Decentralization and Inflation in Developed and Developing Countries

Do political and fiscal decentralization make it easier or harder to control inflation? If high inflation reflects the time inconsistency problem, devolving power might restrict the center’s ability to renege on promises of monetary stability, thus reducing inflation. If inflation results from failure to coordinate on a stabilization plan, devolving power to numerous regional governments should make matters worse. Other factors thought to affect inflation—openness to imports, political instability, etc.—may also correlate with decentralization. This paper examines average annual inflation rates in a panel of 87 countries in the 1970s and 80s. It finds a sharp divergence between developed countries—where decentralization correlates with lower inflation—and developing countries—where it correlates with higher inflation. Empirical analysis suggests that decentralization helps preserve central bank independence in OECD countries, while in non-OECD countries it increases pressures on the government to overspend and get the central bank to monetize the deficit. In developing countries, decentralization of tax authority also seems to reduce imports, thus reducing the political cost to central government of inflationinduced currency depreciation.