Fiscal decentralization and centralization under a majority rule: A normative analysis

In his seminal work on fiscal federalism, Oates [Oates, W., 1972. Fiscal Federalism. Harcourt Brace Jovanovich, New York, NY] addressed the so-called Decentralization Theorem, which states that, if such factors as scale economies and spillovers are left out of consideration, a decentralized system is always more efficient than a centralized system for supplying local public goods. Based on his analytical framework, we show that a decentralized system may at times be inferior in efficiency to a centralized system under a democratic decision rule (Proposition 2). An intuition for this result is that, under majority rule, a majority may choose an extreme policy in a local district that best matches its own preference but ignores the interests of minorities. In some cases, such disregard of minority taste may result in a considerable loss of efficiency. If instead some moderate policies are chosen through voting in an integrated constituency, then the interests of minorities could be better served to some extent. As a result, centralization would improve social welfare.