (1) IMF; (2) Quinn and Inclan (1997), Armingeon et al. (2000); (3) OECD; own calculations.
Table 4: The budget of the European Union, 1960-2001
1960-65
1970-75
1995-01
EU expenditures
(1)
(2)
0.18
0.06
1.42
0.55
2.30
1.09
Note: EU expenditures in % of total public expenditures of EU countries (1), and in % of EU-GDP (2); period averages.
Source: Europäische Kommission (2000); own calculations.
unobserved or cannot be quantified30 , thus solving simultaneity problems in the form of
omitted-variable bias. In order to take indirect (non-linear) effects into account, interactions between integration and different time-invariant factors are additionally included.
However, it should be noted that due to conditioning on the cross-sectional distribution of decentralization, fixed effects (within) estimations might yield different results as
compared to an analysis which deals with cross-country differences.
30 As an example, different conceptions of the role of the public sector or the central government in society are expected to
play an important role. Thus, the Jacobin tradition of the French revolution which emphasizes a strong central government
still determines policy in contemporary France.
11
Formally, the basic estimation equation is
Centrit = αi + βScaleit + γHeterit + δDiverseit + Openit
+ζ(EUit ∗ Expt ) + η(F ixi ∗ Openit ) + uit .
Centrit denotes the share of central government expenditures (revenues) in total government expenditures (revenues) in country i in year t, as described above. Openit denotes
a vector of variables representing the degree of integration of the individual country in
the world economy over time. Among them, the share of exports and imports in GDP
(T openit ), and, alternatively, the Quinn/Inclan-Index of financial openness (F openit ) are
used. In order to capture both the impact of joining the European Union and the advance of political integration, a dummy variable for EU membership (EUit ) is interacted
with the share of EU expenditures in total public expenditures of the member countries
(Expt ). Two more variables have been included, alternatively. First, the share of trade
with EU countries in total foreign trade (Eutradit ) is used as a measure of the extent
of regional economic integration of the individual countries. Second, we construct a
country-specific index of political integration with the EU (Euintit ) which reflects different stages of integration: from free-trade agreements, the establishment of the customs
union, the European Economic Area, until the creation of the Economic and Monetary
Union. By this, different degrees of involvement in EU policy-making of both member countries, such as Denmark or the UK, and non-EU countries, such as the EFTA
countries, are taken into account.31
In order to isolate the effect of integration from other potential determinants of the vertical government structure as described by the theory on fiscal federalism in section 2,
vectors of control variables have been included. Among them, we consider economies of
scale and spillovers of public goods (Scaleit ), inter-regional heterogeneity (Heterit ), and
further explanatory variables (Diverseit ). A vector of time-invariant variables (F ixi )
containing especially institutions is interacted with the degree of economic, and alternatively, European integration. Finally, αi denotes country-specific averages.
As stated above, cost and benefits of the decentral provision of public goods depend
on the extent of economies of scale and spillovers of public goods, and the degree of
inter-regional heterogeneity. Corresponding to the empirical literature, the first aspect
is captured by the size of the country in terms of population (P opit ), and the spatial
allocation of the population, as measured by the degree of urbanization (U rbit ). The
higher the size and the geographic concentration of population, the more likely economies
of scale could be exploited at the regional or local level, thus increasing the benefits of
decentralization. In addition to this, the cost of centralized information, administration,
and decision-making are likely to increase in the size of the country. However, since in
general these variables change only gradually over time, the dynamic effects are expected
to be rather moderate and have to be interpreted with caution. Further time-invariant
factors, such as area, or the number of constituent jurisdictions, which are expected to
affect the extent of economies of scale and spillovers, are captured by the fixed country
effects.
Except for Strumpf and Oberholzer-Gee (2002) who measure preferences directly, previous studies employed indices of ethno-linguistic fractionalization as proxies for the
inter-jurisdictional heterogeneity of preferences, thus implicitly assuming that the ethnic
structure is correlated with the spatial allocation of the population.32 However, the geographical sorting of people with similar preferences constitutes the crucial precondition
for the validity of the Decentralization Theorem. This aspect is partly taken into account
in this study by interacting an index of ethno-linguistic fractionalization (F raci ) with a
31 In
general, see appendix for further information on the variables presented here.
e.g., Panizza (1999), and Garrett and Rodden (2000).
32 See,
12
dummy variable for the existence of regionally concentrated assertive minorities (Regi )33 ,
which, among others, is based on the existence of regionalist parties as a possible indicator for regional assertiveness. However, such fractionalization indices have to be treated
with caution, since they do not reflect differences between ethnic groups, and thus, the
actual degree of preference heterogeneity appropriately. Note that this composite index
is interacted with the degree of economic integration. In addition, the degree of regional
disparity of per capita income (Regdispit ) is taken into account, which allows us to control for changes in the degree of heterogeneity in the course of integration.34 On the one
hand, the degree of centralization is expected to decrease with heterogeneity. However,
on the other hand, by controlling for regional economic disparity the centralizing effect
of increasing demands for inter-regional redistribution is separated from other effects of
economic integration.
The next set of factors consists of standard control variables depicting the demand for
certain public goods. According to the famous Wagner (1876) and Popitz (1927) ”laws”,
economic development and rising income lead to the expansion and centralization of the
public sector. For example, higher demand for income redistribution and the establishment of generous welfare systems are expected to be related to higher income per-capita
levels. Yet, empirical evidence shows that high-income countries are likely to be more
decentralized. This is explained by higher real cost involved with the requirement for
qualified administrative staff and the cost of political coordination and creation of local
institutions.35 In order to test for these effects, we include real GDP per-capita (Rgdpcit )
in our regressions. The regression analysis also takes temporary expenditure and revenue
effects of business cycles into account by including the rate of growth of real per-capita
income (Rgdpc−grit ), and the rate of unemployment (U nempit ). Furthermore, a dummy
variable for national election years (Electit ) captures possible electoral cycles. According
to this, one would expect the central government to choose higher expenditures in the
run-up and, respectively, higher taxes in the aftermath of elections.
The role of institutions is finally taken into account by interacting integration with
time-invariant indicators depicting the decision-making process. First, we include a
dummy variable for the existence of a second chamber of parliament with regionally
elected or delegated representatives (Regparli ) as a proxy for the degree of involvement
of subnational governments in national legislation. This allows us to verify the commonpool-argument especially with regard to public revenues and to control for counteracting
political effects of integration. Second, an index measuring the statutory provisions for
the organization of national referenda (Refi ) has been constructed in order to detect the
decentralizing effect of direct democracy described in the literature.
In light of the previous theoretical discussion, we expect a negative effect of both economic and European integration on the degree of fiscal centralization. However, rising
demand for inter-personal and inter-regional redistribution associated with increasing
exposure to economic shocks and growing regional disparities, as well as central government transfers directed towards separatist regions could provoke an opposite effect. In
33 Just to give an example, for France or the USA relatively high degrees of fractionalization are reported. However,
the different ethnic groups are dispersed throughout the country, and, furthermore, represent recently immigrated people
without deeply rooted regional traditions. The comparison between the index of fractionalization used here and the
regional dummy reports only a correlation coefficient of 0.578.
34 Note that, in general, regional indicators involve certain difficulties. First, in several countries regional boundaries
are often changed for political or administrative reasons, thus questioning the exogeneity and integrity of administrative
divisions, and distorting the degree of disparity measured. For example, certain EU countries, such as Ireland or Finland,
have recently created new development regions without real fiscal autonomy, for reasons of adaptation to the requirements
of EU structural funds policy. This is directly related to a second problem, namely that of comparing countries with
powerful regional governments, with countries where regions merely represent planning or statistical areas of the central
government.
35 See, e.g., Oates (1972). However, as Kee (1977) found out, this aspect is more likely to reflect differences between
industrial and developing countries.
13
addition to that, the outcome should also crucially depend on the specific institutional
framework.
4.3
Results
The results of the estimations are reported below, in the Tables 5 to 7.36 The F tests
indicate significant country effects in the data, Hausman specification tests reject specifications using random effects. Checks for collinearity and influential observations have
been carried out, 35 detected outliers being removed from the estimations. Most of the
outliers found are associated with statistical breaks and changes in the regional organization of some countries. In addition to this, a dummy variable for Germany after
re-unification has been included, too. Due to lack of regional data, Iceland, Luxemburg
and New Zealand are missing from the sample.
The estimates confirm the hypothesis of a negative impact of both economic and European integration on the degree of public sector centralization in OECD countries. The
results are, in general, significant at the 0.01 level and robust to alternative specifications, outliers, and the measurement of centralization. Sensitivity analyses have been
carried out, including and removing outliers, or restricting the sample to countries with
a minimum of 10 observations. The significant coefficients of integration also did not
change when dropping all or certain control variables from the regression. Finally, the
variables used are in general found to explain between 28 and 59 per cent of the variation
within groups.
According to the estimates, an increase in the actual degree of economic openness, as
measured by the share of foreign trade in GDP, reduces the share of central government
expenditures and revenues. This finding is confirmed only with respect to the expenditure side, when including alternatively the Quinn/Inclan-Index which reflects the degree
of openness according to legal provisions. In general, the coefficients are strongest with
regard to direct expenditures, indicating that integration has provoked either the extension of the range of subnational government functions, or a ceteris paribus relative
reduction in direct central government activity.
The same applies to the role of European integration. An increase in both the degree of
political and of regional trade integration exhibit a strong and significant decentralizing
effect, especially with regard to direct expenditures. At first glance, the results confirm
the ”Sandwich” theory. The central level of government seems to have been driven back
both by the process of European political unification, and by the increasing benefits of
decentralization associated with economic integration. However, a causality between
regional economic integration, and the transfer of political and fiscal powers to the
EU level is also possible. Indeed, the simultaneous inclusion of both indicators reveals
only a significant decentralizing effect of regional trade integration, whereas the political
integration variable now becomes insignificant.
The results reported in the columns (5) to (7) also seem to confirm the theoretical considerations concerning the indirect effects of integration. However, the respective direct
effect of integration now becomes insignificant, or is reversed, as in the case of European
integration. Controlling for interactions, both political and trade integration with the
EU entered alone reveal a centralizing effect on public spending. We have confirmation
that the decentralizing impact of economic and European integration on public spending
is strongest in countries with important regional ethno-linguistic heterogeneity.37 Within
36 The
results including social security are reported in the appendix.
fractionalization indices provided by recent studies have been used alternatively. In general, estimations
without the regional dummy variable tend to be less significant, thus confirming the importance of the spatial dimension.
37 Different
14
Table 5: Fixed effects (within) estimates for government centralization, direct expenditures (excl. Soc.
Sec.), OECD countries, 1970-2000
P opit (log)
U rbit
Regdispit
Rgdpcit (log)
Rgdpc − grit
U nempit
Electit
T openit
F openit
EUit x Expt
Dep. Variable: Degree
(1)
(2)
-0.142
0.068
(0.238)
(0.233)
-0.035
0.031
(0.248)
(0.239)
0.329???
0.332???
(0.097)
(0.093)
-0.066 ?
-0.087 ??
(0.037)
(0.036)
0.066
-0.041
(0.138)
(0.132)
0.248 ?
0.194
(0.141)
(0.130)
0.005
0.005
(0.006)
(0.006)
-0.143???
(0.047)
-0.231???
(0.040)
-0.047??? -0.017 ??
(0.007)
(0.009)
of centralization
(3)
(4)
-0.059
-0.200
(0.225)
(0.239)
0.025
-0.003
(0.227)
(0.253)
0.397???
0.326???
(0.092)
(0.097)
-0.071 ??
-0.066 ?
(0.035)
(0.038)
0.192
0.042
(0.132)
(0.138)
0.265 ??
0.193
(0.131)
(0.140)
0.003
0.005
(0.006)
(0.006)
-0.254??? -0.151???
(0.045)
(0.047)
(6)
-0.126
(0.196)
-0.618???
(0.200)
0.184 ??
(0.077)
-0.047
(0.031)
0.133
(0.107)
0.628???
(0.113)
0.005
(0.005)
-0.079 ??
(0.040)
-0.048???
(0.007)
0.028???
(0.010)
-0.648???
(0.070)
Eutradit
(7)
0.094
(0.193)
-0.384 ?
(0.196)
0.248???
(0.079)
-0.056 ?
(0.030)
0.195 ?
(0.112)
0.506???
(0.114)
0.003
(0.005)
-0.248???
(0.038)
0.180
(0.117)
-0.022???
(0.004)
Euintit
(Regi x F raci )
x T openit
(Regi x F raci )
x (EUit x Expt )
(Regi x F raci )
x Eutradit
Refi
x T openit
Refi
x (EUit x Expt )
Refi
x Eutradit
Regparli
x T openit
Regparli
x (EUit x Expt )
Regparli
x Eutradit
Obs.
Countries
adj. R2
within R2
(5)
-0.062
(0.235)
-0.062
(0.257)
0.329???
(0.095)
-0.115???
(0.038)
0.047
(0.135)
0.252 ?
(0.137)
0.005
(0.006)
0.064
(0.098)
-0.491???
(0.177)
-0.314???
(0.031)
-2.414???
(0.310)
-0.049 ?
(0.027)
-0.008 ??
(0.004)
-0.107 ??
(0.045)
0.368 ??
(0.153)
0.026
(0.019)
348
19
0.914
0.321
348
19
0.920
0.368
348
19
0.924
0.394
348
19
0.913
0.314
348
19
0.920
0.371
348
19
0.948
0.594
0.661???
(0.241)
348
19
0.946
0.577
Note: all regressions contain fixed country effects and the German re-unification dummy whose coefficients are not reported.
Standard errors are in brackets. ***, **, and * indicate significance at 1%, 5% and 10% levels, respectively.
15
Table 6: Fixed effects (within) estimates for government centralization, net expenditures (excl. Soc.
Sec.), OECD countries, 1970-2000
P opit (log)
U rbit
Regdispit
Rgdpcit (log)
Rgdpc − grit
U nempit
Electit
T openit
F openit
EUit x Expt
Dep. Variable: Degree
(1)
(2)
-0.617??? -0.597???
(0.112)
(0.113)
0.418???
0.429???
(0.119)
(0.119)
0.135???
0.136???
(0.046)
(0.046)
-0.010
-0.016
(0.018)
(0.018)
0.066
0.029
(0.065)
(0.063)
0.212???
0.190???
(0.065)
(0.063)
0.003
0.003
(0.003)
(0.003)
-0.049 ??
(0.021)
-0.046 ??
(0.019)
-0.016??? -0.010 ??
(0.003)
(0.004)
of centralization
(3)
(4)
-0.605??? -0.638???
(0.113)
(0.112)
0.356???
0.432???
(0.116)
(0.121)
0.148???
0.135???
(0.047)
(0.046)
-0.003
-0.009
(0.018)
(0.018)
0.084
0.061
(0.066)
(0.065)
0.202???
0.188???
(0.065)
(0.064)
0.002
0.003
(0.003)
(0.003)
-0.081??? -0.050 ??
(0.022)
(0.021)
(6)
-0.570???
(0.115)
0.317???
(0.120)
0.110 ??
(0.046)
-0.014
(0.019)
0.080
(0.063)
0.284???
(0.066)
0.003
(0.003)
-0.048 ??
(0.022)
-0.016???
(0.003)
0.002
(0.006)
-0.149???
(0.035)
Eutradit
(7)
-0.486???
(0.108)
0.240 ??
(0.111)
0.096 ??
(0.044)
-0.008
(0.017)
0.060
(0.062)
0.267???
(0.062)
0.002
(0.003)
-0.083???
(0.021)
0.133 ??
(0.066)
-0.008???
(0.002)
Euintit
(Regi x F raci )
x T openit
(Regi x F raci )
x (EUit x Expt )
(Regi x F raci )
x Eutradit
Refi
x T openit
Refi
x (EUit x Expt )
Refi
x Eutradit
Regparli
x T openit
Regparli
x (EUit x Expt )
Regparli
x Eutradit
Obs.
Countries
adj. R2
within R2
(5)
-0.574???
(0.113)
0.519???
(0.127)
0.146???
(0.046)
-0.014
(0.019)
0.082
(0.066)
0.197???
(0.065)
0.003
(0.003)
0.067
(0.047)
-0.217???
(0.084)
-0.049???
(0.018)
-0.396 ??
(0.166)
-0.024 ??
(0.012)
-0.004 ??
(0.002)
-0.082???
(0.023)
-0.068
(0.069)
0.016
(0.011)
376
20
0.981
0.291
376
20
0.981
0.293
376
20
0.981
0.286
Note: see Table 5.
16
376
20
0.981
0.290
376
20
0.982
0.307
376
20
0.983
0.342
0.565???
(0.135)
376
20
0.984
0.383
Table 7: Fixed effects (within) estimates for government centralization, direct revenues (excl. Soc. Sec.),
OECD countries, 1970-2000
P opit (log)
U rbit
Regdispit
Rgdpcit (log)
Rgdpc − grit
U nempit
Electit
T openit
F openit
EUit x Expt
Dep. Variable: Degree
(1)
(2)
-0.688??? -0.710???
(0.111)
(0.114)
0.696???
0.691???
(0.113)
(0.114)
0.118 ??
0.121???
(0.046)
(0.046)
-0.021
-0.026
(0.018)
(0.018)
-0.007
-0.036
(0.064)
(0.064)
-0.271??? -0.299???
(0.064)
(0.063)
0.003
0.004
(0.003)
(0.003)
-0.044 ??
(0.021)
-0.013
(0.018)
-0.009???
-0.008 ?
(0.003)
(0.004)
Eutradit
of centralization
(3)
(4)
-0.690??? -0.701???
(0.112)
(0.111)
0.587???
0.662???
(0.106)
(0.116)
0.120???
0.117 ??
(0.047)
(0.046)
-0.010
-0.017
(0.018)
(0.018)
-0.016
-0.015
(0.066)
(0.065)
-0.300??? -0.295???
(0.065)
(0.063)
0.003
0.003
(0.003)
(0.003)
-0.055 ??
-0.046 ??
(0.022)
(0.021)
(6)
-0.620???
(0.117)
0.680???
(0.121)
0.132???
(0.047)
-0.033 ?
(0.019)
-0.001
(0.064)
-0.276???
(0.067)
0.003
(0.003)
-0.058 ??
(0.023)
-0.010???
(0.003)
-0.014 ??
(0.006)
-0.035
(0.035)
(7)
-0.642???
(0.114)
0.576???
(0.108)
0.106 ??
(0.047)
-0.016
(0.018)
-0.031
(0.066)
-0.287???
(0.066)
0.003
(0.003)
-0.057???
(0.022)
0.025
(0.070)
-0.003 ?
(0.002)
Euintit
(Regi x F raci )
x T openit
(Regi x F raci )
x (EUit x Expt )
(Regi x F raci )
x Eutradit
Refi
x T openit
Refi
x (EUit x Expt )
Refi
x Eutradit
Regparli
x T openit
Regparli
x (EUit x Expt )
Regparli
x Eutradit
Obs.
Countries
adj. R2
within R2
(5)
-0.660???
(0.112)
0.770???
(0.125)
0.129???
(0.046)
-0.025
(0.019)
-0.012
(0.066)
-0.287???
(0.065)
0.003
(0.003)
0.012
(0.047)
-0.080
(0.084)
0.027
(0.019)
0.013
(0.177)
-0.020 ?
(0.011)
-0.002
(0.002)
-0.030
(0.024)
-0.021
(0.068)
0.020 ?
(0.011)
378
20
0.982
0.351
378
20
0.982
0.344
378
20
0.982
0.339
Note: see Table 5.
17
378
20
0.982
0.344
378
20
0.982
0.357
378
20
0.982
0.359
0.265 ?
(0.144)
378
20
0.982
0.349
this context, regional trade integration in Europe proves to have an even stronger impact than the overall degree of openness. The estimates also support the importance of
institutional rules. As predicted by the theory, stronger legal embodiment of referenda
exhibits a decentralizing effect on public spending in the context of both economic and
political integration. However, with regard to direct revenues, only the interaction with
trade openness proves significant. In contrast to this, we find evidence for a centralizing
effect of integration on direct public expenditures in the presence of a regionally elected
chamber of parliament. The effect is even stronger with regard to EU trade integration and is significant for both expenditures and revenues. Particularly in the European
context, this seems to confirm the common-pool argument and the existence of political
forces opposing fiscal competition. Overproportionate representation in national legislation enables especially poor regions to resist decentralization and fiscal competition, and
to stimulate direct central government expenditures and transfers instead.
In line with this finding, the estimates report a strong and significant positive impact of
regional disparity of per-capita income on the degree of both public sector expenditure
and revenue centralization. The inclusion of the regional disparity variable turns out to
improve considerably the goodness of fit of the regression. Since economic integration is
assumed to increase cross-regional disparities, this provides strong evidence for a stimulating effect of integration on the demand for inter-regional redistribution. As for the
other control variables, the results are less clear-cut. A strong significant decentralizing
effect of increasing population is found for net expenditures and the revenue side, thus
partly confirming the empirical literature. The results are the same when using alternatively the median population size of the regions as a proxy for potential economies
of scale at the subnational level. On the contrary, increasing urbanization is associated
with a higher share of central government net expenditures and direct revenues. The
effect is even more accentuated when social security is taken into account. Apparently,
this contrasts sharply with the theory and previous empirical results. However, previous
studies have tested the economies of scale argument only with cross-sectional or pooled
data. Furthermore, the magnitude of the estimated coefficients of urbanization should be
interpreted with caution, since the time variation is in general low. The result probably
indicates higher spillovers and increasing demand for social assistance and other central
subsidies in the course of urban agglomeration. On the revenue side, a higher degree of
urbanization could facilitate economies of scale in the pooling and central collection of
tax revenues.
With regard to the economic development, we find evidence for a negative effect of rising per-capita income on the degree of centralization of direct expenditures. In contrast
to this, the estimates including social security show that higher income is associated
with increased provision of social assistance. These findings could indirectly be in line
with the Meltzer-Richard hypothesis that an increase in mean income relative to the
income of the decisive median voter increases the size of government.38 As expected,
unemployment also increases the share of central government expenditures, especially
when including social security. Correspondingly, a negative sign for the revenue side
corresponds to declining revenues of the central government in times of rising unemployment. Other variables controlling for economic growth and political cycles have proved
insignificant. Apparently, business cycles affect the activity of both central and subnational governments in the same way, thus indicating similar expenditure and revenue
elasticities of income of the different layers of government. Finally, the inclusion of a
dummy variable detects a significant trend towards decentralization during the 1990s,
which can probably be due to the end of the cold war, and the consequent reduction in
38 See Meltzer and Richard (1981). This aspect could have been tested by the use of income inequality measures.
However, due to the lack of internationally comparable consistent time series and general measurement problems, we
refrain from doing so here.
18
central government spending for armament and security.
5
Summary and conclusions
The aim of this paper is to explore empirically the possible causal relationship between
economic and political integration and the observed process of public sector decentralization, in particular in European Union countries. Based on the theory of fiscal federalism,
the analysis draws on recent work on the secession of countries which has shown that
economic integration increases the benefits of independence. These considerations are
extended to include certain aspects provided by the new economic geography literature
and to investigate the effect of both economic and political integration on the vertical
allocation of government functions. It turns out that, by enhancing regional specialization, economic integration could have stimulated the process of fiscal decentralization.
The process of political unification in Europe is also assumed to have diminished the
role of national governments, while at the same time extending the scope of activity of
local and regional governments.
Since integration is assumed to alter the cost and benefits of the decentral provision
of public goods, the investigation takes a panel data approach, controlling for countryspecific technologies, preferences, and institutional rules. The hypothesis of a decentralizing effect of economic and European integration has been tested for a panel of OECD
countries. Controlling for other determinants and including country fixed effects, the
results indicate that economic integration has in fact significantly contributed to the observed decentralization of the public sector. This holds even more for European Union
countries, where an increase in regional trade integration and in EU expenditures is
found to reduce the share of central government expenditures and revenues. According
to these findings, national governments seem to have come under pressure both from the
supranational and the subnational levels of government. Moreover, the decentralizing
impact of integration appears to be stronger in countries exhibiting high ethno-linguistic
heterogeneity and important legal scope for direct democracy. In contrast to this, direct
involvement of subnational governments in central decision-making is associated with
more centralization. We also found that inter-regional income disparity significantly
increases the share of central government expenditures and revenues, thus confirming
the hypothesis of higher demand for cross-regional redistribution with rising exposure to
economic shocks.
However, the empirical analysis suffers from certain limitations, such as the measurement
of fiscal centralization and of the public sector activity in general. Expenditure and revenue figures only partly reflect legislative activities, political coordination among layers
of government, and real decision-making powers of subnational levels of government,
and tend to understate the actual role of the central government. The same applies to
the European Union, which is especially vested with regulating and legislative powers
and the coordination of activities. Future research should also deal with the problem
of aggregation of different government functions. Since these represent different public
goods, a disaggregated analysis would automatically take account of different spillovers
and economies of scale and provide a better understanding of the factors determining the
vertical government structure. Finally, as the inclusion of the trend variable indicates,
the last decade should be examined more closely, in view of a possible effect of the end
of the cold war. However, despite of these shortcomings, the approach taken in this paper permitted us to focus on the particular aspect of the interaction between economic
integration and European unification on the one side, and the vertical organization of
the public sector, on the other side, revealing a significant relationship between those
two broad trends among OECD countries.
19
Appendix
Regressions including social security
Table 8: Fixed effects (within) estimates for government centralization, direct expenditures (incl. Soc.
Sec.), OECD countries, 1970-2000
P opit (log)
U rbit
Regdispit
Rgdpcit (log)
Rgdpc − grit
U nempit
Electit
T openit
F openit
EUit x Expt
Dep. Variable: Degree
(1)
(2)
-0.072
0.030
(0.159)
(0.159)
0.306 ?
0.383 ??
(0.165)
(0.162)
0.194???
0.203???
(0.065)
(0.064)
0.011
-0.007
(0.025)
(0.024)
0.023
-0.054
(0.092)
(0.090)
0.367???
0.310???
(0.094)
(0.088)
0.004
0.003
(0.004)
(0.004)
-0.124???
(0.031)
-0.137???
(0.026)
-0.033??? -0.017???
(0.005)
(0.006)
of centralization
(3)
(4)
-0.023
-0.113
(0.153)
(0.161)
0.307 ??
0.297 ?
(0.154)
(0.170)
0.238???
0.192???
(0.063)
(0.066)
0.012
0.015
(0.035)
(0.025)
0.099
0.002
(0.089)
(0.093)
0.364???
0.320???
(0.089)
(0.094)
0.002
0.003
(0.004)
(0.004)
-0.198??? -0.131???
(0.030)
(0.031)
(6)
-0.076
(0.137)
-0.037
(0.139)
0.102 ?
(0.054)
0.026
(0.022)
0.063
(0.075)
0.597???
(0.079)
0.003
(0.003)
-0.083???
(0.028)
-0.034???
(0.005)
0.017 ??
(0.007)
-0.422???
(0.048)
Eutradit
(7)
0.066
(0.137)
0.051
(0.139)
0.148???
(0.056)
0.023
(0.021)
0.103
(0.079)
0.509???
(0.080)
0.002
(0.003)
-0.193???
(0.027)
0.097
(0.083)
-0.015???
(0.002)
Euintit
(Regi x F raci )
x T openit
(Regi x F raci )
x (EUit x Expt )
(Regi x F raci )
x Eutradit
Refi
x T openit
Refi
x (EUit x Expt )
Refi
x Eutradit
Regparli
x T openit
Regparli
x (EUit x Expt )
Regparli
x Eutradit
Obs.
Countries
adj. R2
within R2
(5)
-0.014
(0.158)
0.290 ?
(0.173)
0.198???
(0.064)
-0.021
(0.026)
0.015
(0.091)
0.375???
(0.092)
0.003
(0.004)
-0.012
(0.066)
-0.265 ??
(0.119)
-0.200???
(0.022)
-1.472???
(0.220)
-0.035 ?
(0.018)
-0.006 ??
(0.003)
-0.070 ??
(0.032)
0.253 ??
(0.103)
0.009
(0.013)
350
19
0.944
0.299
350
19
0.946
0.324
350
19
0.948
0.355
Note: see Table 5.
20
350
19
0.942
0.279
350
19
0.947
0.342
350
19
0.963
0.541
0.363 ??
(0.170)
350
19
0.961
0.510
Table 9: Fixed effects (within) estimates for government centralization, net expenditures (incl. Soc.
Sec.), OECD countries, 1970-2000
P opit (log)
U rbit
Regdispit
Rgdpcit (log)
Rgdpc − grit
U nempit
Electit
T openit
F openit
EUit x Expt
Dep. Variable: Degree
(1)
(2)
-0.533??? -0.554???
(0.087)
(0.089)
0.504???
0.520???
(0.092)
(0.093)
0.061 ?
0.064 ?
(0.036)
(0.036)
0.032 ??
0.025 ?
(0.014)
(0.014)
0.029
-0.005
(0.050)
(0.049)
0.327???
0.296???
(0.050)
(0.049)
0.002
0.003
(0.002)
(0.002)
-0.051???
(0.016)
-0.018
(0.014)
-0.013??? -0.011???
(0.003)
(0.003)
of centralization
(3)
(4)
-0.525??? -0.551???
(0.087)
(0.087)
0.450???
0.510???
(0.090)
(0.094)
0.072 ??
0.061 ?
(0.036)
(0.036)
0.038???
0.033 ??
(0.014)
(0.014)
0.041
0.022
(0.051)
(0.050)
0.316???
0.305???
(0.050)
(0.049)
0.002
0.002
(0.002)
(0.002)
-0.077??? -0.052???
(0.017)
(0.016)
(6)
-0.506???
(0.089)
0.441???
(0.093)
0.041
(0.035)
0.031 ??
(0.014)
0.036
(0.048)
0.376???
(0.050)
0.002
(0.002)
-0.050???
(0.017)
-0.013???
(0.003)
0.003
(0.005)
-0.117???
(0.027)
Eutradit
(7)
-0.456???
(0.085)
0.351???
(0.088)
0.037
(0.035)
0.039???
(0.014)
0.033
(0.049)
0.364???
(0.049)
0.002
(0.002)
-0.076???
(0.016)
0.109 ??
(0.052)
-0.006???
(0.001)
Euintit
(Regi x F raci )
x T openit
(Regi x F raci )
x (EUit x Expt )
(Regi x F raci )
x Eutradit
Refi
x T openit
Refi
x (EUit x Expt )
Refi
x Eutradit
Regparli
x T openit
Regparli
x (EUit x Expt )
Regparli
x Eutradit
Obs.
Countries
adj. R2
within R2
(5)
-0.499???
(0.087)
0.586???
(0.098)
0.071 ?
(0.036)
0.028 ??
(0.014)
0.042
(0.050)
0.316???
(0.050)
0.002
(0.002)
0.036
(0.036)
-0.161 ??
(0.065)
-0.040???
(0.014)
-0.339 ??
(0.132)
-0.019 ??
(0.009)
-0.004 ??
(0.002)
-0.059???
(0.018)
-0.052
(0.054)
0.007
(0.009)
387
20
0.982
0.470
387
20
0.982
0.458
387
20
0.982
0.464
Note: see Table 5.
21
387
20
0.982
0.466
387
20
0.982
0.481
387
20
0.983
0.507
0.267 ??
(0.107)
387
20
0.984
0.517
Table 10: Fixed effects (within) estimates for government centralization, direct revenues (incl. Soc.
Sec.), OECD countries, 1970-2000
P opit (log)
U rbit
Regdispit
Rgdpcit (log)
Rgdpc − grit
U nempit
Electit
T openit
F openit
EUit x Expt
Dep. Variable: Degree
(1)
(2)
-0.543??? -0.550???
(0.083)
(0.085)
0.644???
0.644???
(0.084)
(0.085)
0.067 ??
0.069 ??
(0.034)
(0.035)
0.022 ?
0.018
(0.013)
(0.013)
-0.041
-0.067
(0.048)
(0.047)
-0.100 ??
-0.119 ??
(0.048)
(0.047)
0.003
0.003
(0.002)
(0.002)
-0.037 ??
(0.016)
-0.017
(0.013)
-0.011??? -0.009???
(0.003)
(0.003)
of centralization
(3)
(4)
-0.536??? -0.559???
(0.084)
(0.084)
0.548???
0.627???
(0.080)
(0.087)
0.072 ??
0.066 ?
(0.035)
(0.035)
0.031 ??
0.026 ?
(0.013)
(0.013)
-0.041
-0.050
(0.049)
(0.048)
-0.117 ??
-0.123???
(0.048)
(0.047)
0.002
0.003
(0.002)
(0.002)
-0.055???
-0.039 ??
(0.016)
(0.016)
(6)
-0.502???
(0.088)
0.618???
(0.090)
0.065 ?
(0.035)
0.017
(0.014)
-0.036
(0.048)
-0.086 ?
(0.050)
0.003
(0.002)
-0.044 ??
(0.017)
-0.011???
(0.002)
-0.006
(0.005)
-0.070???
(0.026)
Eutradit
(7)
-0.494???
(0.085)
0.515???
(0.081)
0.053
(0.035)
0.029 ??
(0.014)
-0.050
(0.049)
-0.094 ?
(0.049)
0.002
(0.002)
-0.056???
(0.016)
0.027
(0.052)
-0.004???
(0.001)
Euintit
(Regi x F raci )
x T openit
(Regi x F raci )
x (EUit x Expt )
(Regi x F raci )
x Eutradit
Refi
x T openit
Refi
x (EUit x Expt )
Refi
x Eutradit
Regparli
x T openit
Regparli
x (EUit x Expt )
Regparli
x Eutradit
Obs.
Countries
adj. R2
within R2
(5)
-0.508???
(0.083)
0.752???
(0.092)
0.081 ??
(0.035)
0.020
(0.014)
-0.018
(0.048)
-0.120 ??
(0.048)
0.002
(0.002)
0.038
(0.035)
-0.109 ?
(0.062)
-0.003
(0.014)
-0.146
(0.133)
-0.024???
(0.008)
-0.003
(0.002)
-0.028
(0.018)
-0.051
(0.050)
0.011
(0.008)
389
20
0.984
0.429
389
20
0.984
0.423
389
20
0.984
0.413
Note: see Table 5.
22
389
20
0.984
0.419
389
20
0.985
0.444
389
20
0.984
0.437
0.220 ??
(0.108)
389
20
0.984
0.432
Data sources, definitions, and descriptive statistics
Variable
Centr
Pop
Urb
Reg
Frac
Regdisp
Regparl
Ref
Rgdpc
Rgdpc-gr
Unemp
Elect
Topen
Fopen
EU
Exp
Eutrad
Euint
Description
Centr. gov. exp. (rev.) as a
share of total gov. exp. (rev.)
Dir. exp. (excl. soc. secur.)
Dir. exp. (incl. soc. secur.)
Net exp. (excl. soc. secur.)
Net exp. (incl. soc. secur.)
Dir. rev. (excl. soc. secur.)
Dir. rev. (incl. soc. secur.)
Log of population in 1000
Population in urban areas as
a share of total population
Dummy=1 for regional
ethnically, linguistic or
culturally distinct minorities
Ethno-linguistic fractionalization (0-1): mean value of
Annett and Ethnologue indices
Coeff. of variation of
regional GDP or value-added
per capita
Dummy=1 for second chamber
of parliament with regionally
elected representatives
Sum of indices of statutory
provisions concerning national
constitutional and legislative
referenda (0-6): 0 (none), 1 (facultative-consultative), 2 (facultative-binding), 3 (compulsory);
period average
Log of real GDP per capita, in
prices of 1995, in ECU/EUR
Rate of growth of real GDP p.c.
Rate of unemployment
Dummy=1 for national election
year
Exports plus imports as a share
of GDP
Index of financial openness
(scaled 0-1)
Dummy=1 for EU membership
EU expenditures in % of total
public expend. of the member
countries
Exports plus imports to/from
EU15 as a share of foreign trade
Index of EU integration (0-6): 0
(none), 1 (free-trade agreement),
2 (EEA), 3 (customs union),
4 (EC/EU), 5 (EMS), 6 (EMU)
Source
IMF, Government Finance
Stat. Yearbook; own
calculations
Mean
St.Dv.
Min
Max
0.567
0.668
0.724
0.785
0.722
0.779
4.067
0.740
0.178
0.149
0.168
0.135
0.172
0.139
0.704
0.144
0.211
0.374
0.351
0.464
0.334
0.455
2.312
0.260
0.959
0.968
0.987
0.991
0.963
0.973
5.454
0.970
Classif. according to
Gurr (1993), ethnologue.com,
and regionalist parties
Annett (2000);
www.ethnologue.com
0.348
0.477
0.000
1.000
0.245
0.188
0.015
0.660
Eurostat, REGIO Database,
Regional Accounts; national
statistics; own calculations
CIA, World Fact Book;
Ismayr (1999); national
constitutions
http://c2d.unige.ch;
national constitutions;
own calculations
0.219
0.069
0.092
0.620
0.217
0.413
0.000
1.000
2.390
1.950
0.000
6.000
IMF, Internat. Financial
Statistics; own calculat.
4.249
0.257
3.633
5.901
0.031
0.061
0.292
0.027
0.041
0.455
-0.067
0.000
0.000
0.288
0.237
1.000
0.668
0.384
0.108
2.907
0.807
0.181
0.286
1.000
0.480
1.891
0.500
0.385
0.000
1.200
1.000
2.400
0.544
0.205
0.072
0.865
2.414
2.335
0.000
6.000
IMF; World Bank
World Bank
OECD, Labour Force Stat.
Ismayr (1999); Mackie and
Rose (1991); www.polisci.com
IMF, Internat. Financial
Statistics; own calculat.
Quinn and Inclan (1997);
Armingeon et al. (2000);
own calculations
Europ. Kommission (2000)
OECD, Stat. Compendium
Database; own calculations
own calculations
23
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