Fiscal Decentralization and the Functional Composi

UniversityInternationalStudiesProgramFiscalDecentralizationandtheFunctionalCompositionofPublicExpendituresF.JavierArzedelGranadoJorgeMartinez-VázquezRobertMcNabAndrewYoungSchoolofPolicyStudiesWorkingPaper05-01(Updated)September2005GeorgiaStateUniversityInternationalStudiesProgramAndrewYoungSchoolofPolicyStudiesGeorgiaStateUniversityAtlanta,Georgia30303UnitedStatesofAmericaPhone:[phone]Fax:[phone]Email:[e-mail]:(Updated)F.JavierArzedelGranadoJorgeMatinez-VazquezRobertMcNabSeptember2005InternationalStudiesProgramAndrewYoungSchoolofPolicyStudiesTheAndrewYoungSchoolofPolicyStudieswasestablishedatGeorgiaStateUniversitywiththeobjectiveofpromotingexcellenceinthedesign,implementation,andevaluationofpublicpolicy.Inadditiontotwoacademicdepartments(economicsandpublicadministration),theAndrewYoungSchoolhousessevenleadingresearchcentersandpolicyprograms,includingtheInternationalStudiesProgram.ThemissionoftheInternationalStudiesProgramistoprovideacademicandprofessionaltraining,appliedresearch,andtechnicalassistanceinsupportofsoundpublicpolicyandsustainableeconomicgrowthindevelopingandtransitionaleconomies.TheInternationalStudiesProgramattheAndrewYoungSchoolofPolicyStudiesisrecognizedworldwideforitseffortsinsupportofeconomicandpublicpolicyreformsthroughtechnicalassistanceandtrainingaroundtheworld.Thisreputationhasbeenbuiltservingadiverseclientbase,includingtheWorldBank,theU.S.AgencyforInternationalDevelopment(USAID),theUnitedNationsDevelopmentProgramme(UNDP),financeministries,governmentorganizations,legislativebodiesandprivatesectorinstitutions.ThesuccessoftheInternationalStudiesProgramreflectsthebreadthanddepthofthein-housetechnicalexpertisethattheInternationalStudiesProgramcandrawupon.TheAndrewYoungSchool'sfacultyareleadingexpertsineconomicsandpublicpolicyandhaveauthoredbooks,publishedinmajoracademicandtechnicaljournals,andhaveextensiveexperienceindesigningandimplementingtechnicalassistanceandtrainingprograms.AndrewYoungSchoolfacultyhavebeenactiveinpolicyreforminover40countriesaroundtheworld.Ourtechnicalassistancestrategyisnottomerelyprovidetechnicalprescriptionsforpolicyreform,buttoengageinacollaborativeeffortwiththehostgovernmentanddonoragencytoidentifyandanalyzetheissuesathand,arriveatpolicysolutionsandimplementreforms.TheInternationalStudiesProgramspecializesinfourbroadpolicyareas:Fiscalpolicy,includingtaxreforms,publicexpenditurereviews,taxadministrationreformFiscaldecentralization,includingfiscaldecentralizationreforms,designofintergovernmentaltransfersystems,urbangovernmentfinanceBudgetingandfiscalmanagement,includinglocalgovernmentbudgeting,performance-basedbudgeting,capitalbudgeting,multi-yearbudgetingEconomicanalysisandrevenueforecasting,includingmicro-simulation,timeseriesforecasting,Formoreinformationaboutourtechnicalassistanceactivitiesandtrainingprograms,[e-mail]*,JorgeMartinez-Vázquez**,andRobertMcNab****TheWorldBamk,**InternationalStudiesProgram,GeorgiaStateUniversity,***NavalPostgraduateSchoolAbstractWeexaminetherelationshipbetweenfiscaldecentralizationandthefunctionalcompositionofpublicexpenditures.Usingadistance-sensitiverepresentativeagentmodel,wehypothesizethathigherlevelsoffiscaldecentralizationinduceagentstodemandincreasedproductionofpubliclyprovidedprivategoods.Wetestthishypothesisusinganunbalancedpaneldatasetof45developedanddevelopingcountriescoveringa28-yearperiod.Wefindstrongevidencethatdecentralizationincreasestheshareofeducationandhealthexpendituresintotalgovernmentexpenditures.Wenotethattheinfluenceofdecentralizationonthecompositionofpublicexpendituresmaybegreaterindevelopingcountriesrelativetoindustrializedcountries.Keywords:FiscalDecentralization,FunctionalComposition,PurePublicGoods,PubliclyProvidedPrivateGoods,Education,HealthJELclassification:H30,H50InternationalStudiesProgramWorkingPaperSeries21.IntroductionTheapplicationoffiscaldecentralizationreformsanddemandforfiscaldecentralizationpolicydesignhasgrownsignificantlyindevelopedanddevelopingcountriesinthepasttwodecades.1Thiswaveofdecentralizationreformsisdrivenbydiverseeconomicandpoliticalfactors,fromthepursuitofincreasedeconomicefficiencytotheexpansionofdemocraticgovernance(ShahandThompson,2002;ArzaghiandHenderson2004).Despitebeingattheforefrontofpolicydiscussionofpoorandrichcountriesalike,theempiricalanalysisoftheimpactoffiscaldecentralizationreformsisfairlynewandourknowledgeofmanyoftheseissuesremainslimited.2Researchersandpolicymakersalikehavepromoteddecentralizationreformagendasonthepremisethatdecentralizationresultsinamoreefficientallocationofpub