the effects of economic and political integration on fiscal decentralization: evidence from oecd...

The Effects of Economic and Political Integration on Fiscal Decentralization: Evidence fromOECD CountriesAuthor(s): Dan StegarescuSource: The Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 42, No. 2(May, 2009), pp. 694-718Published by: Wiley on behalf of the Canadian Economics AssociationStable URL: http://www.jstor.org/stable/25478368 .

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The effects of economic and political

integration on fiscal decentralization:

evidence from OECD countries

Dan Stegarescu Economics Department, Deutsche Bundesbank

Abstract. This paper examines the impact of economic and political integration on the

vertical government structure. It argues that, by increasing the market size and the bene

fits of decentralized provision of public goods, integration triggered the recent process of decentralization in OECD countries. A panel analysis relates the degree of fiscal decen tralization to economic and European integration, controlling for interregional hetero

geneity, economies of scale, and institutions. The results mostly support a decentralizing effect of economic integration in general and of European integration in particular for het

erogeneous EU countries, whereas participation of subnational governments in national

decision-making is associated with more centralization. JEL classification: F15, H72, H77

Les effets de Tintegration economique et sociale sur la decentralisation fiscale : resultats

pour les pays de TOCDE. Ce texte examine l'impact de Tintegration politique et sociale

sur la structure verticale de gouvernement. On suggere que, en accroissant la taille du

marche et les avantages d'une fourniture decentralisee de biens publics, Tintegration a

declenche le recent processus de decentralisation dans les pays de TOCDE. Une anal

yse de panel relie le degre de decentralisation fiscale au degre d'integration economique et europeenne, en normalisant pour tenir compte de Theterogeneite interregional, des

economies d'echelle, et des institutions. Les resultats supportent l'effet de decentralisation

de Tintegration economique en general, et de Tintegration europeenne en particulier pour

les pays heterogenes de TUnion europeenne, alors que la participation des gouvernements

sub-nationaux a la prise de decision est associee a une plus grande centralisation.

The views expressed in this paper are those of the author and do not necessarily reflect those of

the Deutsche Bundesbank. Support from the Priority Programme 'Institutional Design of

Federal Systems: Theory and Empirical Evidence' (SPP 1142) of the German Research

Foundation (DFG) is gratefully acknowledged. I would also like to thank especially Thiess

Buettner and Robert Schwager, as well as Gebhard Kirchgassner and other participants at the

27th Annual Meeting of the Canadian Economics Association in Ottawa, May 2003, and two

anonymous referees for thorough and helpful comments. Email: [email protected]

Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 42, No. 2

May / mai 2009. Printed in Canada / Imprime au Canada

0008-4085 / 09 / 694-718 / ? Canadian Economics Association



Effects of economic and political integration 695

1. Introduction

Since the 1970s, and especially during the last decade in several industrial and

developing countries, the public sector has undergone a process of decentral

ization, while, at the same time, integration of the world economy has rapidly

progressed (World Bank 2000). The intensification of the separatist movement

in Quebec, particularly after the creation of NAFTA, as well as increasing de mands for regional autonomy, and even secession, in Spain, Belgium, Italy, and

the UK in the course of European integration seem to support a causal rela

tionship between those two major trends in certain countries. In the European Union, national governments have transferred powers both to a supranational authority and to local and regional governments and are expected to be pushed back further ('Sandwich' hypothesis; see Zimmermann 1990).l

While explaining cross-country differences in vertical government structures, the theory of fiscal federalism in the tradition of Oates (1972) fails to give an

adequate explanation of recent decentralization trends. Inspired by the spread of

separatism, a large political economy literature (e.g., Alesina and Spolaore 1997) explores the creation and disintegration of countries, showing that the size of the

country is determined by the trade-off between economies of scale and costs of

preference heterogeneity, with majority decisions in democracies favouring seces sion. By reducing political and economic transaction costs, economic integration extends the size of the market and lowers the benefits of large jurisdictions, thus further enhancing incentives to separation.2

However, changes in national borders imply high separation costs and there fore seldom occur in functioning democracies (e.g., Young 1994). The direct

implications of integration for the vertical government structure have not been

sufficiently investigated by this literature. Bolton and Roland (1997) show that extended regional autonomy is less costly than secession, since it avoids the effi

ciency losses involved. By lowering the relative costs of local provision of public goods, integration may thus enhance public sector decentralization. This pre sumption is further underpinned by the New Economic Geography literature

(Krugman 1991) which demonstrates that integration generates agglomeration and specialization effects at the regional level. Local governments could exploit these benefits by demanding more powers to provide public goods and set taxes in order to compete for internationally mobile factors. Political integration, too,

might contribute to decentralization, since the costs of supplying certain public goods now assigned to the supranational level are reduced. On the other hand, by increasing economic risk and exposure to asymmetric shocks, economic in

tegration could also raise the need for interregional risk-sharing and income redistribution provided by central government.

1 See also Dreze (1991), or Alesina and Spolaore (2003, 2130 2 A survey of this literature is provided by Bolton, Roland, and Spolaore (1996) and Ruta (2005).

See Alesina and Spolaore (2003), Alesina, Spolaore, and Wacziarg (2000), Etro (2006), and Casella and Feinstein (2002) for more recent contributions.



696 D. Stegarescu

So far, there is little empirical evidence concerning the impact of integration on the vertical government structure.3 A few studies tend to support a nega tive relationship between integration and decentralization. Rodrik (1998) finds

a positive effect of economic openness on the size of the public sector, which he

attributes to higher public expenditure for redistribution and macroeconomic sta

bilization due to increased exposure to exogenous shocks. Since these functions

are generally assigned to the central government, one would expect an increase

in its expenditure share. Based on a panel of industrial and developing countries, Garrett and Rodden (2003) show that increased integration is associated with

fiscal centralization. This is broadly explained by a growing demand for interre

gional risk-sharing and central government transfers to prevent the secession of

rich regions. In a cross-section analysis for OECD countries, Verdier and Breen

(2001) demonstrate a positive relationship between financial openness and fis

cal centralization, whereas the interaction with EU structural funds policy has

a negative sign, which is attributed to the substitution for the national insur

ance function. Finally, van Houten (2003) finds no clear evidence that economic

integration had a stimulating effect on regional autonomy movements in the EU.

This paper investigates the impact of economic integration in general and of

political integration in the EU in particular on the vertical government struc

ture. Based on a theoretical framework that illustrates the effects described in

the literature, we test the hypothesis of a positive effect of integration on fiscal

decentralization for a panel of 23 OECD countries from 1965 to 2001, controlling for preference heterogeneity, economies of scale, and institutions. The analysis differs in certain respects from the related work of Garrett and Rodden (2003).

First, the focus is on highly industrialized long-standing democracies. Secondly, we test additionally for the specific effect of political integration concerning EU

countries ('Sandwich' hypothesis) and also take indirect effects of integration conditional on country-specific preference heterogeneity and institutions into

account. Thirdly, we include additional control variables, such as regional dis

parity, electoral and business cycles, and the Cold War. Finally, different measures

of fiscal decentralization are used, among them a new measure that considers ac

tual tax-raising powers of subcentral government. The estimates mostly support a decentralizing effect of economic integration in general, and of European in

tegration in particular for heterogeneous EU countries, whereas participation of

subnational governments in national decision-making is associated with increas

ing centralization.

The paper is organized as follows. In the next section some theoretical consider

ations relating to integration and the vertical government structure are discussed

and the main hypotheses are derived. Section 3 then describes recent develop ments and the investigation approach. Finally, section 4 provides the results of

the empirical analysis, and section 5 draws conclusions.

3 Alesina and Wacziarg (1998), Alesina, Spolaore, and Wacziarg (2000), and Spolaore and

Wacziarg (2005) provide only evidence for the literature on secessions, showing that large countries benefit less from economic integration than small countries.




2. Theoretical considerations

This section elaborates on the theoretical link between economic and political

integration and the degree of fiscal decentralization, with the aim not so much of

contributing to the theoretical discussion, but of formalizing testable empirical

implications of the literature.

2.1. Economic integration and fiscal decentralization

The following approach extends the theoretical framework provided by the liter ature on secessions (Alesina and Spolaore 1997; Alesina, Spolaore, and Wacziarg 2000; Etro 2006) in order to illustrate the conflicting effects of economic integra tion on the vertical government structure.4 Consider a federation with population

N and two regions i of equal size, with different preferences 8t. The local govern ment of each region provides (non-rival) public services gL, for example, infras tructure or school education, in equal amount, yet of different type, according to

local preferences. In contrast, public services supplied by the central government

gc are of uniform type and include national public goods, for example, defence or

foreign affairs, as well as income redistribution and macroeconomic stabilization. The parameter 8t measures the preference distance between the type of central

government services preferred by the region's inhabitants and the type actually provided, assuming that 8\ = ?82 = 8, with 0 < 8 < 1. The degree of fiscal de centralization is then defined as the local government share in total government services provided in each region: 6 =

gL/g, with g = gc + gL.

In order to obtain simple closed-form solutions, the following log-linear utility function is chosen:

Ul=ln(gL)a + ln(gc)'Kl-i) + yi-t, (1)

and, with gL =

Og and gc = (1

? 0)g, correspondingly,

Ui = ln(0gf + ln((l

- 0)gf{-8) + yi

- t. (2)

0 < ct, fi < 1 denotes general preferences for local and central government services. The tax paid is identical and determined by the per capita costs ofthe public ser

vices, / = (gc/N + gL/(N/2)) =g(l + 0)/N.5 In line with the 'Decentralization

4 In a related model, Panizza (1999) analyzes the determinants of fiscal centralization, though without considering the effect of integration.

5 Since local government services are supplied in equal amounts in each region, but regional incomes differ, we rely on a lump-sum tax in order to abstract from redistributive and

distortionary effects of taxation. A more realistic proportional income tax implies instead different local taxes depending on interregional income distribution. In the case of considering different local tax rates, increased integration and factor mobility would induce additional welfare costs in terms of inefficiently low taxes, owing to intensified fiscal competition. See, for

example, Hayashi and Boadway (2001) for empirical evidence on intergovernmental tax interaction.



698 D. Stegarescu

Theorem,' the greater the heterogeneity of preferences 5, the lower the utility from central government services will be. On the other hand, decentralized provision of public services entails higher per capita cost.

The literature on secessions assumes that integration has a general output

increasing effect induced by the market size. Here, the trade-off between in

creased local growth prospects and higher economic vulnerability is illustrated more specifically. On the one hand, preferences for central government services

P are assumed to depend on the degree of integration of the federation in the world economy, co e [0, 1]. By raising economic risk and exposure to asymmetric shocks, integration drives up the need for income redistribution and macroeco

nomic stabilization by the central government (Garrett and Rodden 2003; Rodrik

1998). On the other hand, integration increases regional output, which is linked

here apart from technology Af to a public good: yt = In At (g1) = In At (Ogf. Ac

cording to the traditional trade theory, by extending the market size, economic

integration facilitates economies of scale in the production, consequently rais

ing the productivity of public inputs and fostering economic growth regardless of the size of the jurisdiction.6 In order to formally separate the two conflicting effects of integration, we assume that only local government services serve as pro duction inputs. It is quite evident that certain central government services such as macroeconomic stabilization have a positive impact on income, too. Yet their

marginal utility is expected to diminish vis-a-vis that of local government services

in an integrating world. The New Economic Geography literature demonstrates

that, given interregional differences in factor endowments and technologies, in

tegration induces agglomeration effects, thus increasing the scope for economies

of scale and leading to interregional specialization (e.g., Krugman and Venables

1996).7 Since local factors of location then become more significant compared with national economic conditions, local public goods are expected to play a

major role in the competition for mobile factors.

Inserting for t and yt and differentiating the utility function with respect to g

and#, we obtain

6*= -u ?L+Zl XV S* = y(<*+"

+ 2/i(l-5)). (3) a + co + 2p(l

? 5) 2

The degree of fiscal decentralization increases with preference heterogeneity 5, while total government services decrease. Since local and central government services are complementary, economic integration raises total public output in

6 See Alesina, Spolaore, and Wacziarg (2000, 2005) for recent contributions on the link between

economies of scale and market size. Ades and Glaeser (1999) provide empirical support for a

positive growth effect of the size of the market. Even though most studies confirm a positive link

(e.g., Frankel and Romer 1999), trade might also have negative effects on growth and terms of

trade, particularly for developing countries. Moreover, the growth effect depends on other

factors, too, such as stable domestic institutions (e.g., Rodrik 2007). 7 Giannetti (2002) and Stirbock (2002) find evidence of a causal relationship for European Union

regions.




this special case. By contrast, only if the marginal effect of integration on prefer ences for central government services is relatively small, that is, pM < ft/(a + co), does integration increase the degree of decentralization. Otherwise, the opposite occurs:

e, = 2(1-3)Q3-/U? + q>)) < Q (a+oj + 2p(l-8))2

>

More generally speaking, in open economies, negative effects of decentralization or secession in terms of higher taxes are partly offset by higher benefits from trade. However, despite the significant removal of barriers to international trade, sub-units of a country are still more deeply integrated with each other than with the rest of the world or even with sub-units of neighbouring countries, owing to

cultural, linguistic, or institutional differences (e.g., Helliwell 1996). Therefore, as long as the benefits from risk-sharing (Alesina and Perotti 1998) and central

government services outweigh remaining heterogeneity cost, decentralization al

ways involves lower transaction costs than secession. Apart from involving higher per capita costs of formerly central government services, secession diminishes the benefits of trade, since formerly domestic trade is reduced.8

2.2. Political integration The literature mostly neglects another aspect, which is of particular relevance for the EU: the additional effect of political integration on the vertical government structure of the countries involved. On the one hand, owing to the transfer of

national competencies to a supranational authority this process entails a central

izing effect. On the other hand, demands for devolution of fiscal powers to local and regional governments are likely to intensify, too, provided that preference het

erogeneity is high. According to the 'Sandwich' hypothesis (Zimmermann 1990), national governments run the risk of getting squeezed between the supranational and the subnational levels of government.

Within the theoretical framework presented above, the provision for political integration would have a twofold effect on the degree of decentralization. First, the degree of economic integration co increases, owing to the removal of remaining impediments to trade and factor movements. Second, the costs of decentralization in terms of higher taxes are further reduced, since a certain part of formerly central

government services gc is now provided by the EU on a larger scale. This involves, for instance, the structural and cohesion policy, which replaces the insurance function of national governments to a certain degree. Secession would imply even higher costs, particularly when the seceding regions are excluded from the

political union. Therefore, regional governments in EU countries are supposed

8 In addition to this, without the existence of credible rules for peaceful secession (e.g., Bordignon and Brusco 2001), the costs of separation are further increased, at worst taking the form of armed conflicts.



700 D. Stegarescu

to prefer extended autonomy in order to avoid these efficiency losses and to carry on sharing the costs for those government functions, which remain mainly in the

competency of national governments, such as income redistribution, with the rest

of the nation.

3. Empirical analysis

Based on the theoretical considerations discussed above, we test the hypothesis of a positive effect of economic integration in general and political integration in Europe in particular on fiscal decentralization. The section starts with a de

scription of both trends, fiscal decentralization and integration, among OECD

countries, after which the investigation approach is presented.

3.1. Overview of recent developments The analysis draws on 23 OECD countries, including comparable industrial na

tions with long-standing, well-functioning democratic institutions. This enables us to control in the empirical analysis implicitly for the positive link between

democracy and decentralization (or secession) demonstrated in the literature

and for other common features, such as the level of economic development, and

similar cultural or political traditions. Table 1 compares the degree of fiscal de

centralization at the beginning of the 1970s and the end of the 1990s, reproducing different measures from Stegarescu (2005). Expenditure decentralization (social

security included in (1), or excluded from (2) the government sector) is defined

as the share of total expenditure of subcentral government exclusive of grants re

ceived from central government (self-financed expenditure) in general government

expenditure, based on IMF Government Finance Statistics. Since this measure

commonly used in the literature neglects the distribution of decision-making pow

ers, we rely additionally on a new indicator of tax decentralization (3). This relates

revenue from taxes over which subcentral government has significant control (au tonomous tax revenue) to general government tax revenue, thereby adjusting data

reported by OECD Revenue Statistics for actual tax-raising powers.

During the last three decades, the median degree of fiscal decentralization

rose from 24.9% to 31.2% in terms of self-financed expenditure (excluding social

security) and, even stronger, from 12.1% to 20.8% in terms of tax autonomy.

Though indicating no uniform pattern, this represents an impressive decentral

ization trend in most OECD countries, considering that vertical government structures display significant inertia over time. However, whereas especially in

Belgium and Spain the subcentral government share of public spending and tax

revenue skyrocketed, the development in the UK or Ireland, among others, went

in the opposite direction. Among EU countries, the rise in decentralization has

been stronger in terms of expenditure, whereas for autonomous tax revenues the

cross-national variance increased considerably. Instead, when social security in




TABLE 1 Degree of fiscal decentralization, OECD countries, 1965-2001

Self-financed expenditure Auton. tax revenue

(1) (2) (3) Country 1970-5 1996-2001 1970-5 1996-2001 1965-70 1996-2001

AUS 27.4 31.6 27.4 31.6 19.6' 20.9

AUT 25.2 22.8 34.9 33.8 3.2C' 3.5

BEL 7.7 25.2 10.0 33.8 6.7 24.2

CAN 48.3 53.2 49.6 56.5 51.1 52.4

DEN 29.4 33.5 30.7 36.1 27.4C 31.8

FIN 26.3 29.4 30.3 34.7 23.6 25.3

FRA 10.8 12.1 18.0 21.5 1.1* 19.2

GER 39.7 33.4 59.3 60.2 1.6C 7.3

GRE 3.7 4.8 0.3C 0.2 ICL 17.8 25.1 21.9 30.1 19.2C 24.7

IRL 16.5 6.6 18.1 7.4 12.1 2.3

ITA 7.9 11.7 11.7 17.2 6.0 8.6

JAP 22.9 18.4 28.4 27.6 28.5 36.7

LUX 8.8 10.0 14.3 17.5 10.8 8.3

NED 7.4 8.5 11.6 13.7 2.V 5.1

NEZ 10.4" 10.0 10.4" 10.0 8.6 5.7

NOR 32.7 21.8 42.2 32.7* 31.0C 22.6

POR 3.4 6.6 4.7 9.0 0.0 3.1

SPA 5.4 17.4 8.7 30.8 5.L 20.8

SWE 32.5 30.1 35.8 34.8 32.9 43.7

SWI 49.9 44.0 63.3 62.2 54.4 53.9

UK 19.6 7.2 22.4 19.3* 12.7 4.9

USA 35.7 39.5 42.8 49.9 34.4 36.3

Median:

OECD 213e 22.3e 24.9s 31.2" 12.1 20.8

EU15 13.7e 14.8e 18.1e 26.2e 6.7 8.3

Std.dev.: OECD 13.53e 12.89s 16.1T 15.5V 15.39 15.97

EU15 11.19* 10.12e 14.18e 13.54e 9.87 12.46

NOTES Total expenditure and lending minus repayments of sub-central government, excluding transfers received from other levels of government (indicator ED2), in % of consolidated general government

expenditure, without EU payments: (1) including, (2) excluding social security. (3) Autonomous own tax revenue of sub-central government in % of consolidated general government tax revenue, without social security and EU payments (indicator TD1). Six-year-averages, except a 1978-80, b 1988-90, c 1973-5, </ 1970;? without GRE. Source: Stegarescu (2005).

the government sector (2) is included as part of central government, the average

degree of expenditure decentralization barely changed during this period. Thus, the observed tendency to reallocate certain functions to subcentral government apparently interfered with the growth of the welfare state in OECD countries, both developments possibly being driven by economic integration.

To compare this development in the public sector with economic integration on a global scale, we follow the empirical literature and focus on the degree of



702 D. Stegarescu

TABLE 2 Degree of economic openness and trade with EU countries, 1970-2001

Trade openness (1) Quinn/Inclan index (2) EU trade (3)

Country 1970-5 1996-2001 1970-5 1996-2001 1970-5 1995-2000

AUS 27.8 41.7 0.55 0.82 27.0 17.9 AUT 62.1 92.2 0.71 0.93 63.3 66.5

BEL 90.9 151.6 0.70 0.96 75.0 73.4 CAN 44.8 79.9 0.88 1.00 13.3 7.4 DEN 57.8 73.7 0.65 1.00 66.7 67.8 FIN 52.6 70.3 0.63 1.00 62.0 55.9

FRA 34.8 50.3 0.79 0.93 59.6 63.5 GER 45.4 59.1 0.99 1.00 58.7 55.9 GRE 35.6 50.4 0.32 0.96 56.0 63.1

ICL 81.0 75.4 55.4 60.2 IRL 84.8 161.3 0.60 1.00 76.5 61.9 ITA 34.9 50.7 0.75 1.00 53.6 58.1 JAP 22.2 19.6 0.55 0.79 11.1 15.3

LUX 171.2 241.0 0.70? 0.96* 75.0 77.8 NED 93.8 111.3 0.86 1.00 71.3 69.3

NEZ 48.8 63.2 0.44 0.96 22.4* 17.3 NOR 75.7 74.4 0.54 0.96 71.0 73.2 POR 57.2 69.1 0.32 0.96 53.9 78.0 SPA 29.7 57.0 0.43 0.93 46.9 68.0 SWE 52.8 81.3 0.74 0.93 62.8 61.4 SWI 63.9 75.1 0.88 0.93 70.1 69.2 UK 48.3 56.5 0.59 1.00 41.8 55.0 USA 13.1 24.3 0.90 1.00 26.0 19.6

Median: OECD 52.7 70.3 0.68 0.96 58.7 61.9

Non-EU15 46.8 68.8 0.55 0.96 26.5 18.7

EU15 52.8 70.3 0.70 0.96 62.0 63.5

NOTES (1) sum of exports and imports in % of GDP; (2) index of financial openness, readjusted on a scale of 0-1, a BEL/LUX; (3) sum of exports and imports to/from EU15 countries in % of total foreign trade. Six-year-averages, b 1987.

SOURCE: (1) IMF; (2) Quinn and Inclan (1997), Armingeon, Beyeler, and Menegale (2004); (3) OECD; own calculations.

trade openness (share of exports and imports in GDP (1)) and, alternatively, the

Quinn/Inclan index of financial openness (2), which reflects the degree of fi

nancial openness according to currency, capital, and current account restrictions

(see table 2). With few exceptions, both indicators increased considerably in most

OECD countries. Owing to the Common Market, EU countries report a higher

degree of trade openness; nonetheless, the rise in global integration has been

more pronounced among non-EU countries. Accordingly, on the regional scale, the share of trade with EU countries (3) indicates slightly increasing economic

integration among EU countries and a considerable decline for other OECD




countries. At the same time, political integration in Europe advanced, the share

of EU expenditure as a percentage of total expenditure of the member states

(or percentage of total GDP) nearly doubling since the beginning of the 1970s, from 1.4% (0.5%) to 2.3% (1.1%). However, considering that the European Com

mission is mainly vested with legislative, regulatory, and coordinating powers, the actual level of political integration is strongly underestimated by budgetary

figures (e.g., Alesina, Angeloni, and Schuknecht 2005). The observed simultane

ity of increasing fiscal decentralization and economic integration in a majority of OECD countries therefore underpins a possible causal relationship between those two trends. At the same time, the 'Sandwich' hypothesis seems to be partly endorsed for EU countries. There, the importance of national governments has diminished in the course of EU integration, at least in terms of public expenditure and revenue.

3.2. Investigation approach The empirical investigation relates the degree of fiscal decentralization to eco

nomic and European integration, while costs and benefits of decentralization are

controlled for in terms of preference heterogeneity and economies of scale and for other factors that determine the division of government functions and the de

mand for certain public services provided by central or subcentral governments. In this way, we take into account the fact that changes in the degree of fiscal decentralization as measured by expenditure or revenue shares either are due to

changes in the assignment of functions and tax-raising powers, or are only the result of shifts in the budget shares of certain expenditure and revenue categories.

The hypothesis of a decentralizing effect of integration is tested for the 23 OECD countries covering the period 1965/1970-2001, the panel being unbalanced.

In order to focus on the impact of changes in the degree of integration, the model is estimated with country fixed effects, which depict all time-invariant

country-specific factors, such as area, institutions, traditions, and interregional diversities, or other characteristics that are unobserved or cannot be quantified, thus solving simultaneity problems in the form of omitted-variable bias. In doing so, we concentrate on the factors that are assumed to determine the costs and benefits of decentralization over time. Formally, the basic estimation equation is9

Decit = fa + Pi Cost a + faHeUt + foDi\it + p?Openit

+ psEUIntit + p6(FiXiOpenit) + uit.

9 Year dummies are not included, since we expect countries to be less exposed to common

patterns of spatial correlation than, for example, subnational entities. We also refrain from

considering the lagged degree of decentralization. Owing to inertia of vertical government structures, this variable would explain most of the variation in contemporary decentralization,

providing no additional evidence on the actual underlying factors.



704 D. Stegarescu

Decn denotes the share of subcentral government expenditure (revenue) in con

solidated general government expenditure (revenue) in country / in period t.10 We use both the common measure of expenditure decentralization and the new indi cator of tax decentralization presented in table 1. In this way, differences between

the expenditure and the revenue sides of the public sector, as well as between for

mally own revenues and actual revenue-raising powers, are taken into account.

Social security is excluded from total government expenditure in order to have a comparable delimitation of the government sector, as in case of tax decentral

ization. In addition, by separating a significant part of the insurance function

from other central government functions, we attempt to control for the possible concomitant rise of the welfare state in the wake of increasing integration. Con

sequently, the decentralizing effect of integration is more likely to prevail in this

case.

Openit stands for the degree of integration in the world economy as measured

by the indicators trade and financial openness presented in table 2. The preferred indicator, the share of exports and imports in GDP, captures the market-size ef

fect described above, whereas the second indicator accounts for other facets of

economic integration. To separate the effects, integration in the world economy and political integration are included simultaneously in the regression. As already

noted, integration might have fostered in EU countries both decentralization and

the transfer of powers to the European level. EU Integration (EUIntit) is taken

into account by different indicators: in order to capture the general impact of

joining the EU as well as of progressing political integration, a dummy variable

for EU membership is interacted with the share of EU expenditure in consoli

dated public expenditure of all member countries (EU EUexp.). This variable

addresses most appropriately the 'Sandwich' hypothesis, referring to the 15 EU

countries in the sample. Two alternative indicators check instead for different

degrees of political and economic integration in the EU of both member and

non-member countries. Accordingly, an index of political integration takes into

account that certain member (e.g., UK) but also non-member (e.g., Norway) countries participated to a different extent in the economic and institutional

structures of the EU in the course of time. The share of trade with EU coun

tries in total foreign trade (EU trade) finally indicates economic integration of

each OECD country with the EU. Since we cannot separately estimate the effects

of country-specific institutions and preference heterogeneity, which are mostly time-invariant and therefore represented by p^, we interact these characteristics

with the degree of integration (FiXiOpenit) and ask whether integration has an

indirect effect conditional on them.

In order to control for the cost of decentralization in terms of economies of

scale and spillovers (Costit), we include the size of the country in terms of popu

lation, and the spatial allocation of the population, as measured by the degree of

urbanization. In line with the empirical literature preference, heterogeneity (Hetit) is represented by the degree of linguistic fractionalization, though relying on data

10 See the data appendix for more details on the variables.




provided by the Ethnologue project (Fractional).11 Given its time-invariance, fractionalization is interacted with the indicators of integration. According to

the theoretical discussion, we expect the positive effect of both economic and

political integration on fiscal decentralization to be particularly strong for frac tionalized countries. In addition, the time-variant degree of regional disparity of per capita income controls for changes in heterogeneity. Interregional differ ences in income are likely to increase as a consequence of economic integration and regional specialization, therefore enhancing the benefits of decentralization.

On the other hand, as pointed out by Bolton and Roland (1997), whereas well endowed regions benefit from extended fiscal autonomy and competition that

permits them to escape from interregional redistribution through national taxes, poor unproductive regions would call for central government support and income redistribution. Since economic integration strengthens the credibility of threats of secession, central government transfers to rich regions could also become nec

essary to prevent them from leaving.12 Diverse control variables (Divit) capture the general demand for decentral

ization and certain public goods, such as per capita income or temporary ex

penditure and revenue effects due to business cycles, such as the growth rate of per capita income and the rate of unemployment. Electoral cycles are taken into account by a dummy variable for national election years. Since fiscal de centralization intensified in the 1990s, we also control for the assumption that this might be due to the decline in international conflicts and enforcement of international law (Alesina and Spolaore 2005). Accordingly, the end of the Cold

War led both to the reduction of central government expenditure on defence and toleration of claims for regional autonomy that are no longer perceived as a threat to national security and integrity. As a proxy of the overall military threat exerted by the communist bloc, we set the share of military expenditure of the

Warsaw Pact states in GNP in relation to the respective share of NATO countries

(Coldwar). The influence of institutions on costs and benefits of decentralization13 is

taken into account by interacting integration with specific decision-making rules that barely change over time. First, we include a dummy variable for the existence of an upper chamber of parliament consisting of representatives appointed by regional governments or legislatures (regionalparliament). According to Brennan and Buchanan (1980), the common-pool problem induced by the participation of subnational governments in national legislation leads to political cartelization

11 Unlike common fractionalization measures, these data consider only indigenous languages and dialects, thus excluding languages of recent immigrants, which mostly have no deep-rooted local traditions and are dispersed throughout the country. They might therefore better reflect the

geographical grouping of people with similar preferences, which is a precondition for the validity of the 'Decentralization Theorem.' However, problems related to measurement of preference heterogeneity are less important here, since omitted aspects are captured by fixed effects.

12 See also Garrett and Rodden (2003) concerning this point. Haimanko, Le Breton, and Weber (2005) provide some theoretical contributions on compensation schemes that prevent regional secession.

13 See, for instance, Besley and Coate (2003) and Lockwood (2004), among others.



706 D. Stegarescu

and excessive fiscal centralization. In line with the argument brought forward

above, progressing integration could induce delegated representatives of poor

regions to oppose devolution of powers and fiscal competition in favour of in

terregional redistribution by the central government. A second dummy variable

identifies legal provisions for national referendums on constitutional and legisla tive matters. Direct democracy is expected to lead to more decentralization, since

it prevents indirectly elected representatives from vote-trading and centralizing

government activities (Redoano and Scharf 2004).14 This approach differs in certain respects from the work of Garrett and Rodden

(2003), which investigates the effect of trade openness and open capital accounts

on fiscal decentralization in a panel of developing and industrial countries during the period 1978-97. First, the focus is on highly developed OECD countries and

a slightly longer period of time. Secondly, we test additionally for the particular

impact of political integration in Europe on EU countries and interact integration with heterogeneity and institutions in order to detect conditional relationships.

Thirdly, further control variables, such as regional disparity and the Cold War

are included. Finally, we consider common measures of decentralization as well

as a new indicator accounting for actual tax-raising powers of subcentral gov ernments. The analysis also differs from that of Verdier and Breen (2001) of

changes in centralization occurring from 1970 to 1994 in a cross-section of 19

OECD countries. They capture globalization and European integration by the

Quinn/Inclan index of financial openness and EU structural funds payments

(for a single year), but neglect the advance of EU integration and other possible determinants of vertical government structures.

In light of the theoretical discussion in section 2, by lowering the relative costs

associated with local provision of public goods, integration is expected to exert

a positive effect on fiscal decentralization, particularly in heterogeneous and EU

countries. Even though in the theoretical framework the assignment of govern ment functions is taken for granted, the degree of decentralization increasing only due to changes in the amount of public services provided by the different govern

ment tiers, the analysis shows that integration raises the benefits of decentralized

supply of local public goods, provided that preferences are heterogeneous and the

public goods also serve as production inputs. Consequently, subcentral govern ments could demand the devolution of further competencies to implement their

own policies and compete for internationally mobile factors. However, with in

creasing demand for income redistribution due to greater exposure to economic

shocks and growing regional disparities, the opposite effect may prevail, too.

Whether demands for decentralization are implemented should also depend on

the institutional framework, particularly the involvement of subnational entities

in decision-making at the national level.

14 Schaltegger and Feld (2001) provide empirical evidence for Swiss cantons, though without

considering integration.




4. Results

4.1. Basic estimations

The results of the regression analysis for decentralization of self-financed expen diture (excluding social security) and autonomous tax revenue are reported in

tables 3 and 4. The base regression with trade openness and EU expenditure as

the preferred indicators of economic and political integration is represented in

column 1. Alternative specifications of either economic integration or European

integration are included in column 2 and, respectively, columns 3 and 4. Finally, in columns 5 to 7 integration is interacted with preference heterogeneity and in

stitutions, based on the basic specification and the alternative specification from column 3. In each case, integration and the corresponding interaction term are in

cluded simultaneously in order to separate direct and indirect effects. The F tests

indicate significant country fixed effects, and Hausman specification tests mainly

reject specifications using random effects. Checks for collinearity and influential

observations have been carried out, large outliers being removed from the sample. Significant changes in regional territorial structures are taken into account by the inclusion of dummy variables for the countries and periods in question. Since tests report serial correlation in the panel data, the variance matrix estimates are

corrected for heteroscedasticity and autocorrelation. In contrast to theoretical predictions and previous cross-sectional analyses,

all regressions report a negative effect of urbanization and population size on

expenditure decentralization, though only the former coefficient is significant. This possibly indicates that if the focus is on the time variation, growing demand for public services provided by the central government prevails over economies of scale aspects that are quite stable over time. In general, both population and ur

banization change only gradually; therefore, the effects have to be interpreted with caution if fixed effects are included. Regional disparity of per capita income also has a highly significant negative coefficient, the inclusion of this variable turn

ing out to considerably improve the goodness of fit of the regression. Provided that economic integration increases regional disparities, this might be indirect evi dence that integration stimulates central government expenditure for the purpose of redistribution and stabilization.15 In line with previous studies, decentraliza tion is positively linked to per capita income, which is often explained by higher costs of decentralized government due to the requirement of additional qualified staff, coordination, and local government institutions (Oates 1972). Also, elec toral and business cycles seem to have a stronger effect on the central government budget. Accordingly, the share of subcentral government expenditure is lower in

years of national elections and higher unemployment, while economic growth in

general has no significant effect. A negative significant coefficient of the Cold War variable permits the reverse conclusion that the decline of the military threat

reduced the share of central government expenditure.

15 In fact, after dropping this variable from the regression, the effect of trade openness reported below becomes insignificant. Yet the size of the sample differs considerably.



708 D. Stegarescu

TABLE 3 Fixed effects (within) estimates for fiscal decentralization, self-financed expenditure (excl. social security), OECD countries, 1970-2001

Dep. var.: Degree of expenditure decentralization (indie. ED2)

_(1) (2) (3) (4) (5) (6) (7)

Population -.117 -.093 -.099 -.125 -.136 -.021 -.062

(.100) (.098) (.101) (.101) (.098) (.085) (.107) Urbanization -.171** -.156** -.164** -.168** -.182** -.207*** -.164**

(.082) (.073) (.078) (.082) (.071) (.079) (.082) Regional disparity -.204*** -.191*** -.216*** -.203*** -.174*** -.166*** -.174***

(.060) (.055) (.062) (.059) (.056) (.052) (.055) Per capita income .084** .025 .068 .088** .088** .045 .072*

(.039) (.037) (.042) (.039) (.040) (.036) (.042) Growth rate -.041 -.018 -.043 -.034 -.009 -.043 -.061

(.074) (.077) (.074) (.073) (.068) (.067) (.071) Unemployment -.340** -.399** -.368** -.324** -.356** -.446*** -.386***

(.159) (.164) (.145) (.156) (.144) (.142) (.135) Election -.005** -.004* -.004** -.005** -.004** -.004* -.004**

(.002) (.002) (.002) (.002) (.002) (.002) (.002) Coldwar -.024*** -.021*** -.024*** -.024*** -.026*** -.026*** -.022***

(.007) (.007) (.007) (.008) (.007) (.007) (.008) Trade openness .098** .119** .119** .099** -.006 .075* .119**

(.047) (.051) (.050) (.047) (.058) (.041) (.049) Finan. openness .123**

(.052)

EUEUexp. .002 -.005 .008* .011

(.006) (.006) (.005) (.011) EU trade .094 -.023

(.070) (.111)

EUpolit. integr. -.000

(.003) Fractional .282*

Trade openness (167) Fractional .108***

(EUEUexp.) (.040) Fractional .516

EU trade (.326)

Referendum -.057***

Trade openness (.020)

Referendum -.032**

(EUEUexp.) (.015)

Referendum ?. 020

EU trade (.024)

Regional parliam. -.185**

Trade openness (.090)

Regional parliam. ? .016**

(EUEUexp.) (.007)

Regional parliam. ?.418**

EU trade (.187)

No. obs. (countries) 467 (23) 440 (22) 465 (23) 467 (23) 467 (23) 467 (23) 465 (23) Adj. R2 .967 .970 .967 .967 .969 .971 .968

Within R2 .330 .363 .333 .329 .387 .409 .356

NOTES All regressions include country fixed effects and dummies for the periods after regional territorial changes in

Canada, Germany, the Netherlands, and Portugal, the coefficients of which are not reported. Newey-West

heteroscedasticity and autocorrelation consistent standard errors (lag=3) are in brackets. ***, **, and *

indicate significance at the 1%, 5%, and 10% levels, respectively.




In line with the literature on secessions, the estimates support the hypothesis of a positive impact of economic integration on expenditure decentralization for OECD countries at the 5% level of significance, for both the degree of trade

openness and the Quinn/Inclan index of financial openness (columns 1 and

2). The additional inclusion of the qualitative indicator significantly adds to the

regression, showing that other aspects of economic integration not related to trade flows have to be taken into account, too. In contrast, in the European context

the evidence refutes the 'Sandwich' hypothesis. Neither political (columns 1 and

4) nor regional trade integration (column 3) prove to have contributed to fiscal

decentralization.16 These results contrast with the centralizing effect of trade

openness and open capital accounts detected by Garrett and Rodden (2003). This

might have several causes, including the different sample, which consists only of

highly developed long-standing democracies; measurement of decentralization; the use of further control variables, such as regional disparity, unemployment, elections, and the Cold War, which turn out to be significant here; and the absence of the lagged endogenous variable.

The evidence concerning the decentralizing impact of integration is even more specifically validated when the estimates including the interaction terms

(columns 5 to 7) are examined. The positive effect of trade openness on the subcentral government share of public spending turns out to be particularly valid for linguistically fractionalized countries. This holds even to a larger ex

tent for political integration of EU countries (EU expenditure), whereas EU trade integration of both member and non-member countries shows no signifi cant contribution. Central governments in heterogeneous EU countries appar

ently have been pushed back by the process of supranationalization as well as

by increasing integration in the world economy, thus supporting the 'Sandwich'

hypothesis in this case. The results also emphasize that institutional rules matter.

Contrary to expectations, countries providing for referendums at the national

level centralized public spending with increasing economic and political integra tion. This might not be surprising when we consider that national referendums are mostly concerned with the validation of international treaties or general con stitutional reforms and, to a lesser extent, with specific issues concerning the central government budget or the assignment of government functions.17 On the other hand, as a result of the common-pool problem, a centralizing effect of

integration is clearly supported for both EU and non-EU countries if regional representatives participate in national decision-making (regional parliament). In general, the inclusion of the interaction terms significantly improves the fit

16 We refrain from considering financial openness in the other specifications, since one country would then be missing from the sample. The indicators of European integration are not included

jointly, as including them did not improve the fit of the regressions. 17 With the exception of Switzerland, most constitutions forbid budget referendums at the national

level. Note, also, that previous studies considered instead the impact of referendums only at the subnational level.



710 D Stegarescu

of the regressions. Note, also, that the corresponding direct positive effects of economic or European integration are partly reversed, yet the coefficients are

insignificant. Next we use the new measure of decentralization, which accounts for actual

tax autonomy of subcentral government, with data available for a longer time

period (1965-2001). The regressions mostly corroborate the previous findings, although some estimates are less precise (table 4). Accordingly, per capita income and elections have no significant effect on tax decentralization, and the effect of the Cold War is weaker in terms of revenue. The reversed (positive) coeffi cient of unemployment indicates that shortfalls in tax receipts in times of rising unemployment are stronger for central government

- which generally relies on

broad-based income and corporate taxes - compared with subcentral govern

ments, which mostly tax profits and property. Regarding economic integration, a decentralizing effect is only weakly confirmed in terms of trade openness, and financial openness becomes insignificant. Again, European integration has no

significant direct effect, and the sign of the coefficient is mostly reversed. The

positive correlation between integration and decentralization in linguistic hetero

geneous countries established above remains valid only for political integration in the EU (column 6), the interaction with trade openness becoming insignifi cant. Institutional aspects play a minor role, only parliamentary representation of the regions significantly reducing tax decentralization when interacted with

trade openness (column 5).

4.2. Sensitivity analysis and robustness checks

In order to check the robustness of the results with regard to the measurement of

decentralization and possible outliers, sensitivity analyses have been carried out.

Appendix tables, including further statistics and selected results of the sensitiv

ity analyses are available in an on-line appendix linked to this article at the CJE

journal archive http://economics.ca/cje/en/archive.php. As a first approach, al

ternative measures of fiscal decentralization are employed (tables 2 to 4 in the on

line appendix), based on direct expenditure (total expenditure exclusive of inter

governmental expenditure) which represent only amounts spent or administered

directly by sub-central government -

compared with self-financed expenditure, That is, public spending financed from formally own sources - total own revenue

(total revenue exclusive of intergovernmental revenues), and total tax revenue,

irrespective of the actual degree of control of subcentral government. Regarding the direct as well as the indirect effects of integration and the control variables, the previous estimates are generally confirmed, though at slightly differing levels

of significance. Only in the case of direct expenditure does the decentralizing effect of trade integration become less accurate, while the impact of financial

openness and of European integration conditional on preference heterogeneity is

further sustained, the EU trade variable also being highly significant. However,




TABLE 4 Fixed effects (within) estimates for fiscal decentralization, autonomous own tax revenue, OECD

countries, 1965-2001

Dep. var.: Degree of tax decentralization (indie. TD1)

(1) (2) (3) (4) (5) (6) (7)

Population -.051 -.101 -.012 -.046 -.061 .016 .016

(.079) (.078) (.078) (.080) (.078) (.069) (.086) Urbanization -.275*** _.278*** -.275*** -.276*** -.284*** -.291*** -.279***

(.093) (.090) (.091) (.091) (.087) (.105) (.094) Regional disparity -.193*** -.212*** -.186*** -.194*** -.190*** -.152*** -.171***

(.058) (.058) (.057) (.057) (.058) (.051) (.056) Per capita income .024 .020 .009 .021 .027 -.002 .009

(.030) (.033) (.031) (.030) (.031) (.029) (.032) Growth rate -.085 -.099 -.083 -.089 -.087 -.072 -.092

(.061) (.065) (.062) (.062) (.062) (.058) (.064) Unemployment .382*** .364** .381*** .371*** .370** .330** .382***

(.138) (.156) (.137) (.138) (.148) (.141) (.135) Election -.001 -.001 -.001 -.001 -.001 -.001 -.001

(.002) (.002) (.002) (.002) (.002) (.002) (.002) Coldwar -.011* -.010 -.010 -.011* -.011* -.011* -.008

(.006) (.006) (.006) (.006) (.006) (.006) (.006) Trade openness .051* .061* .059* .050* .056 .038 .053

(.029) (.032) (.033) (.028) (.050) (.026) (.034) Finan. openness .021

(.042) EU-EUexp. -.002 -.002 .000 -.013

(.005) (.005) (.005) (.013) EU trade .031 -.101

(.068) (.117) EUpolit. integr. -.000

(.003) Fractional .025

Trade openness (123) Fractional .086**

(EU EUexp.) (.034) Fractional .394

EU trade (.313) Referendum -.019

Trade openness (.025) Referendum ?. 006

(EU EUexp.) (.013) Referendum .024

EU trade (.025) Regional parliam. ?. 132**

Trade openness (.059) Regional parliam. ?. 004

(EU-EUexp.) (.007) Regional parliam. ?. 028

EU trade (.139)

No. obs. (countries) 548(23) 522(22) 535(23) 548(23) 548(23) 548(23) 535(23) Adj. R2 .968 .969 .969 .970 .968 .969 .969

Within R2 .195 .198 .207 .195 .207 .239 .218

NOTE See table 3 for further details.



712 D. Stegarescu

this might also be the consequence of the slightly reduced cross-section. Gener

ally speaking, the sensitivity of the results with respect to the measurement of

decentralization is rather limited, even if tax-raising powers are corrected for.

Second, regressions have been run in which social security is included in the

public sector as part of the central government (table 5 in the on-line appendix). The estimates are, with few exceptions, consistent with the regressions excluding social security. The positive effect of integration on fiscal decentralization holds

again for trade and financial openness in general, and for European integration as depicted by EU expenditure as well as EU trade in the presence of hetero

geneity. The estimates for the institutions are weakly confirmed only for regional

parliaments and trade openness. Therefore, we conclude that the decentralizing effect prevails even in the case of accounting for the observed concomitant rise

in welfare state expenditure. There are, however, two exceptional cases of decentralization that deserve

closer examination: Belgium and Spain. The share of subcentral government

expenditure and revenue increased drastically in Belgium from 1989 as a conse

quence of the devolution of competencies to regional governments. At the same

time, Belgium is a small economy with a degree of openness, which has risen

considerably. With regard to Spain, the transfer of powers to the regions and,

simultaneously, economic opening and integration in the EU made significant

progress after the end of the Franco regime. Otherwise, both countries are charac

terized by high linguistic diversity. In fact, following a sensitivity analysis it, turns

out that, particularly when Belgium is dropped from the sample, the coefficients

of trade and financial openness and of the interaction between fractionalization and economic or European integration become less precisely estimated for both

expenditure and tax decentralization, whereas the exclusion of Spain does not

alter the results.

As a test for robustness, 'robust' estimators, such as the least absolute devia

tions (LAD) estimator, are proposed by Koenker and Bassett (1978). A special case of generalized quantile regressions estimates the median of the dependent

variable, conditional on the values of the independent variables. It generally turns

out that this estimator is very robust with respect to outliers in both the depen dent and the independent variables. The corresponding results of median regres sions using country-specific dummy variables (see tables 6 and 7 in the on-line

appendix) are generally less accurate.18 They mostly support a decentralizing im

pact of economic integration (trade and financial openness) with respect to public

expenditure, yet all interactions apart from that between EU expenditure and re

gional parliament become insignificant. The corresponding effects on tax-raising

powers of subcentral government are less conclusive and even partly reversed. Ac

cordingly, trade openness exerts a significant positive effect on decentralization

18 Usual standard errors of median regressions are assumed to be understated in the presence of

heteroscedasticity. However, the computation of bootstrap standard errors turns out to provide

extremely imprecise estimates.




in general, while at the same time in heterogeneous countries the opposite effect

dominates. However, there is still clear evidence for a negative effect associated

with subnational representation in the parliament and national referendums. On

the other hand, whereas EU expenditures have a weak centralizing effect consid

ered alone, the decentralizing effect is confirmed for heterogeneous EU countries.

To sum up, whereas the decentralizing effect of economic and political inte

gration seems to be quite robust to different definitions of fiscal decentralization, it is not surprising that, even though we have checked for outliers, owing to the

limited size of the cross-section and to the fixed-effects approach, individual cases

have a considerable influence on the results. Nonetheless, the analysis provides some robust evidence that, while the overall decentralizing effect of integration in the world economy is particularly strong with respect to public expenditure,

participation of subnational governments in national decision-making counter

acts this effect mainly in terms of tax-raising powers. On the other hand, support for the 'Sandwich' hypothesis concerning the decentralizing effect of European integration is provided only for linguistically heterogeneous EU countries.

5. Summary and conclusions

This paper investigates empirically the relationship between economic integra tion in general and political integration in the EU in particular and the fiscal decentralization trend observed in developed countries during the past decades. The analysis draws on recent work on the disintegration of countries, which shows that economic integration increases the benefits of secession. However, the implications for the vertical government structure have not been sufficiently investigated. In general, by extending the market size and enhancing economies of scale, integration increases the comparative benefits of decentralized provision of public goods according to local preferences. In Europe, decentralization is fur ther sustained by political unification, since market integration is intensified and

formerly central government functions are taken over by a supranational author

ity. On the other hand, with higher exposure to economic shocks, the demand for income redistribution and macroeconomic stabilization by the central govern

ment may prevail, too. Therefore, the net effect of integration on the government structure hinges on the trade-off between increased local growth prospects and

higher economic risk.

Based on a theoretical framework that illustrates the mechanisms described in the literature, we test the hypothesis of a positive impact of economic and

European integration on fiscal decentralization for a panel of 23 OECD coun tries during the period 1965-2001. Since integration is assumed to affect the costs and benefits of decentralization over time, the empirical analysis takes into account country fixed effects and indirect effects of integration conditional on

country-specific preference heterogeneity and institutions. The estimates mostly indicate a significant positive relationship between economic integration, as mea sured by the share of foreign trade in GDP and financial openness, and fiscal



714 D. Stegarescu

decentralization - above all with respect to public expenditure and to a lesser ex

tent when a new measure that accounts for actual tax-raising powers of subcentral

government is used. This contrasts with the findings of Garrett and Rodden (2003) for industrial and developing countries. However, economic integration is found

to be particularly associated with centralization of taxing powers if subnational

governments are involved in national decision-making through a regional cham

ber of parliament. This is in line with the common-pool argument, according to

which poor regions could enforce interregional redistribution or macroeconomic

stabilization by the central government to offset negative effects of integration.

Indeed, the evidence also supports a centralizing effect of growing regional in

come disparity. Contrary to expectations, integration is also related to higher centralization in the case of provisions for national referendums. There is only some limited evidence for the 'Sandwich' hypothesis postulating a diminishing role of national governments in the course of European integration. Political

integration as measured by EU expenditure exerts a positive effect on decentral

ization of both expenditure and tax-raising powers in linguistically heterogeneous EU countries. These main findings are even confirmed by robust regressions that

take account of exceptional cases of decentralization, as, for instance, in Belgium and Spain.

The empirical analysis therefore provides new cross-national evidence in sup

port of the 'Decentralization Theorem' and the implications of the literature on

secessions for the vertical government structure. A significant relationship is re

vealed between those two broad trends among OECD countries, integration and

fiscal decentralization, in general as well as in particular for EU and heteroge neous countries. The analysis also indicates that institutions play an important role in determining the impact of integration on the government structure and

should therefore be examined in more detail. The investigation finally suggests that integrating regional agglomeration and growth effects described by the New

Economic Geography literature with the theory on fiscal federalism and seces

sions would provide a starting point for more comprehensive research.




Data appendix

TABLE Al Data sources and definitions

Variable Description Source

Dec Degree of fiscal decentralization; IMF, GFSY; Stegarescu (2005); own

different measures calculations

Population Natural log of population in 1000 IMF; World Bank

Urbanization Share of urban population Eurostat; OECD; World Bank

Fractional Linguistic fractionalization (0-1) www.ethnologue.com F = 1 ?

YTi=\ Pf witn Pi population share of language group /

Regional disparity Coeff. of variation of regional GDP, Eurostat, REGIO Database, GVA or income per capita Regional Accounts; national

statistics; own calculations

Regional parliam. Dummy = 1 for second chamber of CIA, World Fact Book; Ismayr

parliam with represent, delegated by (1999); constitutions

the regions

Referendum Dummy = 1 for legal provisions Research and Documentation Centre

concerning national constitutional on Direct Democracy and legislative referendums (http://c2d.unige.ch);

constitutions Per capita income Log of real GDP per capita, in prices of IMF, International Financial

1995, in ECU/EUR Statistics; own calculations

Unemployment Rate of unemployment OECD, Labour Force Statistics Election Dummy

= 1 national election year Ismayr (1999); Mackie and Rose

(1991); www.polisci.com Coldwar Military expenditure in % of GNP of U.S. Arms Control and

Warsaw Treaty relative to NATO Disarmament Agency; own

countries calculations Trade openness Exports plus imports as a share of GDP IMF, International Financial

Statistics; own calculations Finan. openness Index of financial openness (re-scaled Quinn and Inclan (1997); Armingeon

0-1) etal. (2004) EU Dummy

= 1 for EU membership own compilation EU expend. EU expenditure in % of total public Europ. Commission (2000)

expenditure of EU countries EU trade Exports plus imports to/from EU 15 as OECD, Statistical Compendium

a share of foreign trade Database; own calculations

EUpolit. integ. Index EU integration (0-6): 0-none, own calculations 1-free trade agreement, 2-European

Economic Area, 3-customs union,

4-EC/EU, 5-EMS, 6-EMU



716 D. Stegarescu

TABLE A2. Descriptive statistics

Variable Mean Std.Dev. Min. Max.

Degree of fiscal decentralization Dir. expend, (exclsoc. sec.) 0.420 0.184 0.041 0.789 Dir. expend, (inch soc. sec.) 0.321 0.154 0.031 0.626

Self-fin. expend, (exclsoc. sec.) 0.280 0.167 0.013 0.649

Self-fin. expend, (inch soc. sec.) 0.219 0.135 0.009 0.543 Total own revenue (excl. social security) 0.283 0.173 0.037 0.666 Total own revenue (inch social security) 0.225 0.140 0.027 0.545 Autonomous own tax revenue 0.191 0.166 0.000 0.615 Total tax revenue 0.233 0.172 0.001 0.645

Population 9.348 1.624 5.257 12.560 Urbanization 0.737 0.140 0.239 0.972

Fractional 0.246 0.201 0.000 0.650

Regional disparity 0.196 0.087 0.000 0.452

Regional parliament 0.090 0.287 0.000 1.000

Referendum 0.634 0.482 0.000 1.000 Per capita income 9.588 0.460 8.150 10.698

Growth rate 0.026 0.029 -0.105 0.272

Unemployment 0.054 0.041 0.000 0.241 Election 0.291 0.455 0.000 1.000

Coldwar 2 All 0.594 1.150 2.680 Trade openness 0.645 0.373 0.093 2.907

Financial openness 0.782 0.194 0.214 1.000 EU 0.448 0.498 0.000 1.000

EU expenditure 1.732 0.562 0.300 2.400 EU trade 0.544 0.202 0.072 0.865

EU political integration 2.233 2.301 0.000 6.000

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