A Dynamic Model of Fiscal Decentralization and Public Debt Accumulation

Si Guo, Yun Pei and Zoe Xie

No 9927, Policy Research Working Paper Series from The World Bank

Abstract: This paper develops a dynamic infinite-horizon model with two layers of governments to study theoretically and quantitatively how fiscal decentralization affects local and central government debt accumulation and spending. In the model, the central government makes transfers to local governments to offset vertical and horizontal fiscal imbalances. But the anticipation of transfers lowers local governments’ expected cost of borrowing and leads to overborrowing ex ante. Absent commitment, the central government over-transfers to reduce local governments’ future need to borrow, and in the equilibrium both local and central debts are inefficiently high. Consistent with empirical evidence, when fiscal decentralization widens vertical fiscal imbalances, local governments become more reliant on transfers, and both local and central debts rise. Applied to Spain, the model explains 39 percent of the rise in total government debt when the vertical fiscal imbalances widened during 1988–1996, and 18 percent of the fall in debt when the imbalances narrowed during 1996–2006.

Keywords: Democratic Government; Public Sector Administrative and Civil Service Reform; Public Sector Administrative & Civil Service Reform; De Facto Governments; Economic Adjustment and Lending; Public Finance Decentralization and Poverty Reduction; Public Sector Economics; Macro-Fiscal Policy; Financial Sector Policy; Public Financial Management (search for similar items in EconPapers)
Date: 2022-02-07
New Economics Papers: this item is included in nep-dge and nep-ure
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Citations: View citations in EconPapers (7)

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Journal Article: A dynamic model of fiscal decentralization and public debt accumulation (2022)
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