Equalization Transfers, Fiscal Decentralization, and Economic Growth

This paper analyzes the fiscal decentralization and equalization transfers in a two-region model of endogenous growth. In our model, two levels of government with different objectives are considered: the local governments maximize the utility of the residents of the region, and the central government makes the equalization transfers to close the gaps in fiscal capacity among the regions and pays attention to the economic growth rate. Our first result demonstrates that the preferred tax rate chosen by the local government is positively affected by the magnitude of fiscal decentralization. The second result shows that the fiscal equalization policies of the central government have no influence on the speed of interregional growth convergence. Furthermore, the normative implication is obtained from our final results that there exists an optimal degree of fiscal decentralization to reach the central government's goal of growth maximization, but the magnitude of fiscal decentralization chosen by the central government is excessive to entail the highest regional welfare.