The Decentralized System
In contrast, the decentralized system (ii) is more suitable when an informational gap exists between central and local governments with respect to regional-specific needs and when residents are heterogeneous. For example, if residents in a region have different preferences about their local government’s activities compared with residents in other regions, unified intervention by central government does not work well in all regions.
For example, imagine that central government intends to provide a local public good to all regions. If residents in one region evaluate the good as more desirable compared with residents in another region, preferences diverge among regions. If central government has precise details about the residents in their regions, it may differentiate the levels of local public goods according to region-specific preferences.
However, it is plausible to assume that central government may not have such details. If so, it is likely to provide the same level of the local public good to all regions. Thus, not all residents in the regions are satisfied with the level of the local public good. In order to coordinate region-specific preferences, central government should provide a larger amount to the region with a higher evaluation of the desirability of the good and a smaller amount to the region with a lower evaluation.
Under the concept of informational asymmetry whereby local governments may know more about residents’ preferences than central government, it is desirable for local governments to have the main role in the provision of local public goods.
In Fig. 13.1, the vertical axis denotes the marginal benefit of local public goods and the horizontal axis denotes the level of public goods. Curves Y1 and Y2 denote the marginal evaluation of local public goods in region 1 and region 2 respectively. We assume that residents in region 1 evaluate the public goods as more important compared with residents in region 2. Curve OF is the common marginal cost.
If central government provides the goods at the same level of Y*, the marginal benefit is not equal to the marginal cost in each region. For region 1, the marginal benefit and marginal cost are the same at OH, while for region 2 they are the same at
Fig. 13.1 Fiscal decentralization
OL. Comparing these cases, the level at Y* produces an excess burden of triangle AABD in region 1 and triangle AACE in region 2.
The above example assumes different preferences with respect to the quantity of public goods. A similar argument is maintained in a situation where the quality of public goods diverges among regions. Alternatively, the cost of public goods may differ among regions. When preferences and/or costs diverge significantly, it is difficult for central government to recognize the information more effectively than local governments. Thus, it is desirable for local governments, not central government, to provide these public goods.
We must also consider the possibility of the free rider problem. Local governments may be able to handle this problem effectively because they are relatively familiar with the preferences of their local residents. Thus, we have the decentralized theorem:
It is desirable for local governments to have the main role in the provision of local
This decentralized theorem was first highlighted by Oates (1972).
Moreover, certain competitive incentives work for local governments. Note that a government does not behave in order to maximize profits. Its supposed objective is to maximize social welfare. However, in reality politicians may be rent seekers and may not represent the interests of residents or voters. Thus, it is difficult to evaluate government behavior quantitatively. With regard to central government, changes through elections are the only method that voters can use to express their judgments. With regard to local governments, elections are also effective. In addition, local residents can easily apply and/or revoke political pressure. Indeed, voice, as well as voting, is very effective for local residents as a means to control and monitor politicians. Further, local residents can choose their optimal local government by moving from one region to another. This is called voting with their feet. Since it is easy for local residents to compare similar local governments, the decentralized system has the benefit of choosing a desirable government more clearly.