Political Budget Cycles and Fiscal Decentralization∗

In this paper, we study a model à la Rogoff (1990) where politicians distort fiscal policy to signal their competency, but where fiscal policy can be centralized or decentralized. Our main focus is on the equilibrium probability that fiscal policy is distorted in any region, which we call the probability of a Political Budget Cycle (PBC). With centralization, there is the possibility of selective distortion: the incumbent can be re-elected with the support of just a majority of regions. This has both direct and indirect effects which lower and raise the probability of a PBC respectively. Voter welfare under the two regimes is compared. A notable finding is that whether taxes are uniform or differentiated makes a difference to the information available to voters, and can change the equilibrium probability of a PBC. This is distinct from the yardstick competition effect as in our model, there is no cost correlation between regions. ∗We are grateful to the participants of the HECER Workshop on ”Fiscal Federalism” (Helsinki, November 18-19, 2005), the ”Political Economy Workshop” (Exeter, January 20, 2006) and seminar participants at Sevilla and Lisbonne for their comments. We would also like to thank Gani Aldashev, Robert Gary-Bobo, Christos Kotsogiannis Pilar Sorribas and Dave Wildasin, for helpful comments on a previous draft. †Universidad Pablo de Olavide, Sevilla, Spain. [email protected]. ‡Université Catholique de Louvain, CORE, Louvain-la-Neuve, Belgium. [email protected] §University of Warwick, UK. [email protected] ¶Universidad Pablo de Olavide, Sevilla, Spain. [email protected].