Abstract
This paper develops a model to explain how sub-national political regimes affect the variation in retention rates in a country in which a region and a central government bilaterally bargain over the distribution of tax revenue given a particular tax rate (and thus fiscal decentralization is asymmetric). This study examines cases in which both sub-national and national governments have the same political regime (democracies and non-democracies) and situations in which the central and regional political regimes differ. This article shows that in the latter case, regions receive a smaller share of tax revenue for a broad set of parameters of the model (as opposed to the case of a pure non-democracy); in the case of identical political regimes, the comparative fiscal decentralization is determined by the productivity-enhancing effect of regional public goods.
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Notes
As a caveat, the broad literature on hybrid remains outside the scope of this paper; see, e.g., Collier and Levitsky (1997) and Diamond (2002). It should be noted that in what follows I will use the notion of “mixed regimes”, i.e. countries where political regimes on the national and on the sub-national levels differ—this, however, should not be mistaken for the “hybrid regimes” as they are discussed in political science literature.
A further remark is required with respect to the terminology. Many economists use “fiscal decentralization” and “fiscal federalism” to refer to concepts that are closely related or even synonymous (Tanzi 1995). Boucher and Migue (2002: 2) explicitly state that “federalism is decentralization”. Political science and legal studies are significantly more cautious: e.g. Rodden (1994: 489), for example, claims that “federalism is not a particular distribution of authority between governments, but rather a process—structured by a set of institutions—through which authority is distributed and redistributed” (see also Elazar (1987) and Riker (1975) for other classical definitions). From this perspective this paper is concerned with explaining the variation in “decentralization” (i.e., the allocation of fiscal resources). However, this study does allow for differences in terms of the process of making decisions regarding fiscal decentralization, as will be described subsequently.
I will henceforth refer to these cases as pure democracies and pure non-democracies.
Even the Soviet Union in the 1970s and 1980s turned to a political system in which the elites of the southern Soviet and autonomous republics maintained relative independence from the central government and enjoyed a wide-scale control over economic activities in their territory (which were often hidden beyond public loyalty proclamations); see Furman (2010). Latin America experienced a significant move toward decentralization under authoritarian leaders (Eaton 2006), as did China in the last decade (Montinola et al. 1995; Blanchard and Shleifer 2001).
The literature further distinguishes between asymmetries in national constitutions and in further acts (e.g., power-sharing treaties). Consistent with the constitutional political economy literature, I will refer to both of these asymmetries (i.e., to the level of rules) as constitutional, whereas the level of policy outcomes (e.g., split of fiscal revenue) shall be described as post-constitutional.
These papers discuss both constitutional asymmetries and asymmetric fiscal decentralization in the sense defined above.
The expenditure side is not considered because it is extremely difficult to measure how direct federal expenditures are distributed throughout the territory of a country; see the East-West Institute (2001) for a discussion of this issue for Russia.
In both the model of this paper and the models of vertical tax competition, two governments (a federal and a regional government) rely on the same tax base as the sole source of revenue. However, although all governments in the vertical tax competition models are allowed to establish their own tax rates, the governments in this model attempt to split the revenue for a given tax rate.
As a caveat, note that there may be some indirect links: for example, sub-national regimes could influence the formation of tax bases in regions to varying extents. These effects are not considered to ensure the tractability of the model.
Faletti (2005) provides an example of the interplay of fiscal and political decentralization in Latin American countries (without any examination of asymmetries) and shows that the links are highly complex in this context.
The notation follows the terminology that is suggested by Treisman (2007), who distinguishes between administrative and political decentralization.
For example, the construction of roads or public education may not actually produce additional utility to the public but could increase individual productivity.
Equivalently, these agents could also purchase luxury goods abroad as bureaucrats and government do.
Tax split rate is therefore simply one minus retention rate.
The technical implementation of the basic assumptions in Sect. 3 for this model follows the ideas of Inman and Rubinfeld (2008). As mentioned above, assume that the government spends part of its fiscal revenue on public goods and the remainder on luxury goods. Then, the population prefers greater public goods provision and disregards luxury goods, whereas the elites obtain utility only from luxury goods but not (at least directly) from public goods. This assumption is reasonable if one considers developing countries: elites have much better access to private goods, which may act as “substitutes” for poor public good protection (e.g., private security agencies, universities, medical facilities), and are able to move abroad to consume services that are provided by other countries (e.g., receive medical services from foreign clinics or hire foreign specialists, educate their children in foreign schools and universities). In contrast, the general population is significantly less mobile, and its income is too low to purchase substitutes for public goods.
This assumption is less realistic, but I will rely on it for the sake of simplicity at this stage of analysis. Otherwise, a problem of commitment in the negotiations between the center and the region would become crucial (one government can be interested in “shifting the blame” to its counterpart, as discussed by Bednar 2004, 2008); thus, such a study would require a more careful modeling of dynamics than is used in this paper.
This assumption is made without a loss of generality in a world without cross-regional spillovers: if I drop this assumption, the central government will merely produce a sufficient amount of public goods in the larger region to gain re-election and will act as a non-democracy in the second region.
This game tree may seem inconsistent because farmers use public goods (produced at stage 3) for generating output at stage 1; however, the model is primarily static, and the production of public and private goods is assumed to be nearly simultaneous. Stated otherwise, the model restricts attention to “steady states” in which the production of private and public goods is balanced in each period.
I have also investigated a set of extensions relaxing the main assumptions of the model, specifically (a) possibility of transfers paid by various governments to population; (b) negative secession costs; (c) fixed costs of public goods provision; (d) the altered timing of events (regions as Stackelberg leaders); (e) situations in which non-democratic regions control central elections in their territories; (f) cases when the central government decides on the provision of regional public goods in regions A, and not merely on the tax split rate; (g) β < 0.5; (h) costs of repressions in non-democratic regimes; (i) inter-regional migration and (j) cases of tinpot and totalitarian non-democracies as in Wintrobe (1990). While the detailed discussion of these modifications is omitted in this paper due to place constraints, it is available at request.
All proofs are reported in the Appendix. In the paper I present only the general logic of the proofs without mathematical details due to place constraints; detailed proofs are available at request.
This situation may be less plausible because, unlike the non-democratic case, both secession and non-secession generate equal revenue to the center (which is zero). Furthermore, given the electoral system that is assumed, the motivation of the central government is not sufficiently clear. However, the assumption still appears to be reasonable given the empirically observed experience of the central government behavior in the secession cases.
For the purpose of interpretation, one can also relate C to political regimes. It seems plausible that the costs of secession will increase in more integrated economies. Democracies exhibit a higher degree of internal economic integration than non-democracies (which, for example, use internal barriers to extract additional rents or impose restrictions on the movement of people between regions). However, to “deal” with a separatist region, a non-democracy can use much more severe measures that are excluded from the toolbox of a democracy. Therefore, such an interpretation is less evident but possible.
Transfer allocation may act as a substitute for retention rate renegotiations if retention rates are identical for all regions.
These dimensions also include two more questionable components: economic liberalization and corruption, which, however, are also defined in a way focusing on political aspects; excluding these variables does have a very small impact on the final value of the index.
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Acknowledgments
I am grateful to Eckhard Janeba, Anastassia Obydenkova, as well as the Editor and two anonymous referees for important suggestions. The paper was presented at the European Public Choice Society, International Institute of Public Finance, European Economic Association and German Economic Association conferences, and at the Public Finance and International Trade Group seminar at the University of Mannheim. The author thanks participants of the seminars, in particular Joan Costa i Font, Panu Poutvaara and Harry Seldadyo for helpful comments. The paper was part of my PhD thesis defended at the University of Mannheim. All mistakes are my own.
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Appendix
Appendix
Proof to Lemma 1
By differentiating (6) with respect to f A and f P one can see that optimal f A does not depend on t P and f P on t A . Given that, from (7) and (9) follows that r A does not depend on t P and r P on t A for both democratic and non-democratic regional governments. Given that, we can re-write (6) inserting the equilibrium quantities of public foods provision. By differentiating the expression with respect to t A and t P it follows that optimal t A does not depend on t P and vice versa. Hence, central optimum for A and P are independent from each other; since the output of r P and f P is independent of t A and vice versa regardless of whether secession happens or not, equalizing tax split rates t P and t A are also independent of each other. \(\square\)
Proof to Lemma 2
To (i): Assume that for region A the equilibrium is different from central optimum. Then the central government has incentive to deviate (and hence either increase the public goods output for democracy or the net revenue for non-democracy)—a contradiction.
To (ii): There are two cases to be considered. (1) Assume that the revenue of the region (non-democratic) under central optimum is larger, than in case of secession, or the production of public goods of the region (democratic) is larger, than in case of secession. Then neither the region nor the central government deviate from central optimum, which is the equilibrium. (2) Assume that the previous condition does not hold, and the central government offers any other tax split rate than the equalizing tax split rate, which, however, is acceptable to the regional government (so that secession does not happen). This can happen only if the central government has an objective function, which is not single-peaked in tax split rate. For pure non-democracy, pure democracy and mixed regime with central democratic government the objective function of the central government is concave and therefore single-peaked. For the case of non-democratic central and democratic regional government, the objective function of the central government is, generally speaking, not concave, but one can show that it contains a concave part and decreasing when it is not concave—hence, for a continuous function the maximum can be achieved only in the concave part, and the objective function is single-peaked again. Thus, an offer different from the equalizing tax split rate should never be preferred by the central government to the equalizing tax split rate. \(\square\)
Proof to Proposition 1
To (i): In order to prove the claim, one has to show that (a) central optimum is strictly positive (so, no corner solution t P = 0 is possible) and (b) there exists a tax split rate t P different from zero such that the net revenue for non-democratic regional government (public goods output for the democratic regional government) under secession is at least weakly smaller than without secession. This can be established for all four regimes. (a) directly follows from solving the optimization problem of the central government. In order to prove (b) for pure non-democracy and both mixed regimes, one has to demonstrate that the expression describing the difference between revenue of the region in case of secession and in case of non-secession (“equalizing condition”) is strictly positive for t = 0 (and hence by continuity of the function should either have positive roots between 0 and 1 or be strictly positive—then the central optimum is always accepted by the region). For pure democracy, one can explicitly calculate the equalizing tax split rate and show that it is positive for any combination of parameters, under which production of public goods in case of secession is feasible (and if the production of public goods in case of secession were not feasible, the region would accept central optimum anyway).
To (ii): It is sufficient to calculate the central optimum to see that it is independent of C and d. Furthermore, if one calculates the first derivative of the central optimum with respect to β, it is negative for three regimes, so that central optimum is decreasing in β. For the mixed regime with democratic regional government the result can be obtained from equalizing condition by implicit function theorem.
To (iii): From the closed-form central optima for pure non-democracies and pure democracies one can immediately see that they are strictly smaller 1 (central optimum is decreasing in β; and for β = .5 (which can never be achieved by definition) the central optimum is equal to 1 for pure non-democracy and smaller 1 for pure democracy). Hence for central optima and equilibria in A the result holds. Consider equalizing tax split rates. For pure non-democracy, as follows from part (i), equalizing tax split rate is strictly positive (if it exists). It may be equal to 1 for certain values of parameters, but, since the central optimum is smaller than one, it implies, that the region would accept the central optimum at this value of β P . For a pure democracy the equalizing tax split rate can be equal to 1 only if region is unable to produce public goods under secession. But in this case central optimum is chosen, and it is smaller 1.
To (iv): In region A the equilibrium tax split rate is the central optimum. If in region P the equilibrium is also the central optimum and β A = β P , the equilibrium tax split rates are identical in both jurisdictions (since they do not depend on d). If in region P equalizing tax split rate is chosen, it is smaller than the respective central optimum (which is, as mentioned above, identical for all regions). In case of pure non-democracy it follows from the fact that the net revenue of the region is strictly declining in t P ∈ [0;1]. For a pure democracy the region increases its public goods provision if t P goes down, because central public goods are less efficient in terms of productivity increase of the population. This is obviously true for a mixed regime with non-democratic central government (which produces even less public goods than the democracy). For a mixed regime with non-democratic regional government, assume that the equalizing tax split rate actually chosen is larger than the rejected central optimum. That means that the central optimum is smaller than the smallest root of the equalizing condition. But it implies that there exists a tax split rate for which central government can produce more public goods than for the central optimum—contradiction to the definition of central optimum. Hence, equalizing condition is (weakly) smaller than central optimum. If region P has the equalizing tax split rate in equilibrium, it is more decentralized than region A.
To (v): First it is necessary to show that the proposition is true for the equalizing tax split rate. The result can be established for pure non-democracy and both mixed regimes by applying implicit function theorem to the equalizing condition. For the pure democracy implicit function theorem is not applicable, because the equalizing condition is actually a system of equations, but one can calculate the solution of this system and differentiate it directly. In the next step, the proof goes as follows. Consider a pair \(\hat{\beta_P} < \check{\beta_P}\) and distinguish among four cases: (1) For both \(\hat{\beta_P}\) and \(\check{\beta_P}\) the equilibrium is the central optimum. Than the equilibrium is decreasing in β P , as demonstrated above and \(t_P(\hat{\beta_P}) > t_P(\check{\beta_P})\). (2) For both \(\hat{\beta_P}\) and \(\check{\beta_P}\) the equilibrium is the equalizing tax split rate and \(t_P(\hat{\beta_P}) > t_P(\check{\beta_P})\). (3) For \(\hat{\beta_P}\) the equilibrium is the the central optimum, and for \(\check{\beta_P}\) it is the equalizing tax split rate. Since the equalizing tax split rate is smaller than the central optimum calculated for the same β P and the central optimum calculated for \(\check{\beta_P}\) is smaller than for \(\hat{\beta_P}, t_P(\hat{\beta_P}) > t_P(\check{\beta_P})\). (4) For \(\hat{\beta_P}\) the equilibrium is the the equalizing tax split rate, and for \(\check{\beta_P}\) it is the central optimum. Obviously, the equilibrium is always the smallest value of two values: central optimum and equalizing tax split rate. At \(\hat{\beta_P}\) the equalizing tax split rate was smaller, than the respective central optimum, at \(\check{\beta_P}\) vice versa. Now recall that the equalizing tax split rate is declining in β P . Therefore for \(\check{\beta_P}\) the central optimum is smaller than some value, which is smaller than the equalizing tax split rate for \(\hat{\beta_P}\), and hence \(t_P(\hat{\beta_P}) > t_P(\check{\beta_P})\). The proof for C and d is obtained by considering analogous four cases in similar way. \(\square\)
Proof to Proposition 2
To (i): Both central optima under different political regimes are declining in β i . Moreover, there exists a unique point of interception. Evaluate both expressions for β i → .5. One can show that the central optimum of the non-democracy converges to 1, while for the democracy it converges to a value smaller 1. Hence, one can conclude, that the central optimum for non-democracy for β i → .5 is larger in a democracy, while for β i larger than the unique interception point between two functions it is smaller than in a democracy.
To (ii): Assume that C is large enough, so that under both regimes the central optimum is chosen. Than, applying the result from part (i) of this proof, the proof is complete. \(\square\)
Proof to Proposition 3
To (i): For a mixed regime with democratic central government central optimum can be written as a sum of the central optimum in a pure non-democracy and a second term, which is always positive: so the result holds. For a mixed regime with democratic region the problem of the central government, as mentioned, consists of two terms: the problem of the central government in case of pure non-democracy and an additional term. Evaluating the first derivative of the second term at t equal to the central optimum of pure non-democracy one can show that the expression is negative for β small enough and positive for β high enough. Given the shape of the function describing the optimization problem of the central government, the proposition holds.
To (ii): The central optima in pure democracy and mixed regime are strictly declining in β i . Moreover, they intersect at one point within the in the interval of β i ∈ (0.5;1). It has been shown that the central optimum for a mixed regime for β i → .5 is larger than for a pure non-democracy, which, in turn, is larger than for a pure democracy. Given a unique point of intersection and monotonicity in β i the proof is complete.
To (iii): Given the results of part (i) of this proof, one has to consider the equalizing tax split rate. First consider the mixed regime with democratic central government. The central government produces strictly more public goods in a mixed regime, than in the non-democracy. Hence the equalizing condition for a mixed regime can be written as sum of the equalizing condition for the pure non-democracy and an additional positive term (let us call it A). The equalizing condition for the pure non-democracy is decreasing in t P , as shown above. Assume that the solution for the equalizing condition for a mixed regime is equal to that for the non-democracy—a contradiction, because it implies 0 + A = 0 for a strictly positive A. Assume that the solution for the equalizing condition for a mixed regime is smaller than for the pure non-democracy: but in this case for a smaller t P the equalizing condition for the pure non-democracy becomes positive (due to its monotonicity in t P ), and A remains positive—a contradiction. Hence, the equalizing tax split rate for a mixed regime is larger than for the pure non-democracy. Now consider the mixed regime with democratic region. I consider the limit of the equalizing tax split rates for d → 1, β P → 1 (recall that they are monotonously declining in both arguments). For a mixed regime the limit is equal to .5, for the pure non democracy it is zero (by applying the L’Hospital rule). Now recall the following theorem from analysis: if the limit of the function is equal to, say, a, and a < p, than the function itself is smaller p from a certain point. Having established the results for the equalizing tax split rates for both regimes, one has to consider four possible combinations as in proof of part (v) of Proposition 1, and by logic similar to that obtain results of the proposition. \(\square\)
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Libman, A. Sub-national political regimes and asymmetric fiscal decentralization. Const Polit Econ 23, 302–336 (2012). https://doi.org/10.1007/s10602-012-9126-3
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DOI: https://doi.org/10.1007/s10602-012-9126-3