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Analyzing the Effectiveness of Fiscal Decentralization in Economic Growth:

The Role of Institutions

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Iranian Economic Review 2022, 26(2): 325-341
DOI: 10.22059/IER.2020.78144
RESEARCH PAPER

Analyzing the Effectiveness of Fiscal Decentralization in

Economic Growth: The Role of Institutions
Muhammad Zeeshan Arifa,*1, Muhammad Zubair Chishtib

a. Pakistan Institute of Development Economics, Islamabad, Pakistan

b. School of Business, Zhengzhou University, Henan, China

Received: 08 March 2020, Revised: 12 August 2020, Accepted: 29 September 2020

© University of Tehran

Abstract
Decentralization is expected, theoretically, to be a route to efficient provision of the local public
services. This efficient utilization of scarce resources is further expected to boost economic growth.
Despite solid theoretical footings, the existing empirical literature presents mixed results for the
presumed positive relationship between decentralization and economic growth. It is important to note
here that the second-generation theories of fiscal federalism talk about the enabling environment for
decentralization to yield positive results; talking explicitly, an enabling institutional setup is required.
Therefore, the current study examines the complementarity between fiscal decentralization and
institutions stimulating growth. A sumptuous cross-country panel data from 1990 to 2018 is used for
analysis. Results suggest that fiscal decentralization and institutions both are instrumental in economic
growth, and there is complementarity between the two. However, over-exposure of local
representatives seems to divert their attention from service provision to countering opponents’
strategies.
Keywords: Decentralization, Institutions, Economic Growth, Panel Data.
JEL Classification: E62, O43, O47.

Introduction

Most societies have a primary objective to serve their people efficiently and effectively, and
they perform this task through different tiers of government along with the collaboration of
the private sector and civil societies. The efficiency objective of the government makes the
discussion of fiscal federalism relevant and exciting. For the past few decades, there is a
growing trend in favor of decentralization. The distribution of responsibilities among
different tiers of the government seems plausible because the federal government takes
responsibility for issues that have a public domain. While the lower tiers of government focus
mainly on service provision. Resource transfer from the national to sub-national government
is essential for the enhancement of the welfare of the public at the local level. The national
government is not in a position to achieve Pareto efficiency directly; instead, the sub-national
tiers of government are the source of efficiency because their representatives are located near
to the local people and are aware of local preferences and needs. Thus decentralization helps
in efficient resource allocation leading to greater local participation, faster market
development and in turn better economic growth.
The First Generation (FG) Theory of fiscal decentralization states that due to the fiscal
decentralization economic performance can enhance by ensuring economic proficiency in the

* Corresponding author email: [email protected]

326 Arif and Chishti

delivery of the public services. The given theory is based on different theoretical contributions
in favor of local government. 1 Nevertheless, empirical studies show a mix effect of fiscal
decentralization (FD) on economic growth in developing and developed countries. Though
several studies indicate a positive association between FD and economic growth (Martinez-
Vazquez and McNab, 2003; Malik et al., 2006; Oates, 1993; 1995; Yilmaz, 1999) inter alia.
Yet many studies have found insignificant or even negative relationship between FD and
economic growth.2
There are two widely used measures of fiscal decentralization, namely the revenue
decentralization and the expenditure decentralization based on ‘Budget Data’. Revenue
decentralization (RD) is measured as a ratio of the sub-national government revenue to the
total government revenue (national plus sub-national). Expenditure decentralization (ED) is
measured as a ratio of sub-national government expenditures to the total government
expenditures (national plus sub-national). Oates (1972) defines expenditure centralization as
the share of the central government spending in the total public spending and revenue
centralization as the share of central government revenue in the total revenue. Davoodi and
Zou (1998) measure fiscal decentralization as the expenditure/revenue of the sub-national
government as a fraction of total government expenditure/revenue.
Woller and Phillips (1998) re-define fiscal decentralization measures after making few
adjustments. First, in measuring revenue decentralization, they subtract the grant-in-aid given
to sub-national government from the total revenue and treat it as an expense to avoid double
counting. Second, in measuring expenditure decentralization, they exclude social security and
defence spending from the total public spending as these are considered to be the main part of
non-decentralized government spending. After these adjustments, Woller and Phillips (1998)
measure fiscal decentralization in the following four ways. First, the ratio of sub-national
government revenues to the total government revenues. Second, the ratio of sub-national
government revenues less grant-in-aids to the total government revenues. Third, the ratio of
sub-national government spending to the total public spending. Fourth, the ratio of sub-
national government spending to the total public spending less spending on defence and social
security.
Nevertheless, this mismatch between the theoretical and empirical results can still be
explained in the literature. For these unexpected results, literature has identified many reasons
as discussed in the second generation (SG) theories of fiscal federalism. SG theories
summarise that there are certain risks associated with fiscal decentralization; if it is not
designed properly. Like fiscal decentralization can result in: increased regional inequality and
encourage corruption (Rahman et al., 2012), weak democracy in developing countries
hampers efforts (Tanzi, 1996), low growth performance due to bad institutional setup (Akai
and Sakata, 2002; Iqbal et al., 2013) and difference in true extent of decentralisation prevalent
during different periods. SG theories also focused on many economic theories like theory of
principal agent problem, theory of contract, theory of firms (Oates, 2005). Thus the SG
theories has emerged as the sufficient condition for the success of decentralization process
and explains that difference in results can be expected for even a similar policy undertaken in
different political scenarios. So, the extensions of FG with the SG theories talk about the
integration of fiscal decentralization and institution and bring these in one dimension.
Further, there is a need to examine the role of institution and that of asymmetric
information on the success of the decentralization process. Well-managed institutions are the
major channel through which decentralization can influence long run economic growth. In the
words of Acemoglu and Robinson, “Nations sometimes adopt inefficient institutions and

1. See for example Hayek, 1945; Tiebout, 1956; Musgrave, 1959; Olson, 1969; Oates 1972.
2. See for example Oates, 1972; 1985; Davoodiand Zou, 1998; Baskaran and Feld, 2009; Akai and Sakata, 2002;
Rahman et al., 2012; Tanzi, 1996.
Iranian Economic Review 2022, 26(2): 325-341 327

achieve poverty”. Similarly North (1990) mentioned that “Institutions are generally defined
as the “constraint that human beings impose on themselves”. Though, talking specifically of
institutions, plethora of literature on the institutional mechanism is available that have tried to
find out the direct relationship between institutions and economic growth.1
Although several studies focuses on investigating the relationships between the fiscal
decentralization and economic growth, however, this article contributes to the existing
literature by assessing the role of institutions in the effectiveness of fiscal decentralization
which ultimately is believed to lead towards economic growth. Furthermore, our study takes a
rich sample of 43 economies for panel data analysis. Beyond that, we apply Fixed effects and
Random effects models to estimate our panel data coefficients.
Despite the fact that there is huge literature available on the fiscal decentralisation as well
as institutions for their impact on economic growth, only a few 2 has looked at their
interaction. There is a need to analyse the situation for the fact that whether the fiscal
decentralisation and institutions, in isolation, impacts the economic growth or these are
complements to each other. Therefore, this study tries to explore the effectiveness of fiscal
decentralization relating it to the quality of institutions. Main questions that this study seeks to
find answers to are: Does role of institutions matter to enhance the economic growth through
the channel of decentralisation?
Overall, the objective of this study is to find out the empirical relationship regarding the
effectiveness of fiscal decentralization especially considering the role of institutions. This
study targets to find out that whether or not it is the difference in institutional quality that has
resulted in differing results related to the effect of fiscal decentralisation on economic growth.
Thus this study will examine the role of fiscal decentralisation and institution in achieving
higher economic growth.

Literature Review

In recent decades, the rapid rise in the sovereignty and responsibilities of sub-national
government tiers are one of the most notable trends in governance, especially in emerging and
transition economies. There is decent literature available examining the growth effects for
different countries emerging through fiscal decentralization and institutions, with direct and
indirect effect. This section presents a brief review of the existing studies that separately
analysed the link between fiscal decentralisation and institutions with economic growth. A
tabulated summary of the literature discussed is also given in Table I, at Appendix.

Fiscal Decentralization and Economic Growth

Most of the studies theoretically as well as empirically examined the positive association
between FD and economic growth. Some of these are reviewed below.

Fiscal Decentralization in Favour of Economic Growth

Oates (1993) was in favour of fiscal decentralization. According to author, FD is more growth
improving if carried out by the local government tiers in social and infrastructure sector than
central government which may ignore the variation in the preferences. So, to test the
theoretical relationship between FD and economic growth indirectly Martinez-Vazquez and

1. See for example Acemoglu et al., 2012; Rodrik et al., 2004; Sarwar et al., 2013; Vijayaraghavan and Ward,
2001; Potrafke, 2011; Knack and Keefer, 1995; Nawaz, 2015; Ahmad and Hall, 2012.
2. Like, Iqbal et al. (2013) focused on the role of democratic institution on the process of FD in single country
case. Iimi (2005) also tested the hypothesis with international cross sectional data that political freedom and
fiscal decentralization are complementary.
328 Arif and Chishti

McNab (2001) empirically analyse the positive association between FD and economic growth
through macroeconomic stability. This study explored that decentralization does not seems to
present a danger to price stability in the developing as well as developed countries but in
reality revenue decentralization leads to more stable prices. Decentralization allows
mobilizing revenue at different level which leads to less pressure on consolidated budget and
more stable prices. Furthermore, Martinez-Vazquez and McNab (2003) also argued that there
is unidirectional or bi-directional relationships exist between FD and economic growth. This
study found that FD and economic growth has relationship through distribution of the
resources, consumer efficiency, the geographical producer efficiency, less resources captures
by the elites, macroeconomic stability, less corruption and concluded that there is
unidirectional non-monotonic relationships exists between decentralization and economic
growth. Further, Iimi (2005) empirically examined in his cross country study by concluding
that fiscal decentralization and economic growth is positively related. This study used the data
from time period 1997 to 2001 by employing instrumental variable technique in analysis. By
continuing the empirically examination process Malik et al. (2006) showed in his study that
fiscal decentralization and the economic growth have positively related. This study used
secondary source of data for Pakistan over period 1971-2005 and employed Ordinary Least
Square (OLS) method for estimation by using moving average and autoregressive method to
tackle the problem of the auto correlation.

Fiscal Decentralization and Economic Growth: No Relationship

The relationship between fiscal decentralization and economic growth has been constantly
challenged so it is difficult to measure the precise relationship. Various studies have tried to
find the relationship but unable to find the exact relationship.
So, First of these studies has been focused on fiscal decentralization and economic growth
by Davoodi and Zou (1998). The given study’s objective is to provide an analytical
framework and empirical practise to test the existence and size of the efficiency enhancements
from the fiscal decentralization. This study used the panel data set of 46 countries over five
and ten year’s intervals by using time period 1970-1989 and concluded that the relationship
between FD and economic growth is negative in developing economies but none for
developed economies. This study explored the reasons i.e. why this study have failed to turn
up with final result of the FD role on economic growth. The reasons are decentralization
measure used in this study does not express what a subnational government bargains, wrong
revenue assessment, revenue collection and expenditure decisions by the local authority is the
constrained by the central government and in practice local authority may not responsive to
local people’s needs and preference. Second study conducted by Baskaran and Feld (2009)
this study is basically extension of the Thornton (2007) study. They applied the true measure
of fiscal decentralization by capturing the true amount of sub-federal autonomy by using 23
OECD countries over the time period 1975 to 2001. New panel data has been used in this
literature and explored negative but insignificant relationship between the FD and economic
growth. They employed the similar data with some extension, slightly large number of
countries and more detailed specifications and also found that RD is unrelated to economic
outcome. On the other hand a high degree of political instead of fiscal autonomy of sub-
federal units seems to hamper economic growth. Thus, Iqbal et al. (2013) showed in single
country study revenue decentralization promote economic growth while expenditure
decentralization hinders the economic growth in Pakistan. This is mainly due to the low
institutional quality which public representatives make less accountable and also may rise the
corruption level. Lack of human and physicals capabilities can also lead to ineffective
outcome of expenditure decentralization in Pakistan. This study used endogenous growth
Iranian Economic Review 2022, 26(2): 325-341 329

model to investigate the relationship between the FD and economic growth by using time
series data covering from the period of 1972 to 2010.
Therefore, multiple studies have debated on the issue of the negative relationships between
FD and economic growth. So, It is argued that the local governments is fully aware about the
local needs and preferences and provides goods and services accordingly to the their
preferences but Tanzi (1996) criticized this assumption by saying that local population have
not power to impact the action of the local authorities that’s why local goods have not
produced according to the local needs and preferences. Thus, in the developing countries local
democracy is relatively weak and ineffective as compare to developed countries. Next Akai
and Sakata (2002) argued in their study that due to the use of incorrect measures of the fiscal
decentralization the relationship between FD and economic growth doesn’t exist. This study
has applied Ordinary Least Square (OLS) method for 50 US states. Similarly, Rahman et al.
(2012) also explored the negative relationships between fiscal decentralization and economic
growth. This study used panel data set of 30 provinces of Indonesia from the time period 2004
to 2009 by using fixed effect model and concludes that the decentralization process has some
weaknesses especially they focused on the result that due to the decentralization regional
inequality promotes and encourage corruption which may result the lower economic growth.

Institution and Economic Growth

Institution plays a vital role on the domestic economic environment through political stability,
high stock of social capital, protection of property rights, well-organizing judiciary system,
low risk of expropriation Jutting (2003), so the body of literature determined the economic
growth-institutions nexus directly and indirectly.

Institution and Economic Growth: Direct Relationship

First, Vijayaraghavan and Ward (2001) used four important measures of institution i.e.
institutional infrastructure, security of property rights, political freedom, governance and
government consumption as proxies of the institutional quality. They concluded that
institution is the most significant source of the variation in the growth rates of the countries.
They focused on the neoclassical growth model with 43 nations from the time period of 1975-
1990 and concluded that size of the government and security of property rights are most
important institutions for the variation in the economies. While, Rodrik et al. (2004) used
index of the “rule of law” as a proxy of institutions. This study found the determinants of the
level of income i.e. trade, geography and institution and explore institutions exercise influence
strong and positive on the income level of the country while geography and trade are not
much impressive and showed insignificant result. Acemoglu et al. (2001) argued in his study
that Europeans have very different colonization policies and have very different types of
institution in these colonies. The reason behind the different institutions is the mortality rate
that’s why this study used European mortality rate as an instrument of the institutions. For
those colonies that have high mortality rate are more extractive institutions and found large
effect on the income per capita. Iqbal et al. (2013) argued in the study that expenditure
decentralization has negative effect on the growth rate of per capita. So this study employed
SGT in the analysis by using interaction term of ED and RD with democratic institution and
found positive outcome on the economic growth.
It is stated that in developing countries lack of institution quality is one of the major issues.
Without enforcement of the power and implementation of any policy the country cannot be
run in the way of development corridor. Sarwar et al. (2013) found in his study the case of the
South Asia. This study argued that average quality institutions are prevailing in the
330 Arif and Chishti

developing country that’s why south Asian region is under developed while in developed
countries through institution’s performance long run economic growth exists. They used fixed
effect model and Generalize Method of Movement (GMM) by using panel data over the
period of time 1995-2010. This study used more comprehensive measure i.e. institution and
GDP index and found positive and significant effect on the economic growth. Nawaz (2015)
in favour of investment level and argued in the study that institution and economic growth
relationship is different in the development stages of the country. This study examined the
impact of the institution and economic growth at aggregate level by showing the result that
institutions are positively linked with economic growth and also find that quality of
bureaucracy, law and order and control over corruption, are high in the industrialised
countries as compare to emerging countries. Impact of the investment level is more growth
enhancing in low income countries as compare to high income countries.

Institution and Economic Growth: Indirect Relationship

Institution can indirectly influence the growth performance of the country. The body of
literature has developed indirect relationship between institution and economic growth. So,
one of the study conducted by Knack and Keefer (1995) argued in the study about conditional
convergence in per capita income of the countries and found the result that the proxies of
quality of institutions are political violence, Gastil political and civil liberties are inefficient
for the protection of the property rights. While, security of the property rights has positive
effect not only on investment level but also allocated efficiency of inputs. They concluded
that conditional convergence will achieved through well organize institutions. Thus, One of
the studies has been examined in the favour of the investment i.e. investment is more growth
enhancing in the development of the countries. Potrafke (2011) explored the result in his
study by using the cross sectional data and concluded that those countries with high IQ
populations enjoys less corruption. Through security of contractual property rights,
investment and effectiveness of the provision of the public goods countries can grow faster.
Insecure contractual property rights may discourage the investment of the country. Ahmad
and Hall (2012) focused on the East Asian countries and experienced a fabulous economic
growth since 1990s but due to the financial crisis in the 1997-1998 the results are; growth
process has abruptly end and severe recession has been happened then the recovery process
has been delayed. They concluded that institutions may matter in the developing countries via
total factor productivity. Similarly, Nigar (2013) argued in study by exploring the indirect
relationship between the institutional quality and economic growth through inequality. This
study found the institutions effect positively on the economic growth. Inequality is considered
harmful for the countries especially in the lower-middle income countries. This study
especially focused on the interaction of institutional quality and inequality and found negative
impact on the economic growth. One of the studies has been carried the indirect effect of the
institution through intelligence. Kalonda et al. (2014) found the effect of intelligence on the
quality of institutions by using regulatory quality, political stability, voice and accountability,
government efficiency and rule of law as proxies of institutions and show that intelligence has
strong and positive impact on the institutional quality and ultimately foster the economic
growth.
Canavire et al. (2020) take the sample of world economies to analyze the dynamic effects of
fiscal decentralization and economic growth. The result of study confirms positive link such that
10% increase in the subnational expenditures casues to increase the GDP by 0.82%. Likewise,
Ding et al. (2019) also conclude that decentralization plays a significant role in triggering the
economic growth in China. Another study by Elheddad et al. (2020) determine that there is
positive association between fiscal decentralization and economic growth in China.
Iranian Economic Review 2022, 26(2): 325-341 331

On the basis of presented literature review, current study come up with this conclusion that
the under lying causes of the weak or no relationship between FD and economic growth are;
economic, cultural, geographical and institutional setups are weak, so one of the major
constraints in the FD process of economic growth is weak institutions. Without effective
institution growth process of the country is difficult to run in the way of development
corridor. Therefore, current study incorporates institutions in the growth enhancing process of
the fiscal decentralization and fills the missing gap.

Data and Methodology

Theoretical Model

Endogenous growth model is in fashion to capture the impact of fiscal decentralization and
economic growth following Davoodi and Zou (1998) and the same is followed for analysis in
this study with few adjustments. The said study extendBarro’s (1990) endogenous growth
model by assuming that public spending is carried out by three level of government: federal,
local and state. The level of fiscal decentralization is defined as the fraction of spending by
the subnational government to total government spending i.e. Fiscal decentralization increases
if spending by state and local government rises relative to spending by the federal government
(Davoodi and Zou, 1998). Now following literature on institutions (North, 1990; Nawaz,
2015), this study modifies the model by incorporating institutions into the empirical model to
analyse it influence on the effectiveness of fiscal decentralisation for better economic growth.

Econometric Model

The relationship between fiscal decentralization and economic growth discussed in the
theoretical studies help us to express the empirical version of the model.It is noteworthy that
the contribution of this study isit introduces institutional quality to the Davoodi and Zou
(1998) model to judge the enabling environment for fiscal decentralization to be effective.
Hence to capture the true effect of fiscal decentralization, this study will incorporate
institutions as a complement in the process of fiscal decentralization at cross-country level.
This study will use three main variants of the existence of good institutions (i.e. Government
stability, Control over corruption, Democratic accountability). So, accordingly their
interaction terms with fiscal decentralization will be used to analyse the effectiveness of fiscal
decentralisation for better economic growth.
Thus, the empirical equation to analyse the model for fiscal decentralization, institution
and economic growth can be defined as:

𝑔𝑖𝑡 = 𝛽0 + 𝛽1 𝐺𝐸𝑖𝑡 + 𝛽2 𝐹𝐷𝑖𝑗𝑡 + 𝛽3 𝐼𝑁𝑆𝑖𝑘𝑡 + 𝛽4 𝐹𝐷𝑖𝑗𝑡 ∗ 𝐼𝑁𝑆𝑖𝑘𝑡 + 𝛽5 𝑋𝑖𝑡 + 𝑈𝑖𝑡 (1)

where i(=1...I) and t(=1….N) refers to the country i at time t; I denotes the number of the
countries while N represents the time period; β0,β1,β2,β3,β4 and β5 are the scalar parameters; git
is the GDP per capita growth rate for country i at time t. Even though, the prior studies
deploy government expenditures (GE) and taxes as a proxy of fiscal policy, however, this
study prefers to employ only GE to measure fiscal policy. The primary reason is the
availability of sufficient data for GE to satisfy the requirement of our sample of 43 (developed
and emerging) countries, while the data of tax rate were limited. Besides the list of the
selected economies is given in the Appendix-I.
Furthermore, Nawaz (2015) used GE/GDP ratio in the growth regression,FDijtrepresent the
measures of fiscal decentralization (where j indicates the revenue and expenditure indicators
332 Arif and Chishti

for fiscal decentralisation), INSikt represents variables for institutional quality (k indicates the
above mentioned three distinct variables) and lastly X indicates the vector of other important
control variables affecting growth. Uit is the error term while X consists of the variables i.e.
trade openness, human capital, physical capital, inflation, growth rate of population and
urbanization. In this model the interaction term FD*INS is the focus of attention and allow us
to test the hypothesis that whether or not fiscal decentralization and institution are
complementary. Table1 provides basic definitions for each variable alongside the sources of
data.

Table 1. Variables Names, Definition and Sources of Data

Variable Names Definition Source
World Development
Dependent Variable git GDP per capita growth rate (annual %)
Indicator (WDI)
List of independent Variable
Expenditure Percentage of Sub-National Expenditure/ Total
fdexp GFS-World Bank
Decentralization Expenditure(National plus sub-national)

Revenue Percentage of Sub-National Revenue / Total

fdrev GFS-World Bank
Decentralization Revenue(National plus sub-national)

Government World Development

Ge Government expenditure as % of GDP
Expenditure Indicator (WDI)
World Development
Trade Openness Op (Imports plus Exports) as % of GDP
Indicator (WDI)
World Development
Human Capital Hc School enrolment, secondary (% gross)
Indicator (WDI)
World Development
Physical Capital K Gross fixed capital formation as % of GDP
Indicator (WDI)
World Development
Inflation Inf % change in CPI(consumer price index) annual
Indicator (WDI)
Growth rate of World Development
pgr Population growth % (annual)
population Indicator (WDI)
World Development
Urbanization urb Urban population as % of total
Indicator (WDI)
“This captures risk linked with the government's
ability to stay in office and carry out its declared
PRS Group
programs through governmentunity, legislative
Government stability Gs International Country
strength and public support. Ranges between 0
Risk Guide (ICRG)
(very high risk) and 12 (very low risk)”.ICRG
Definition
“This is an assessment of corruption within the
political system that causes distortion in the
economic and financial system, reduces the
efficiency of public as well as private sector by PRS Group
Control over
Cc enabling the people to hold positions of power International Country
Corruption
through patronage rather than ability and creates Risk Guide (ICRG)
instability in political system. Ranges between 0
(very high risk) and 6 (very low risk)”.ICRG
Definition
This is an assessment of how responsive
government is to its people, by assuming that the
less responsive it is, the more likely it is that the PRS Group
Democratic
Da government will fall, peacefully in a democratic International Country
accountability
society, but possibly violently in a non-democratic Risk Guide (ICRG)
one. Ranges between 0 (very high risk) and 6 (very
low risk).ICRG Definition
Iranian Economic Review 2022, 26(2): 325-341 333

Data

There are a several studies that investigated the effect of fiscal decentralisation on economic
growth; however data availability is always indicated as a constraint. For the sample selection
at cross country, data availability played an important role. In year 2018 the World Bank
launched a rich cross country data of the fiscal decentralization indicators, having
observations from 1972-2018; however, the data coverage is not universal.This data set is
used for the current study. However, as discussed earlier, this study also incorporates
institutions in the analysis and as data for institutions is available in the range of 1990 to 2018
therefore, the data range reduces to that available for institutions. Bridging issues, this study
end up with 43 countries, while Table 2 provides the descriptive statistics for the variables.
The list of the sample countries is presented in the Appendix.

Table 2. Descriptive Statistics

Variable Mean Std. Dev. Min Max Observations
overall 1.91 3.37 -14.57 18.62 N = 1187
GDP Per Capita
between 1.05 -0.23 5.41 n = 43
Growth Rate (git)
within 3.23 -18.08 18.01 T-bar = 27.60
Fiscal overall 25.89 16.02 1.03 97.74 N = 542
Decentralization
Expenditure between 15.92 1.19 60.14 n = 43
(FDexp) within 5.08 -11.04 65.82 T = 12.60
Fiscal overall 27.58 15.48 1.03 98.27 N = 530
Decentralization between 16.07 1.15 60.81 n = 43
Revenue (FDrev) within 4.77 -3.44 65.04 T = 12.32
overall 17.83 4.56 2.98 38.23 N = 1187
Government
between 4.12 9.63 27.16 n = 43
Expenditure (ge)
within 2.01 10.25 28.90 T-bar = 27.60
overall 76.52 45.35 12.34 352.90 N = 1187
Openness (op) between 42.57 22.68 244.21 n = 43
within 16.78 9.75 185.21 T-bar = 27.60
overall 94.77 21.04 28.88 160.62 N = 1089
Human Capital
between 19.50 43.24 142.03 n = 43
(hc)
within 10.48 59.59 139.12 T-bar = 25.32
overall 21.89 4.00 11.46 52.94 N = 1187
Physical Capital
between 2.73 15.26 29.14 n = 43
(k)
within 2.98 11.12 50.28 T-bar = 27.60
overall 22.58 352.04 -4.48 11749.60 N = 1141
Inflation (inf) between 72.36 0.57 466.37 n = 42
within 344.28 -442.86 11305.81 T-bar = 27.17
overall 0.83 0.88 -2.57 6.02 N = 1245
Population
between 0.77 -0.53 2.73 n = 43
Growth Rate (pgr)
within 0.43 -1.30 4.58 T-bar = 28.95
overall 55.95 25.53 5.03 100.00 N = 1247
Urbanization (urb) between 25.52 7.93 100.00 n = 43
within 3.88 32.24 72.69 T = 29
overall 7.94 1.83 2.00 11.50 N = 1197
Government
between 0.76 6.75 10.41 n = 43
Stability (gs)
within 1.67 1.94 12.19 T-bar = 27.84
overall 4.05 1.36 1.00 6.00 N = 1197
Control Over
between 1.19 2.03 5.99 n = 43
Corruption (cc)
within 0.68 2.01 6.15 T-bar = 27.84
Democratic overall 5.09 1.17 1.00 6.00 N = 1197
Accountability between 0.93 2.94 6.00 n = 43
(da) within 0.72 2.01 7.28 T-bar = 27.84
Source: Research finding.
334 Arif and Chishti

Estimation Methodology

The extensive data sets usedfor this studyhave both benefits and risks. Benefits can be
considered as the rich and improved data coverage across the countries and time while issue
can be highlighted as the missing observations in the series. Due to missing data issue this
study come up with unbalanced panel for available countries.In the given situation, where we
have to tackle the unbalanced panel data which has missing observation issue, the one to fit
best can be pointed out as the Baltagi and Wu (1999) method. The Baltagi and Wu (1999)
method is specially designed for the unbalanced panel and produces resultsboth for the fixed
effects and random effects models. The estimators also account for the panel
heteroscedasticity and for the panel specific error autocorrelation (Chishti, in press; Chishti et
al., 2020; Ullah et al., 2020). Therefore, the Baltagi and Wu (1999) model suites this data set
the best.

Result and Discussion

Empirical result for the estimation of the different institutional indicators and different fiscal
decentralization measures on the GDP per capita growth rate are shown in the Tables 3 and 4.
The evidence from the Hausman test is in the favour of the fixed effect, indicating that fixed
effect produces consistent results for our models and the same are presented in Tables below.
The Result for the effect of the different Fiscal Decentralization indicators along with
multiple measuresfor institutions, on the economic growth is discussed as under. The main
focus remains on the variables of interest, while the set of the other explanatory variables are
discussed at the end. For the analysis two regression models are run for the each set of the FD
and institutions measures. The first model adds the two indicators separately while the second
model includes the relevant interaction terms to check the complementarities between the two
for economic growth.

Estimation Result with Government Stability

Model 1 at Table 3 presents results of Expenditure Decentralization, which has positive and
significant impact on the economic growth, which is consistent with the fiscal decentralization
theory. This positive association indicate that higher level of fiscal decentralization (on the
expenditure side) leads to higher GDP per capita. The result of the Government stability on
the economic growth is also positive indicating that more the government’s ability to stay in
office and carry out its declared programme, more the growth will be.
Furthermore, the positive impact of the government stability is important for the
entrepreneurs. It will encourage the entrepreneurs to invest freely and confidentially without
anyfear of loss or change in government’s policies. It is argued that foreign investors prefer
less uncertainty with stable government atmosphere1. So in line with the expectations, the
current studyalso finds that more stable government is associated with high GDP growth
rate.However,when interaction term is included in model 2, the coefficient for interaction
term unexpectedly yields negative sign.2
Similarly, the impact of the revenue decentralization on economic growth is also positive
and supportive with the expenditure decentralization theory on the economic growth. The
transfer of the revenue promoting responsibilities to local governments is conducive for the
economic growth. Moreover, the government stability also influence positively and

1. Nawaz, (2015) found similar result for the positive relationship of the GS and economic growth.
2. Despite this surprisingly unexpected result, the individual coefficient for FD and GS still remain positive.
Hence there is need for separate study to thoroughly investigate the factors influencing negative interaction term.
Iranian Economic Review 2022, 26(2): 325-341 335

significantly on economic growth. In addition when interaction term included in the model the
coefficient of the interaction term is also negative and significant (Models 1 and 2 of Table 4).
Thus, theresult is not supportive of our expectation that government stability is
complementary to decentralization in order to enhance the economic growth.

Table 3. Regression Result for Expenditure Decentralization

(Dependent Variable: GDP per capita Growth Rate (annual %))
Democratic
Government Stability Control over Corruption
Accountability
Variable Model 1 Model 2 Model 3 Model 4 Model 5 Model 6
fdexp 0.0525* 0.2296*** 0.0566* 0.0341 0.0504* 0.3833***
gs 0.2193* 0.7786***
fdexp*gs -0.0212***
cc 0.6028** 0.4345
fdexp*cc 0.0080*
da 0.6750 2.3162***
fdexp*da -0.0702**
ge -1.1166*** -1.1815*** -1.1415*** -1.1343*** -1.1844*** -1.2515***
k 0.3289*** 0.3119*** 0.3333*** 0.3347*** 0.3347*** 0.3219***
hc 0.0234 0.0227 0.0246 0.0242 0.0275 0.0148
op 0.0642*** 0.0636*** 0.0617*** 0.0612*** 0.0553*** 0.0529***
pgr -1.8285*** -1.9761*** -1.7992*** -1.8015*** -1.7801*** -1.8508***
inf -0.0001 -0.0084 -0.0154 -0.0156 0.0013 -0.0063
urb 0.0067 0.0118 0.0139 0.0113 0.0008 -0.0401
Constant 5.5672** 3.8886 4.9431** 5.3963** 5.5487** 3.6461
Total Obs. 451 451 451 451 451 451
Countries 43 43 43 43 43 43
Minimum Obs. 1 1 1 1 1 1
Average Obs. 11 11 11 11 11 11
Maximum Obs. 16 16 16 16 16 16
Hausman test 117.01 93.51 116.42 115.09 110.72 114.94
chi2 (P-value) 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
legend: *p<.1; **p<
Source: Research finding.

Estimation Result with Control over Corruption

Models 3 and 4 (at Tables 3 and 4) report the empirical result of the Fiscal decentralization with
control over corruption on the economic growth. The impact of the fiscal decentralization on the
economic growth is again captured by using two measures. Empirical evidence showed it
clearly that different fiscal decentralization measures have different consequences for the
decentralized setup if we take the control over corruption into account. Table 3 presents the
expenditure decentralization with control over corruption and result showed that expenditure
decentralization is positively related with the GDP growth rate of the per capita and control over
corruption is also positively and significantly related with the GDP per capita.
These findings suggest that control over corruption with healthier institutional framework
scales up the economic activities. When corruption is minimum then the political bureaucratic
systems generates more economic growth. Our findings are similar to Mauro (1995) and
Podobnik et al. (2008). By adding interaction term in model of expenditure decentralization
the coefficient of this interaction term has become positive and significant. Given positive
336 Arif and Chishti

result is support over theory that fiscal decentralization and control over corruption are
complementary.This shows that the process of fiscal decentralization is effective when control
over corruption is high in the economies or with less corrupt countries the fiscal
decentralization is effective. However, we could not get similar results for decentralization
models.The result of the interaction term is positive as expected but remained insignificant.
So, overall it can be said that control over corruption is instrumental for the decentralization.

Table 4. Regression Result for Revenue Decentralization (Dependent Variable: GDP per capita
Growth Rate (annual %))
Democratic
Government Stability Control over Corruption
Accountability
Variable Model 1 Model 2 Model 3 Model 4 Model 5 Model 6
fdrev 0.0254 0.2295*** 0.0274 -0.0396 0.0237 0.3258**
gs 0.2119* 0.8947***
fdrev*gs -0.0245***
cc 0.6410** 0.0839
fdrev*cc 0.0240
da 0.6181 2.1758**
fdrev*da -0.0639*
ge -1.1794*** -1.2593*** -1.2056*** -1.2157*** -1.2392*** -1.2697***
k 0.3367*** 0.3179*** 0.3419*** 0.3494*** 0.3429*** 0.3274***
hc 0.0204 0.0187 0.0208 0.0211 0.0241 0.0128
op 0.0646*** 0.0655*** 0.0623*** 0.0618*** 0.0556*** 0.0537***
pgr -1.8626*** -1.9734*** -1.8436*** -1.8246*** -1.8297*** -1.8777***
inf -0.0006 -0.0103 -0.0162 -0.0190 0.0022 -0.0040
urb 0.0252 0.0074 0.0322 0.0328 0.0194 -0.0209
Constant 6.5861*** 4.1175 5.8674** 7.1551*** 6.7025*** 4.4010
Total Obs. 440 440 440 440 440 440
Countries 43 43 43 43 43 43
Minimum Obs. 1 1 1 1 1 1
Average Obs. 10.7317 10.7317 10.7317 10.7317 10.7317 10.7317
Maximum Obs. 16 16 16 16 16 16
Hausman test 114.11 100.30 116.18 117.80 110.72 114.94
chi2 (P-value) 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
legend: *p<.1; **p<
Source: Research finding.
Note: #Fixed effects model estimated with Baltagi and Wu (1999), between cluster robust standard
errors along with AR1 errors

Estimation Result with Control over Corruption

Models 3 and 4 (of Tables 3 and 4) report the empirical result of the Fiscal decentralization with
control over corruption on the economic growth. The impact of the fiscal decentralization on the
economic growth is again captured by using two measures. Empirical evidence showed it
clearly that different fiscal decentralization measures have different consequences for the
decentralized setup if we take the control over corruption into account. Table 3 presents the
expenditure decentralization with control over corruption and result showed that expenditure
decentralization is positively related with the GDP growth rate of the per capita and control over
corruption is also positively and significantly related with the GDP per capita.
These findings suggest that control over corruption with healthier institutional framework
Iranian Economic Review 2022, 26(2): 325-341 337

scales up the economic activities. When corruption is minimum then the political bureaucratic
systems generates more economic growth. Our findings are similar to Mauro, (1995) and
Podobnik et al., (2008). By adding interaction term in model of expenditure decentralization
the coefficient of this interaction term has become positive and significant. Given positive
result is support over theory that fiscal decentralization and control over corruption are
complementary.This shows that the process of fiscal decentralization is effective when control
over corruption is high in the economies or with less corrupt countries the fiscal
decentralization is effective. However, we could not get similar results for decentralization
models.The result of the interaction term is positive as expected but remained insignificant.
So, overall it can be said that control over corruption is instrumental for the decentralization.

Estimation Result with Democratic Accountability

It is expected that with strong democratic institutions,fiscal decentralization will yield positive
effect on the economic growth. Current study check the role of institutions in the fiscal
decentralization process (Model 5) and the interactive term of democratic accountability is
also added (Model 6) at Tables 3 and 4. The estimation results indicate that expenditure
decentralization is positive and have significant impact on the economic growth. Democratic
accountability also has shown positive and significant impact on the economic growth in the
Table 3, model 4.
The positive sign of the democratic accountability indicates that the countries with strong
democratic institutions perform better. Helliwell (1994), Nawaz (2015), and Rodrik (2000)
have found same result as current study found. Rodrik (2000) argued that with strong
democratic institutions, countries can promote economic growth by allowing accountability
and stability in the system. However, with the inclusion of the interaction term in the model,
the coefficient of the interactive term becomes negative. Thus, the result is not supportive of
the expectation that democratic accountability is complementary in catalysing the growth
effect of fiscal decentralization.
Similarly, the revenue decentralization model showed that revenue decentralization and
democratic accountability have positive impact individually. When the interaction term is
added in the model the result seems to be different.1 The coefficient of the interaction term
becomes negative but significant. Iimi (2005) found similar result for the interaction of FD
and Political freedom and concluded that FD and political freedom are not complementary. It
is noteworthy that Iimi showed the political freedom in term of accountability.
The negative effect of the democratic accountability may be interpreted as that excessive
freedom of the peoples makes it difficult for the sub-national tiers to internalize the
economies of scale and optimize in the local public goods provisions. It shows that when
officials elected become more accountable to the local population, such a situation hampers
their ability for policy coordination and reduces de factocollaboration among the office
holders. This explains the reason for non-complementarities between the fiscal
decentralization and democratic accountability.
Having discussed the variables of interest, Table 3 and 4 also contain the estimation result
for the rest of the control variables.Regarding other control variables, an increase in the public
spending slows the economic growth. Iimi (2005) showed similar result with tax to GDP ratio
and conclude that higher tax to GDP ratio slows the economic growth.The current study also
showed negative impact of the population growth rate on GDP growth which is consistent
with the basic growth theory. Iimi (2005); Davoodi and Zou (1998) showed similar result of
negative relationship between the two. Physical capital is positively associated with growth
rate of per capita implying that countries can increase GDP per capita growth rate by

1. As the individual coefficient for FD and DA becomes positive and significant.

338 Arif and Chishti

investing more in the physical capital. Iqbal et al. (2013) and Nawaz (2015) also presented
similar impact for physical capital on the per capita GDP growth rate. The result of the trade
openness is also positive and significant implying that trade is beneficial for the economies.
The positive relation associated with benefits evolving from the competition, economies of
scale and specialisation.Multiple studies showed similar positive relationship (Iqbal et al.,
2013). Rest of the independent variables i.e. (inflation, urbanization, and human capital)
remained insignificant in the analysis.

Conclusion and Policy Implications

The relationship between fiscal decentralization and economic growth has attracted
significant consideration in previous years. Plethora of the studies has shown positive impact
of the fiscal decentralization on the economic growth while a number of studies also have
shown negative impact of fiscal decentralization on the economic growth. So, in this study,
the growth effect of the fiscal decentralization is examined by using endogenous growth
model.
Moreover, Institutions plays significant role in development. Thus, current study
incorporated different measures of institutions along with the process of fiscal
decentralization as suggested by SG theories of fiscal federalism.This study used rich cross
country panel data of 43 countries over the period 1984-2012 and applied Baltagi and Wu
(1999) method for unbalanced panel data to investigate whether fiscal decentralization (in the
presence of better institutions) has any growth impact.
The empirical analysis shows that decentralization is growth enhancing. Decentralization
(i.e. expenditure capabilities as well as the revenue generation responsibilities) create positive
externalities and due to this positive externalities, per capita income of the countries increases.
It can be concluded that fiscal decentralization is instrumental in promoting economic growth.
Furthermore, the analysis reveals that the impact of government stability, control over
corruption and democratic accountability on the per capita GDP growth rate is also positive
and in favour of the growth.
Moreover, analysis reveals that fiscal decentralization is effective in the development
process if it is complemented with institutions as is shown that interaction term of expenditure
decentralization with control over corruption has as positive and significant impact on the
economic growth. However, non-complementarity exists between fiscal decentralization
(expenditure and revenue decentralization) with government stability and democratic
accountability.
From the empirical analysis the policies implications are follows as under. First, the
domestic environment plays a significant role on the way of the economic development.
Therefore, countries should take benefit from the fiscal decentralization to achieve long term
economic growth. Second, for the high and sustainable development the institutional quality
needs to be strengthened. Third, countries should focus on the stable government and make
officials accountable without compromising their ability to work, so that the benefit of fiscal
decentralization can be achieved. When provinces have adequate administrative capacity than
the fiscal decentralization can be effective.

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 Iranian Economic Review 2022, 26(2): 325-341 341

Appendix:

Table I. List of Sample Countries

Sr. no Name Sr. no Name Sr. no Name
1 Argentina 16 Germany 31 New Zealand
2 Australia 17 Greece 32 Norway
3 Austria 18 Honduras 33 Poland
4 Belgium 19 Hungary 34 Portugal
5 Bolivia 20 Iceland 35 Romania
6 Canada 21 Ireland 36 Russian Federation
7 Chile 22 Israel 37 South Africa
8 Columbia 23 Italy 38 Spain
9 Congo, Rep. 24 Jamaica 39 Sweden
10 Cyprus 25 Japan 40 Switzerland
11 Denmark 26 Lithuania 41 Turkey
12 El Salvador 27 Luxembourg 42 United Kingdom
13 Estonia 28 Malta 43 United States
14 Finland 29 Morocco
15 France 30 Netherlands

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