Decentralization in Developing Economies (FF #114)

This 114th edition of Facty Friday continues September's focus on decentralization, looking at the benefits of locally-collected revenue vs federal grants and then considering why “developing” countries tend to have relatively low levels of tax decentralization.

Municipalities generally spend tax revenue more responsibly than grants from the central government

An important part of decentralization is which level of government finances public services. Municipalities can collect taxes and finance services themselves (fiscal decentralization) or receive grants from the federal government (fiscal centralization). An article in Brazil analyzed how that funding source affects service delivery. It compared how Brazilian municipalities spend increases in local tax revenues (generated by a tax capacity program) to how they spent increases in federal grants. It found that increases in local tax revenue improved both the quantity and quality of locally funded public infrastructure; increases in grants had no impact on public infrastructure. These results are consistent with other research showing that tax revenues seem to be spent more on local public goods than transfer revenues. This research suggests that strong tax-benefit linkages incentivize the productive use of municipal resources.

Developing countries today have low levels of tax decentralization

While recent decades have seen a push toward decentralization in developing economies, overall levels of decentralization (especially revenue/tax decentralization) remain relatively low. A review article considered why strong formal local tax systems have not emerged. The researchers summarized several potential explanations: (1) central governments limit local taxing authority, (2) natural resource income and foreign aid as primary sources of government revenue, (3) government expenditures focused on redistribution, and (4) historical legacies from colonial tax systems that make it difficult to enforce land and property taxes, the main source of revenue for local governments. This research suggests that developing countries may be failing to capture many of the potential gains from decentralization.

Related Resources

• International Growth Centre report describing the key principles for successful decentralization.

Got a study we should share for Facty Friday? Email drg.el@usaid.gov!