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Essay Title: To what extent is devolution contributing to the increase of regional disparities? Explain with the example.
The last three decades have witnessed increasing global trend for the transfer of power and resources from central government to sub-national government, as well as the rising inequalities, which give rise to a sea of controversy on the correlation between devolution and regional disparities. A problem that is widely discussed in the current debate is whether devolution brings about significant economic benefits or the economic impact of devolution is fundamentally negative. On the one hand, the "efficiency through devolution" argument is at the heart of recent devolutionist and "new regionalist" discourses (Pose & Bwire 2004), on the other hand, as suggested by Thiessen (2003), there are significant arguments cautioning against fiscal decentralization, based on the key point that devolution can reinforce regional inequalities, which may hinder economic growth. This essay aims to demonstrate the role of devolution plays in contributing to the evolution of regional disparities. In order to be more justified, case studies from both developed and developing countries will be selected. It will illustrate two ways in which devolution may foster regional inequalities, with the first half concentrating on the link between fiscal decentralization and regional disparities, and second half highlighting the link between efficiency and regional disparities. The conclusion is that although devolution is not the only determinant of the rising income inequalities, robust evidence exists in supporting the positive correlation between devolution and regional disparities, especially in fiscal decentralization.
Link between fiscal decentralization and regional disparities
Interest in devolution has grown worldwide in the past three decades, at the same time, the global trend towards the increasing regional disparities has been identified by Scott and Storper (2003) that "50% of global GDP today is produced by only 15% of the world's people, most of them concentrated in the Triad nations of the North, the poorer half of the world's population produced just 14% global GDP". As a result, there arises debate over the impact of devolution upon the increase of inequality. However, among the three dimensions of decentralization: fiscal, administrative and political decentralization, the sector hereafter will highlight the fiscal decentralization, ignoring the latter two, because fiscal decentralization has been adopted by large numbers of already decentralized developed countries as well as recently devolved developing countries all around the world, in order to "produce genuine governmental restructuring" (Ebel & Yilmaz 2002) and achieve the objective of development.
Fiscal decentralization (FD) is the devolution of fiscal power from national government to sub-national governments. However, such kind of process is no easy job, as it is quite difficult and complicated to measure the impact of fiscal decentralization. According to Zhang, T. and H. Zou (2001), in fiscal federalism literature, FD is measured by the relative sizes of local spending and revenue collection and central spending and revenue collection. DeMello (2000) takes the ratio of the fiscal deficit to GDP as the measurement of the impact of FD on budget balance. In short, the level of FD in most literature is measured by the sub-national share in total government expenditure (Oates 1985, 1993; Davoodi and Zou 1998, cited in Ezcurra & Pascual 2006).
Base on the empirical evidence from 12 European Union countries with "a two-way fixed effects panel data model", Ezcurra & Pascual suggest that there is a negative correlation between fiscal decentralization and the level of regional inequality, since devolution of fiscal power from central government to regional and local government may generate a more balanced distribution of resources across regions. Such kind of argument has also been supported by Oates (1993) that fiscal decentralization contributes to economic development and eventually results in the reduction of regional disparities (Qian and Weingast 1997). However, Prud'homme (1995) strongly advocates the danger of decentralisation, since fiscal decentralization could have spatially regressive effects in reducing the equalization role of central government, thus could definitely lead to the increase of regional disparities. Furthermore, through the scrutiny of the evolution process of territorial inequality and decentralization in Brazil, China, India, Mexico, Spain and the USA, Pose & Gill (2003) find that there are some coincidence between rising sub-national expenditure and increase in regional disparities except for the case of Brazil. In light of these controversial arguments, it is significant to further examine the link between fiscal decentralization and regional disparities based on available case studies.
According to Pose & Gill (2003), there are two forms of the fiscal inequalities engendered by devolution: static and dynamic forms. On the one hand, from a static point of view, devolution focuses on the autonomy of regions, different regions are obtaining diverse tax bases and welfare responsibilities. The initial reduction of fiscal transfers (particularly in the cases with decentralized tax collection) is likely to make actual government spending at sub-national levels regressive. Such kind of system may have the advantage of greater incentive to put in place an effective tax system at regional levels supported by the advocates of devolution. However, a lower fiscal base in poorer regions with lower regional budgets and lower capacity to implement public policies may lead to territorially regressive system, as a result of falling further behind other regions, in other words, promoting regional inequalities. On the other hand, from dynamic point of view, the shift of disproportionate negotiating power from central government to the sub-national government located in richer and more populated regions, since rich regions matter more to the economy, furthermore, they carry the greatest threats to its own political legitimacy. In this case, rich places will become richer and poor become poorer, it will definitely result in polarization. This hypothesis has been supported by a number of case-study countries, such as the USA, Argentina and China.
Sawicky (2000) illustrates the problems of new devolution in the USA. On the revenue side, state and local government in the USA has received increasingly revenue since 1980, in spite of the anxiety about "tax competition" for more and more footloose taxpayers in the global economy. On the expenditure side, about 68 percent of federal expenditure is contributed to social security, defence, medical care and net interest outlays in 1997, 80 percent of the remaining expenditure is devolved to the sub-federal governments. In addition, most public investment such as infrastructure, education and training has to be financed by the state and local government. Such kind of system is quite efficient in prosperous economic time, however, in less happy economic period, "the new extent of decentralization in the U.S. public sector could cause some important pressure points to blow their gaskets ... the leading concern is the effect of moving large numbers of welfare recipients into labor markets (Bernstein, 1998), since unemployment will probably not remain low indefinitely". Furthermore, federal government has now even transferred the expenditure of health care to the state-local sector, which will increase the fiscal burden of the state and local government. Meanwhile it will also change the status of nursing home residence originally supported by federal government. It is undoubtedly a huge challenge for the poor people in the USA which may increase regional disparities.
Fiscal decentralization may result in fiscal perversity, which has been confirmed by Prud'homme (1995) in his example of fiscal indiscipline of the sub-national government in Argentina. In Argentina, provincial expenditures rose hugely in 1986, while government revenues dropped. The provincial deficit was financed by either transferred from central government or by borrowing, thus led to the inflationary effect. Moreover, mismanagement of sub-national government resulted in large government deficit, unsustainable public sector fiscal and quasi-fiscal deficits. As a result, the poorer regions suffered greater than the rich regions.
China has witnessed the "growth miracle" (Budd 2005) since the implementation of opening up policy in early 1990's. However, the development in China is significantly uneven between sectors and regions during the same period. The coastal regions have experienced the most rapid economic growth. At the same time, China has also experienced the process of devolution, particularly fiscal decentralization. The impact of devolution upon the regional disparities in China has been examined by Pose & Gill (2003) in great detail. Driven by the transformation from planning economy to market economy, Chinese sub-national expenditure has been increased since 1980 when the infant devolution system known as "eat in separate kitchens" was initiated, making regional and local government partially depending on their own collected revenue for the first time. As a result, Tsui finds that the FD in China is closely related to the rise in disparities that took place in 1980. (Tsui 1996, cited in Canaleta et al. 2004: 75). In 1985, the system was developed, the sub-national government had more autonomy in pooling the revenues and redistributing them, as a consequence, the role of central government was gradually contracted. However, the devolution process in China is no easy task, by the year of 1988, the richer regional and local government lost their incentive to collect taxes due to the new system. From 1990 onwards, under Dengxiaoping's uneven development model and opening up policy, foreign direct investment in China started booming, the preferential fiscal policies were devolved to provinces, particularly the rich costal regions in order to attract FDI. As a result, the costal provinces in China has become more autonomous and more affluent, in contrast, the inland areas in China are getting poorer.
Summing up, the above case studies representing both developed and developing countries show that there is a positive correlation between fiscal decentralization and the increase of regional disparities.
Link between efficiency and regional disparities
One of the objectives of fiscal decentralization is economic growth. Advocates in favor of devolution consider FD as an effective way to increase the efficiency of public expenditure. The following sector will demonstrate the relationship between efficiency and regional disparities.
Arguments supporting devolution advocates that governments closest to the citizens can adjust costs and make tailored policies to the preferences of local population which will lead to consumer efficiency, while the counter arguments illustrate that preferences are not identical, consumer efficiency maybe improved, but it does mean a positive impact on economic growth, since efficiency does not equal to economic growth (Pose & Bwire, 2004). In addition, pro-devolution arguments indicate that inter-territorial competition can generate efficiency and innovation, while the counter arguments find that detrimental aspect of competition when financial enticements such as tax concessions are involved, local government will attract the investors who are already interested (Cheshire & Gordon, 1998). Moreover, in response to the arguments that devolution will enhance the "combination of greater political participation, transparency and accountability", resulting in "economically advantageous institutions such as trust" (Putman 1993, cited in Pose & Bwire, 2004), Prud'homme (1994) argues that devolution will lead to worse career opportunities and salaries while Thiessen (2003) indicates that local government will be more easily swayed by locally powerful entities after devolution, in other word, there will be more possibility of the corruption.
Pose & Gill (2003) point out that devolution may promote regressive effect at the sub-national level because of the cost that devolution involves, including administrative cost and competition cost. Devolved system indicates greater coordination costs among governmental tiers to avoid overlapping and "imply greater incentives for revenue maximization" at all government levels (Pose & Bwire 2004).
Different regions have different capacities in dealing with the administrative cost of devolution. Richer regions have greater capacities because of their more abundant resources more access to the skilled labor market. On the contrary, poorer regions have lower capacities to set effective bureaucracies in place (Putnam 1993) and reveal efficient public management. Devolution is costly in administrative cost can be supported by the case study in Scotland. Cost of running administration in Scotland is 227 million pounds in 2003, compared with 154 million in 1999 (Rafferty 2003), taxpayers are tired of forking out money for what seems to be the only growth industry in Scotland government (Monteith 2003).
Competition cost mostly refers to the competition for FDI, "the intensity of competition increases as more regions from more countries compete for the same mobile industry", such kind of competition can be inefficient, because in most cases the attraction of FDI is still very much incentive based (Cheshire and Gorden 1998, Pose & Gill 2003). This finding can be proved by the case study of US and Brazil in the automobile industry, as well as China in attracting FDI which have been demonstrated by Pose & Gill. In the USA and Brazil, it is the less developed states or regions that tend to bear greatest cost of employment for MNEs in order to maintain FDI in place. The cases in Alabama and South Carolina in the USA (Donahue 1997; Florida 1996) or Bahia in Brazil (Pose & Arbix 2001) are good example. In China, the spiraling decline in the quality of working conditions in many special economic zones that have emerged in attracting FDI fails to justify the implicit solution that poorer states are forced to adopt (McKenney 1993, cited in Pose & Gill 2003). In order to be more efficient in attracting FDI, public resources are more unequally distributed concentrating in the east coastal areas of China, as a consequence, there is an unbalance development between the coastal and inland areas of China. In short, the competition cost through devolution will lead to the increase of regional disparities.
Furthermore, the lack of adjustment between responsibilities and resources will result in large public debts, some times in the central budget when the devolution of resources exceeds that of authority, or at the regional level when the devolution of authority exceeds that of resources, which will cause macroeconomic instability (Pose & Bwire 2004). The case of Brazil by Prud'homme (1995) is a good example in illustration such kind of phenomenon. Brazil has witnessed very poor macroeconomic performance in recent years because of the constitutional reform to reduce central government's ability to conduct macroeconomic policies by devolution since 1988. The state governments have more autonomy in setting tax rates and have more shares of the taxes. In order to improve the poor performance, new legislation is implemented aiming to enhance the central control over sub-national spending and borrowing.
To sum up, devolution leads to lower economic efficiency and greater regional disparities.
This essay has demonstrated the relationship between devolution and increase of regional disparities in two ways, the fiscal impact and efficiency impact of devolution. In the past three decades, there is a global trend towards both the devolution and increase of regional inequalities. Arguments in favor of devolution suggest that devolution is associated with great social and political or even economic benefits, and finally result in the reduction of regional disparities (Pose & Gill 2003, Oates 1993, Qian and Weingast 1997, Ezurra & Pascual 2006). However, based on the case studies of both developed and developing countries, the counter arguments argue that "fiscal decentralization could have spatially regressive effects, as a result of the weakening of the equalization role of central government" (Prud'homme 1995, Ezurra & Pascual 2006). Moreover, devolution may lead to lower economic efficiency and generate greater regional disparities.
Although other determinants such as trade also exist which will cause the increase of regional inequalities, strong evidence has shown that devolution is definitely one of the factors. To summarize, there is positive correlation between devolution and the increase of regional disparities, particularly in fiscal decentralization.