What is it about?
What instruments can governments deploy to prevent fiscal crises in decentralized fiscal systems? This paper studies policy and institutional tools to prevent fiscal crises under decentralization. This analysis reveals that good public sector institutions, controls by the central government over local fiscal balances and borrowing, and intergovernmental transfers could be effective instruments for reducing the probability of a crisis.
Featured Image
Photo by Charles Postiaux on Unsplash
Why is it important?
Many public services are provided by subnational governments worldwide because they know local needs better than the central government does. However, this may come at a cost to fiscal sustainability since local governments do not internalize the effect of their actions on the country-wide fiscal position. Indeed, recent studies find that fiscal decentralization may increase sovereign risk and raise the probability of a fiscal crisis. This raises questions about how fiscal sustainability can be maintained when revenue and spending responsibilities are decentralized. Specifically, how can countries prevent fiscal crises in fiscally decentralized systems? Such prevention is critical for policymakers, as fiscal crises hurt people's daily lives, while fiscal decentralization is ubiquitous across countries.
Perspectives
Intergovernmental transfers are associated with a lower probability of a fiscal crisis because they can play a role in interregional risk sharing among subnational governments. Strengthening good institutions mitigates the unwanted effects of devolution on fiscal unsustainability by inhibiting allocative inefficiencies caused by the moral hazard of governments. Expenditure decentralization to local governments increases the probability of a crisis only when local governments run large budget deficits, indicating that controls by the center over the local budget balance or borrowing ability may help to avoid overspending and the resulting excessive indebtedness. Subnational fiscal rules and administrative constraints also reduce the probability of a crisis.
Dr. Ryota Nakatani
International Monetary Fund
Read the Original
This page is a summary of: Preventing Fiscal Crises under Decentralization, IMF Working Paper, May 2025, International Monetary Fund,
DOI: 10.5089/9798229009089.001.
You can read the full text:
Contributors
The following have contributed to this page
