The Optimal Design of Fiscal Decentralization

For the last three decades, fiscal decentralization has been a priority of the institutional reform agenda of many countries. The view of fiscal federalism as an efficiency-enhancing mechanism – though empirically and theoretically controversial – has widely influenced such a prevailing and spreading movement. Answering some main questions is crucial to the investigation of the economics of federal reforms: how to optimally assign powers to different tiers of government? How competition and coordination feature intergovernmental relations? How behaviors of firms and households constraint decentralized policies? Economic, institutional, and political dynamics seem to be the driving forces shaping the scope of optimal fiscal decentralization. However, such a crucial role have been overlooked by the traditional theory of fiscal federalism. The economic theories of information and political economy have provided a worthy contribution to a better understanding of such processes. Building on these research advancements, our inquiry sheds some light on the optimal design of fiscal decentralization. As first, the economic argument stressing that fiscal decentralization is an efficiency-enhancing mechanism relies very much on incomplete constitution: incomplete information plays an important role in this respect only if it is considered in an incomplete constitution framework. Moreover, the dynamics of fiscal decentralization (say, ex plures uno - in the cases of consolidated federations and confederations, or ex uno plures - in the cases of devolved-power states) shapes the relevant information setting and, in turn, the design of optimal intergovernmental relations. Finally, the economic features of decentralized functions and services (e.g. substitutability of private services) affect the optimal structure of public programs of local governments as well as their very capacity to finance them.