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Fiscal Decentralization and Political Budget Cycles


  • We are especially indebted to Ben Lockwood for his contribution on earlier versions of the paper. We would also like to thank Gani Aldashev, Robert Gary-Bobo, Christos Kotsogiannis, Pilar Sorribas, and Dave Wildasin, as well as seminar participants at Lisbon, Sevilla, Vanderbilt University, and different conferences, for helpful comments on a previous draft. The comments by the Associate Editor and two anonymous referees substantially improved the paper. P. González acknowledges financial support for herself and for N. Porteiro from projects SEJ-02936 and SEJ-04992 (Junta de Andalucía) and projects ECO2008-04321/ECON and ECO2012-36480 (Spanish Ministry of Education and Science).


We analyze a problem à la Rogoff where incumbents can distort fiscal policy to signal their competency, but where fiscal policy can be centralized or decentralized. Our main focus is on how the equilibrium probability that fiscal policy is distorted in any region (the political budget cycle, PBC) differs across fiscal regimes. With centralization, there are generally two effects that change the probability of a PBC. One is the possibility of selective distortion: the incumbent can be reelected with the support of just a majority of regions. The other is a cost diversification effect, which is present unless costs are perfectly correlated across regions. Both these effects work in the same direction, with the general result that the PBC probability is lower under centralization when decentralization also involves PBC. Welfare analysis shows that voters tend to be better off when the PBC probability is lower, so voters prefer centralization when decentralization involves PBC. Our results are robust to a number of changes in the specification of the model.