On the Welfare Gains from Fiscal Decentralization

The traditional economic case for decentralised fiscal choice is based on the welfare gains from an improved allocation of resourceswithin the public sector. Fiscal decentralizationallows individualjurisdictions(I shall refer to them as «local governments») to tailor the levels of local public outputs to the particular tastes and other circumstances that characterizetheir respective communities. In this paper, I want to explore in more depth the precise nature of these gains, the determinants of their magnitude, and a further dynamic source of welfare gains from so-called laboratory federalism. But first it is necessary to address the issue of why fiscal decentralization is needed to realize these gains. In a world of perfectinformation,a benevolent central planner could presumably introduce the differentiation in local outputs required to maximize social welfare. The traditionalresponse to this point is to argue that, in reality, there exist important imperfections in infonnation. More specifically, individual local governments are much closer to the people and geography of their respective jurisdictions; they possess knowledge of local preferences and cost conditions that are hard to come by for a more distant central agency. There is, in addition, a second (and I think also persuasive) point here. There are, typically, basic political pressures for a certain degree of uniformitY of treatment under central directives. It is not easy for a central government, for example, to provide higher levels of services in somejurisdictions than others. Such political constraints generally prevent central government from introducing the sort of local fiscaldifferentiation that is requiredfor optimization in a multi-level public sector. There are thus important informationand politicallimitations on central government that typically prevent centralized programs from mimicking an optimal pattern of local outputs.The welfare gains, in short, from fiscal decentralization can hardly be expected to be realized through centralized provision of all public goods.