Inequality and Fiscal Policy
Chapter

Chapter 17. Income Inequality, Fiscal Decentralization, and Transfer Dependency

Author(s):
Benedict Clements, Ruud Mooij, Sanjeev Gupta, and Michael Keen
Published Date:
September 2015
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Author(s)
Caroline-Antonia Hummel and Mike Seiferling 

Introduction

Within the context of reigniting postcrisis macroeconomic growth, income inequality has emerged as a topic of significant interest for both academics and policymakers (Bastagli, Coady, and Gupta 2012). Fiscal decentralization has also gained considerable attention in many countries because of its potential ability to raise the efficiency of government (Oates 2005; OECD 2006, 2009a, 2009b). Where state and local governments do gain a significant degree of autonomy in the formation of redistributive policies (Bahl, Martinez-Vazquez, and Wallace 2000), the question arises as to if, and how, this decentralization might interact with income inequality. The purpose of this chapter is to provide some initial empirical evidence regarding this link, mainly (1) whether income inequality is systematically associated with the decentralization of government finances, and (2) whether greater fiscal autonomy, or lower revenue dependency, at the state and local levels could potentially improve a country’s income distribution.

The relationship between redistributive fiscal policy and income distribution has a long history in the literature, suggesting that differences in the progressivity of tax and spending policies account for much of the observed variation in inequality of average disposable income within countries (for example, Bastagli, Coady, and Gupta 2012). A smaller collection of interregional literature on fiscal decentralization and income inequality suggests the two should be related, particularly if government redistribution is decentralized and subnational governments are not highly dependent on transfers to finance their expenditures. Taking advantage of the intertemporal variation in posttax income inequality, along with variation in the degree to which state and local governments engage in redistributive policies, allows the way in which they interact to be analyzed empirically.

This chapter tests for these potential links using macro-level data for a globally representative, multisector sample of countries for a 30-year period. In addition to previous studies, this chapter examines decentralization patterns using an aggregate measure of decentralization along with redistributive spending subaggregates to achieve a better fit with theoretical expectations. On the revenue side, the analysis also tests for potential effects from the decentralization of income taxation and the level of subnational transfer dependency. The results are generally consistent with past findings, suggesting that the decentralization of government expenditure can help achieve a more equal distribution of income. However, several conditions need to be fulfilled. First, the government sector needs to be sufficiently large. Second, decentralization should be comprehensive and should include redistributive government spending. Third, decentralization on the expenditure side should be accompanied by adequate decentralization on the revenue side, such that subnational governments rely primarily on their own revenue sources instead of relying on intergovernmental transfers.

Fiscal Decentralization and Inequality, A Literature Review

In the large body of literature on income inequality, government redistribution plays a pivotal role in explaining both interregional and cross-country variance (Gustafsson and Johansson 1999; Li, Xie, and Zou 2000; Chu, Davoodi, and Gupta 2000; Galli and van der Hoeven 2001; Dollar and Kraay 2002; Lundberg and Squire 2003). At the same time, the literature on fiscal federalism suggests that fiscal decentralization can affect redistributive efficiency within an economy. The existing empirical literature has generally confirmed the existence of a relationship between these two strands; however, the theoretical connection between fiscal decentralization and income inequality remains somewhat less clear.

The first wave, or “first-generation theory,” of fiscal federalism argued that state and local governments should not engage in income redistribution (see Oates 2008). According to this literature, decentralized redistribution creates incentives for “poor” households to migrate into alternative jurisdictions that provide more generous redistribution schemes, while “rich” households could, in turn, move to areas with minimal tax and transfer schemes (Stigler 1957; Musgrave 1959; Oates 1972). This “voting by feet” phenomenon would make redistribution at subcentral levels of government, or in economic unions with full mobility of labor, self-defeating and unsustainable (Tiebout 1956; Prud’homme 1995). In this case, income inequality within each homogeneous income region might decrease because of in-migration of the poor and out-migration of the rich, but national income inequality would be left unaffected. Because local authorities would be severely constrained in their capacity to alter the existing national income distribution, they would likely not engage in extensive redistribution (Oates 1972). According to this strand of literature, a system of decentralized redistribution should lead to lower levels of redistribution than are socially desirable (Tiebout 1956; Prud’homme 1995). In other words, local government attempts at redistribution through decentralization would be both too little and ineffective at altering the national income distribution. Therefore, less redistribution and more inequality should be expected when redistributive policies are decentralized.

The “second generation of fiscal federalism” challenged this claim. McKinnon (1995, 1997) and Qian and Weingast (1997) suggest that jurisdictional competition triggered by comprehensive decentralization, including varying degrees of welfare provision, could be more effective in reducing regional inequality than centrally mandated redistribution. Local governments of poorer regions could take advantage of less generous welfare provisions and lower taxes to attract investment and increase growth (McKinnon 1997). The resulting factor movements could therefore reduce regional income differentials, which would also lower income inequality on a national basis. Transfers from central to subcentral governments are also highlighted in the second generation literature as a potential source of distortions in the spending priorities of recipient governments. Transfer dependency could hinder the adjustment and convergence processes where reliance on own-source revenue would otherwise induce equalization.

Padovano (2007) presents a political economy model in which redistribution is more efficiently carried out by subcentral entities. In this model, regions must finance redistributive policies with own resources in decentralized fiscal systems. In contrast, centralized redistribution allows regions to access revenues from other regions, which produces distortions that impede the relocation of factors of production that would normally lead to long-term income convergence. Because these forces more than offset the initial direction of redistribution, Padovano (2007, 42) concludes that “centralizing income redistribution, rather than being a means to reduce income inequalities of less developed regions, tends to perpetuate the very problems that it is meant to solve.” Using the cases of Italy and the United States, his contribution provides suggestive evidence that centralized systems may lead to “more” redistribution, while decentralized systems achieve greater effective incidence and stability of redistributive flows. In sum, the second-generation authors maintain that broad fiscal decentralization, encompassing redistribution, is likely to achieve more income equality when it is financed primarily by own revenues.

Empirical work examining the effects of fiscal decentralization on income inequality has generally shown a conditional negative relationship between income inequality and fiscal decentralization. For example, Sepulveda and Martinez-Vazquez (2011) test the relationship between decentralization and inequality using five-year-averages over the 1971–2000 period for a sample of 56 countries. Measuring fiscal decentralization as the share of subnational expenditure in total government expenditures, they estimate the effect of fiscal decentralization on income inequality conditional on the size of government, with findings suggesting that fiscal decentralization reduces income inequality, conditional on the general government representing at least 20 percent of the economy.

Other related empirical work examines the effect of decentralization on inequality within regions. Tselios and others (2012) investigate this relationship using a panel of 102 European Union regions for the 1995–2000 period. They find that greater fiscal decentralization, proxied by the subnational share in total government expenditure, reduces regional inequality. This effect, however, declines with rising levels of regional per capita income. Lessmann (2012) examines the impact of decentralization on inequality within regions using a panel of 54 developed and developing countries from 1980 to 2009. The general findings are consistent with those of Tselios and others, suggesting that fiscal decentralization, measured either through the degree of “vertical imbalance” (Eyraud and Lusinyan 2013; Aldasoro and Seiferling 2014) or subcentral shares of overall expenditure, revenue, or taxes, tends to decrease regional inequality contingent on regional development. In other words, decentralization increases inequality at low levels of development.

All of the above empirical work constructs decentralization ratios covering either aggregate expenditure or revenue, but not both. Such measures may be too broad to capture the channels through which decentralization affects inequality. If decentralization can help reduce income inequality, for example, does it matter whether subnational governments are given greater responsibility over health care or defense? Does redistributive expenditure decentralization have a separate relationship from the decentralization of total expenditure with income inequality? The remainder of this chapter provides some initial empirical evidence regarding the relationship between decentralization of redistributive expenditure subaggregates, progressive revenues, transfer dependency, and income inequality.

What do the Data Tell US?

Income Inequality

Over the past 40 years, income inequality has undergone significant dynamic and cross-regional changes in several parts of the world. Figure 17.1 shows annual Gini coefficient averages for post-tax-and-transfer income by regional country groups for 150 countries.1 Despite significant changes in average Gini coefficients over time in some regions or country groups, differences in disposable income inequality across regions tend to exceed variation within country groups over time.2

Figure 17.1Average Gini Coefficients by Country Group, 1970–2010

Sources: Bastagli, Coady, and Gupta (2012); and World Bank, World Development Indicators.

Note: CIS = Commonwealth of Independent States.

Although variation within these regional groupings exists, income inequality appears to be somewhat clustered over time.3 Latin America and the Caribbean countries have, on average, consistently experienced the highest levels of income inequality, with Gini coefficients ranging around the 0.5 mark since the early 1980s. Since the early 2000s, income inequality reductions seem to have been following a progressive trend. Sub-Saharan Africa, the second most unequal region, closely followed the dynamic path of Latin American and the Caribbean in the 1980s, but average inequality began a gradual downward trend beginning in the early 1990s. Moving to the other end of the y-axis, the income distribution in advanced economies has consistently been, on average, the most equal, but has also experienced a slow trend toward more inequality since the 1980s, with Gini coefficients increasing from an average of 0.27 to more than 0.3 in the early 2000s.

Some of these dynamics may be attributable to movement along the Kuznets curve (Kuznets 1955), where rising inequality in many emerging market regions could be viewed as a side effect of the high economic growth experienced during a period of market liberalization. For example, average Gini coefficients rose steadily in developing Asia during periods of high growth. A sharp increase in income inequality also occurred in the countries of the former Soviet Union and emerging Europe following the breakup of the Soviet Union. Average Gini coefficients in the Commonwealth of Independent States have, however, decreased since reaching a peak above 0.38 in 1996, but they continue to rise in emerging Europe.

As noted, much of the observed differences in inequality between regions from Figure 17.1 can be explained by the level and progressivity of a country’s redistributive systems (see Bastagli, Coady, and Gupta 2012). For example, while the generous tax and transfer system reduced the average Gini coefficient in 15 European countries by about 15 percentage points in the mid-2000s, government redistribution in six Latin American countries achieved only a 2 percentage point reduction (Goñi, López, and Servén 2008). Given the significant role of the volume and effectiveness of government redistribution in explaining variation in income inequality, it is important to consider who holds fiscal authority over these redistributive functions.

Fiscal Decentralization and Transfer Dependency

For the majority of countries, a reduction in inequality of market income is achieved mainly through the expenditure side of the budget. Not all government expenditures are equally redistributive or decentralized, so it may be helpful to divide these expenditures into functions. On the revenue side, progressive tax structures—in particular, income taxes—should be expected to play a significant role in shaping the income distribution. As noted, the degree to which such redistributive spending is financed by own-source revenues or intergovernmental transfers may also be an important factor in determining any potential effects on income inequality.

Decentralized Redistributive Expenditure

Government spending usually leads to redistribution, but certain government activities have more pronounced or explicit redistributive roles and achieve higher levels of income redistribution. The assignment of these functions to different levels of government is what fiscal federalism theories saw as crucial in triggering factor movements, which would be key in determining income inequality. Decentralization ratios do not imply that subcentral governments have full autonomy over the entirety of their spending share given that a significant amount of state and local expenditure can still be mandated by higher levels of government and can thus be constrained by central government legislation or directives. However, it has been shown that even devolving the administrative responsibility for redistributive programs to subcentral levels of government creates substantial within-country differences in the efficiency and generosity of welfare systems (Padovano 2007).

Non-means-tested and means-tested cash transfers make up the majority of redistribution across countries. However, in-kind transfers have also been shown to significantly decrease inequality, with health and education achieving almost all of the redistributive impact. The Classification of Functions of Government (COFOG) data contained in the IMF Government Finance Statistics Yearbook (GFSY) provide the necessary disaggregation of expenditure to isolate these spending categories. COFOG classifies government outlays into 10 divisions.4 Among these, social protection, health, and education correspond closely to the types of redistributive expenditure.

To measure expenditure decentralization, this analysis constructs an index of decentralization (γ) for each area of functional expenditure j by calculating the share of subcentral, that is, state and local, government expenditure as a percentage of total government expenditure in country i in year t.5 The index can range from 0 (decentralization does not exist or there are no state and local governments) to 1 (all expenditure is executed by state and local governments).

An additional index of decentralization is also calculated for total expenditure and redistributive spending (the sum of the three selected COFOG areas). Cross-country averages for decentralization of total and redistributive expenditure are depicted in Figure 17.2. Although the two measures generally appear to have moved in parallel during the past 40 years, substantial differences of up to 40 percentage points exist within this sample of countries, suggesting that decentralization of total expenditure can be quite different from decentralization of redistributive expenditure.

Figure 17.2Average Decentralization Ratio of Total and Redistributive Expenditure, 1972–2010

Source: IMF, Government Finance Statistics Yearbook (1972–2011).

Note: Based on a maximum sample size of 59 countries. Decentralization ratios range from 0 (no decentralization) to 1 (full decentralization).

A more detailed breakdown of decentralization and government expenditure is shown in Figure 17.3, which depicts the extent of, and correlation between, decentralization ratios for eight categories of functional expenditure.6 Areas such as public services, public order and safety, and social protection tend to be highly centralized (clustered around 0), but a much larger degree of decentralization can be observed in economic affairs, housing, health, education, and recreation and culture. There also appears to be a positive correlation between all areas of functional expenditure, however, a significant variance exists around them suggesting a potential loss of information from aggregation. For example, some degree of positive correlation is discernible for the redistributive categories of social protection, education, and health, but the decentralization ratios do not appear to form a single underlying dimension.

Figure 17.3The Composition and Correlation of Decentralized Government Expenditure

Source: IMF, Government Finance Statistics Yearbook (1972–2012).

Note: Sample of 77 countries. Decentralization ratios range from 0 (highly centralized) to 1 (highly decentralized). Each data point corresponds to one country in one year.

Isolating redistributive spending categories, Figure 17.4 shows dynamic trends in average decentralization ratios during the period 1976–2010.7 The general trend suggests that these functions have become more centralized since the 1970s, with some interesting movement in the late 1990s and early 2000s. Until the late 1980s, the majority of education spending occurred at the subnational level—decentralization ratios frequently exceeded 50 percent. However, the degree of decentralization in education spending exhibits a downward trend, most recently seen since the mid-2000s. The cross-country average decentralization ratio has also fallen for health expenditure, with about 38 percent of spending taking place at the subnational level in 1999 falling to about 26 percent in 2010. Social protection expenditure appears to have a relatively stable and highly centralized history for the entire 1976–2010 period. Finally, the solid line in Figure 17.4 shows the aggregate measure of decentralization for the three redistributive spending areas; it has, on average, ranged between 20 and 30 percent since the 1970s.

Figure 17.4Evolution of Average Decentralization Ratio by Redistributive Function

Source: IMF, Government Finance Statistics Yearbook (1976–2011).

The higher average degree of decentralization in health and education spending compared with social protection can also be interpreted as a reflection of the fiscal federalism theory: these two areas—while also contributing to an equitable income distribution—contain a mixture of local and national public goods, and should therefore involve subnational government participation.

Transfer Dependency and Decentralized Redistributive Revenue

Transfers to subnational government are frequently designed to perform an equalizing role and reduce differences in fiscal capacity across jurisdictions (OECD 2009b) but can also reduce their policy autonomy. As noted, second-generation fiscal federalism advocates decentralized redistribution in a setting of jurisdictional competition that is financed primarily by own-source revenues as opposed to intergovernmental transfers (Qian and Weingast 1997; Padovano 2007). Following this line of argument, this analysis measures the extent to which state and local governments rely on transfers from other government units to fund their redistributive and other expenditures.

The GFSY database provides information on “grants from other general government units” for all subsectors of general government, allowing an indicator of transfer dependency to be constructed. Transfer dependency is calculated as the share of total subnational expenditure (expitLG+expitSG) that is financed by transfers from other levels of government (grantrevitLG+grantrevitSG):

An additional important ingredient on the revenue side is the progressivity of the tax system. For theoretical and empirical reasons, an analysis of decentralized redistribution and its impact on inequality should also consider redistributive revenues—in particular, progressive taxation—raised by government. As the main counterpart of transfers, tax revenues are as much a part of the motivation for household and factor mobility in the theoretical models of both generations of fiscal federalism as the transfers and public services that they help to finance.

Income taxes generally achieve the greatest amount of redistribution (Bastagli, Coady, and Gupta 2012). Given their important role, this analysis calculates an index of income tax decentralization using the GFSY revenue category “taxes on income, profits and capital gains” broken down by subsector (central, state, local).8 Similar to the spending decentralization ratios, this index is calculated as local and state income tax revenue (inctaxitLG+inctaxitSG) relative to total income tax revenue (inctaxitCG+inctaxitLG+inctaxitSG):

Figure 17.5 plots average movements in the transfer dependency and income tax decentralization indices. Since the mid- to late 1990s, subnational governments’ reliance on intergovernmental transfers has steadily increased, reaching about half of their total expenditure by 2010. Average expenditure decentralization remained relatively constant during the same period, suggesting a relative increase of transfers in the revenue mix of state and local governments. Rising transfer dependency is accompanied by falling shares in income tax revenues since the early 2000s. Income taxes appear to have become less important revenue sources for subnational governments.

Figure 17.5Average Transfer Dependency and Average Income Tax Decentralization Ratios, 1990–2011

Source: IMF, Government Finance Statistics Yearbook (1990–2011).

Note: Figures are based on a maximum sample size of 62 for transfer dependency and 68 for income tax decentralization. “Transfer dependency” measures the share of state and local government expenditure financed from transfers from other levels of government. “Income tax decentralization ratio” measures the share of state and local income tax revenue relative to total income tax revenue.

Estimation

Building on past findings, this analysis estimates the impact of decentralized redistributive expenditure on income inequality using equation (17.4):

in which

αi are country fixed effects.

γj,it is the decentralization ratio for functional expenditure on j (social protection, health, education, aggregate redistributive spending) in country i at time t.

sizeit is the size of the general government in country i at time t, measured as general government expenditures as a percentage of GDP.

trans_depit is subnational government transfer dependency for country i at time t.

inctax_decit is income tax decentralization for country i at time t.

Following theoretical expectations and past specifications, X is a matrix containing GDP per capita (log) and openness (exports plus imports as a percentage of GDP); and δk (k = 1,…,4) and β are unknown parameters to be estimated.9 A “baseline” specification from past literature is also estimated using γj,it in which j = total government expenditure. Table 17.1 shows summary statistics and sources of Gini coefficients and independent variables. Table 17.2 lists the countries included in the sample.

Table 17.1Summary Statistics of Gini Coefficients and Independent Variables
VariableObservationsMeanStandard DeviationMinimumMaximumSource
Gini Coefficient6020.320.080.200.67Bastagli, Coady, and Gupta (2012); World Bank WDI
Decentralization Ratio,5770.140.1300.96Computed from
Social ProtectionIMF GFSY
Decentralization Ratio,5770.510.2800.96Computed from
EducationIMF GFSY
Decentralization Ratio,5690.340.3300.98Computed from
HealthIMF GFSY
Decentralization Ratio,5690.270.1800.75Computed from
RedistributiveIMF GFSY
Expenditure
Decentralization Ratio, Total6020.280.1400.62Computed from
ExpenditureIMF GFSY
Transfer Dependency6020.390.1800.79Computed from IMF GFSY
Income Tax Decentralization6020.280.2601.00Computed from
RatioIMF GFSY
GDP per capita (log)6029.441.156.3111.46IMF IFS
Size of General Government6020.410.100.120.64Computed from
(% of GDP)IMF GFSY
Openness Ratio6020.870.390.212.79World Bank WDI
Source: Authors’ calculations.Note: GFSY = Government Finance Statistics Yearbook; IFS = International Finance Statistics; WDI = World Development Indicators.
Table 17.2List of Countries
Country GroupCountries
Advanced EconomiesAustralia, Austria, Belgium, Canada, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Ireland, Israel, Italy, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, United Kingdom, United States
Emerging and Developing EconomiesBelarus, Bhutan, Bolivia, Bulgaria, Egypt, El Salvador, Georgia, Hungary, Iran, Kazakhstan, Latvia, Maldives, Moldova, Poland, Romania, Russia, Serbia, Seychelles, South Africa, Thailand, Turkey, Ukraine

Because of serial correlation and the unbalanced nature of the panel, the analysis uses the estimator proposed by Baltagi and Wu (1999) in which the disturbance term εit in equation (17.4) follows a stationary AR(1) process (εit = ρεi,t−1 + υit) in which |ρ|<1,ɛit(0,σu2/(1ρ2)),vitN(0,σu2), and cov(α, uit) = 0. This estimator is a modification of the Prais-Winsten transformation, which accounts for the unbalanced nature of the panel.10 This analysis also deviates from the standard approach by focusing exclusively on within-country effects.

This exercise focuses on within-country effects for three reasons. First, because the theoretical literature is based on within-country income distributions, changes in national income distribution as they relate to within-country circumstance are at the core of the examination. Second, focusing on the relationship between fiscal decentralization and income inequality over time, the relatively large static cross-country variance in Gini coefficients, and difficulty in explaining this variance, makes the parametric results potentially misleading. Isolating the estimates to within-country effects avoids any ecological fallacy (Simpson’s paradox) problems—especially in the presence of omitted variable bias. Third, country-constant information that is important in cross-country analysis (region, federal or nonfederal structure of government, culture, and so on) can be ignored because it is captured by country fixed effects. This allows the number of explanatory factors to be contained to a small subset of what is necessary to correctly specify a cross-country equation.

A potential reverse causality argument may also be present, stemming from the seminal work of Meltzer and Richard (1981). Meltzer and Richard’s results indicate that the size of government, or level of government redistribution, within a country is a function of the distance between mean and median income (income inequality) within that country. In contrast to Meltzer and Richard’s model, this chapter’s specification focuses on net and not gross inequality. Reverse causality between Gini coefficients of post-tax-and-transfer income and the size of government should not pose a concern because this measure nets out government income redistribution. Although it is difficult to provide clearer insight into causality using lags or Granger causality tests, with slow-moving series (income inequality and size of government) we run a series of government size lagged specifications (one, two, and three period) and still cautiously report parametric results as correlative.

A related reverse causality issue concerns the type of inequality found in an economy and the degree of decentralization of redistribution. One might argue along the lines of Beramendi (2007) that preferences for decentralization of redistribution are a function of the degree of regional inequality within a country. The specification employed in this chapter focuses on national inequality and not regional inequality, so reverse causality of this form seems less likely.

Results

The results in Table 17.3 show estimates from five specifications. The first column of results breaks down the decentralization of redistributive expenditures into three categories (education, health, social protection). The second and third columns of Table 17.3 show estimates from an aggregate redistributive decentralization measure for a full sample and subsample of countries (those with at least 10 years of observations). The fourth and fifth columns of Table 17.3 show estimates from an aggregate expenditure decentralization measure for a full sample and subsample of countries (those with at least 10 years of observations).

Table 17.3Econometric Results
IncomeIncomeIncomeIncomeIncome
InequalityInequalityInequalityInequalityInequality
Variables(1)(2)(3)(4)(5)
Income Tax Decentralization Ratio0.023*0.023*0.042**0.0140.033**
(0.014)(0.014)(0.016)(0.014)(0.016)
Size0.253**«0.292***0.409***0.332***0.414***
(0.097)(0.097)(0.109)(0.097)(0.118)
Size Squared−0.278**−0.267**−0.393***−0.267**−0.338***
(0.113)(0.113)(0.124)(0.109)(0.129)
GDP per Capita (log)0.015***0.015***0.014***0.014***0.014***
(0.003)(0.003)(0.003)(0.003)(0.003)
Openness0.017**0.015*0.021**0.0120.020**
(0.008)(0.008)(0.009)(0.008)(0.009)
Transfer Dependency0.031**0.025*0.026*0.025**0.026*
(0.013)(0.013)(0.015)(0.012)(0.014)
Ratio, Health−0.012
(0.008)
Ratio, Education0.010
(0.012)
Ratio, Social Protection0.006
(0.026)
Ratio, Redistribution0.108*0.116
(0.063)(0.077)
Ratio, Redistribution Squared−0.074−0.062
(0.084)(0.112)
Ratio, Redistribution X Size−0.222**−0.283**
(0.110)(0.119)
Ratio, Total Expenditure0.326***0.381***
(0.117)(0.134)
Ratio, Total Expenditure Squared−0.288*−0.347**
(0.156)(0.171)
Ratio, Total Expenditure X Size−0.374***−0.473***
(0.140)(0.164)
Country Sample4848274827
Sample Size521521416554430
p(AR(1))0.720.710.640.770.73
R2 (within)0.200.210.310.340.43
Source: Authors’ calculations.Note: Standard errors in parentheses. Column 1: decentralization ratios for three redistributive expenditure categories (health, education, social protection), full sample. Column 2: decentralization ratio for redistributive expenditure, full sample. Column 3: decentralization ratio for redistributive expenditure, subsample of countries with at least 10 years of observations. Column 4: decentralization ratio of aggregate expenditure, full sample. Column 5: decentralization ratio of aggregate expenditure, subsample of countries with at least 10 years of observations.* p <.10; ** p < .05; *** p < .01.

These results are largely consistent with past findings. GDP per capita and relative economic openness have a significant and robust relationship with income inequality (log-linear for GDP per capita). This finding is consistent with a complex and well-developed history on the relationship between economic growth and income inequality (see, for example, Persson and Tabellini 1994; Barro 2000, 2008).

With respect to the variables of interest, despite a battery of specifications, there appears to be no significant relationship between redistributive expenditure and income inequality for any of the redistributive spending categories (see the first column of results in Table 17.3). There does appear to be a significant relationship between income inequality and both aggregate redis-tributive and total expenditure. This finding is also robust to the inclusion of a time trend (not reported). It suggests that expenditure decentralization can have a significant effect on income inequality only when aggregate expenditure rather than a select area of expenditure is decentralized. It is clear from Figure 17.3 that some areas are more likely targets for decentralization, but an aggregate increase (regardless of its dispersion) is the only way to achieve greater income equality.

Taking the first derivative of equation (17.4) with respect to the measure of expenditure decentralization breaks the marginal effect of fiscal decentralization down into the following:

In equation (17.5), from Table 17.3, δ1 is consistently positive, while δ5 and δ2 are consistently negative, and γj* (from equation (17.5)) is the threshold at which the quadratic effect of decentralization begins to negatively affect income inequality.

Because of the significant interaction between the size of general government and degrees of decentralization, the relationship with income inequality is mutually dependent. Figure 17.6 plots this relationship with fiscal decentralization (redistributive and total expenditure) on the x-axis and predicted Gini coefficient from equation (17.4) on the y-axis. This relationship is plotted for three discrete levels of government size (20 percent, 30 percent, and 40 percent of GDP). As the estimates from Table 17.3 suggest, the effect of decentralization of redistributive expenditure has a significantly softer slope than that of total expenditure.

Figure 17.6Decentralized Expenditure, Income Inequality, and the Size of General Government

Source: Authors’ calculations.

Note: Size refers to general government expenditure as a percentage of GDP. Predicted effect holds all other control variables at their mean values.

Looking more closely at the continuous effect of government expansion (measured as total general government expenditure as a percentage of GDP), the results are relatively consistent with those of Sepulveda and Martinez-Vazquez (2011). Again, taking the first derivative of equation (17.4), the marginal effect of a change in government size can be shown as in equation (17.6):

in which, from Table 17.3, δ3 is positive, and δ4 and δ5 are both negative. As in Sepulveda and Martinez-Vazquez 2011, the marginal effect of government expansion on income inequality is positive at low levels; however, it significantly decreases income inequality once past a threshold (where size = (δ3+δ5γj)2δ4). The magnitude of this effect, and location of the threshold, is dependent on what proportion of an increase in general government is at the subnational level γj. For example, plugging the results from column three of Table 17.3 into equation (17.6) gives size* = 0.51 – 0.36γj implying that, for a fully decentralized government (γj = 1), this “threshold” government size is 15 percent of GDP, whereas for a fully centralized government, the threshold is 51 percent.

Figure 17.7 illustrates this dependence, plotting the predicted relationship between income inequality and the size of general government for three fixed levels of decentralization (as measured by decentralization ratios of 30, 50, and 70 percent).

Figure 17.7Decentralized Redistribution and Size of General Government

Source: Authors’ calculations.

Note: DR = decentralization ratio. Size refers to general government expenditure as a percentage of GDP. Predicted effect holds all other control variables at their mean values.

Consistent with the expectations of Padovano (2007) and Qian and Weingast (1997), transfer dependency also appears to have a significant relationship with income inequality. Where subcentral revenues are less dependent on intergovernmental transfers, lower levels of income inequality within countries should be expected. This result is fairly robust across specifications. Figure 17.8 plots this relationship with transfer dependency on the x-axis (0 = no transfer dependency; 1 = full transfer dependency).

Figure 17.8Income Inequality and Transfer Dependency

Source: Authors’ calculations.

Note: Predicted effect holds all other variables at their mean values.

At the same time, Table 17.3 shows that income tax decentralization is associated with higher inequality in this sample. Although it is not significant in all specifications, this result suggests that although own revenue sources for subnational governments are important, they need to be chosen with care. In view of income inequality, income taxes may not be the best choice.

These empirical results are generally consistent with past analytical work, and with the second generation of fiscal federalism, regarding the relationship between income inequality and fiscal decentralization. The results provide further evidence that the effect of an expansion of government on income inequality depends on the extent to which the expansion takes place at the subnational level. The analysis also confirms past approaches that measure redistribution at the aggregate level. If only selected expenditures are decentralized, without any increase in total decentralization, the results suggest that income inequality will be unaffected. Consistent with the second-generation literature of fiscal federalism, the extent to which subnational governments are more dependent on transfers from other government levels appears to have a negative effect on income inequality within countries. These results should be interpreted carefully as interesting correlations that require further work on a micro level to validate the path of causation. For instance, a high degree of transfer dependency might also be the result of inequality and regional disparities. Central governments might increase transfers to relatively poor jurisdictions to enable them to provide a more adequate amount of local public goods.

Conclusion

The purpose of this chapter is to empirically test the relationship between fiscal decentralization and income inequality within countries. Past research on interregional income inequality and fiscal decentralization suggests that the two should be related, particularly when government redistribution is decentralized and subnational governments are not highly dependent on transfers to finance their expenditures. The macro-level results in this chapter lend support to these findings, as well as to the tenets of the second generation of fiscal federalism, which recommends redistribution in a setting of comprehensive fiscal decentralization in which subnational governments have sufficient access to own resources (as opposed to transfers).

The decentralization of specific categories of redistributive spending appears to have no significant impact on income inequality, suggesting that decentralization should occur on an aggregate level to reduce income inequality. A significant quadratic relationship only emerges once we move to a higher level of aggregation by jointly considering all redistributive, or total, spending items. In all cases, the effect of expenditure decentralization is also contingent on the total size of government, consistent with evidence in past empirical literature.

The degree to which subnational governments rely on grants from other government levels to finance their expenditure is an important mediating factor: other things being equal, income inequality is more pronounced when transfer dependency is high. However, decentralization of redistribution on the revenue side of the budget, measured by the subnational share of income tax revenues, is found to increase rather than decrease inequality. This, in turn, reflects expectations from the first-generation fiscal federalism literature more so than from the second.

In sum, the decentralization of government expenditure can help achieve a more equal distribution of income. However, several conditions need to be fulfilled. First, the government sector needs to be sufficiently large. Second, decentralization should be comprehensive, including redistributive government spending. Given the softer slope associated with decentralizing redistributive expenditure, such expenditure may be a good target for an initial move toward greater decentralization. Third, decentralization on the expenditure side should be accompanied by adequate decentralization on the revenue side, so that subnational governments rely primarily on their own revenue sources as opposed to intergovernmental transfers. Fourth, when assigning revenue sources to subnational governments, preference should be given to revenue categories that do not have strong redistributive implications. Given limited empirical work in this area and growing interest in achieving inclusive growth, further evidence and qualitative case studies would be beneficial to clarify policy conclusions for achieving a more equal income distribution.

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Income inequality data are based on disposable income where possible, and are otherwise based on consumption or expenditure. Posttax Gini coefficient data are obtained from Bastagli, Coady, and Gupta 2012, covering 150 advanced and developing economies drawing data from five data sources: European Union Statistics on Income and Living Conditions; Luxembourg Income Study; Organisation for Economic Co-operation and Development; Socio-Economic Database for Latin America and the Caribbean; and the World Bank World Development Indicators. Country groups are defined following the classification of the IMF World Economic Outlook.

Because of a small number of missing observations for some country-years and the slow-moving nature of income inequality over short periods, missing values for a small group of countries with sufficient data are linearly interpolated to derive meaningful estimates. This approach appears to be justified because the degree of income inequality as measured by the Gini coefficient typically evolves slowly and steadily over time, which is also reflected in the available data. Linear interpolation is a cautious approach because it assumes that Gini coefficients do not fluctuate beyond the range defined by the given data points. The extent of variation in income inequality will thus be understated because of the interpolation.

Standard deviations within regional groupings are as follows: Latin America and the Caribbean = 0.06; sub-Saharan Africa = 0.08; Middle East and North Africa = 0.04; developing Asia = 0.06; Commonwealth of Independent States = 0.05; advanced economies = 0.04; emerging Europe = 0.05.

The 10 divisions are general public services; defense; public order and safety; economic affairs; environmental protection; housing and community amenities; health; recreation, culture, and religion; education; and social protection.

This is computed using consolidated general government in the denominator for total expenditure. In the case of functional expenditures, the analysis is run on both consolidated and unconsolidated data to maximize the number of observations. Although local and state governments in the numerator cannot be consolidated, transfers between these levels of government are not likely to be extensive and, in most countries, a state government subsector does not exist. Data source is Government Finance Statistics Yearbook.

Defense, which is very highly centralized in all countries, is excluded, as is environmental protection because of the small sample of data for this category.

The figure is based on 65 advanced, emerging, and developing economies in which a local government level or a local and state government level exist in addition to the central government, thus excluding completely centralized countries for which decentralization ratios are always equal to zero. For most countries, data are not available for all years.

Under the Government Finance Statistics (GFS) classification, taxes are attributed to the government unit that “(i) exercises the authority to impose the tax…; and (ii) has final discretion to set and vary the rate of the tax” (IMF 2014, 90). Consequently, income tax revenues that are collected by state and local governments under tax-sharing arrangements, where they have no authority to impose the tax or vary its rate, should not be classified as tax revenue under GFS. Such revenues should be recorded as current grants. Thus, the income tax decentralization ratio is a useful measure for subnational engagement in income redistribution through taxation.

GDP per capita and data on exports and imports are taken from the World Bank’s World Development Indicators. General government expenditure is taken from the IMF GFSY.

For balanced panels this is equivalent to the Prais-Winsten transformation.

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