Optimal fiscal decentralization: Redistribution and welfare implications

- The literature is inconclusive on the welfare effects of fiscal decentralization (FD).
- We present a formal model to analyze the welfare and redistributive effects of FD.
- As an increase in the tax rate reduces tax effort, FD increases to improve welfare.
- We show that extreme levels of FD lower welfare and worsen income distribution.
- When regional spillovers exist, increasing FD decreases welfare and redistribution.

The literature has been inconclusive regarding the welfare effects of fiscal decentralization (FD), defined here as the extent to which local governments collect and spend local tax revenues. We present an original model to investigate formally the distributional and welfare implications of FD. In contrast to the standard approach that compares the implications of full FD with that of centralization, we consider that the central government chooses the level of FD to maximize welfare in a heterogeneous country. Noncooperatively, local governments choose their tax collection effort to maximize local utility. We show that an increase in the tax rate leads optimal FD to increase so as to compensate for the welfare loss from decreasing optimal local tax effort. Hence, welfare and income distribution improve in FD at its intermediate, rather than extreme, levels. We coin this result as the decentralization-Laffer curve. As regional spillovers increase, FD is less desirable as it deteriorates welfare and income distribution. This finding provides a novel support for the decentralization theorem and contributes to the fiscal policy debate.