Does Decentralization Reduce Government Size? A Quantitative Study of the Decentralization Hypothesis

Abstract

The ‘‘decentralization hypothesis’’ in the theory of fiscal federalism suggests that fiscal decentralization may have a dampening effect on government size, implying that government intrusion into the economy can be restricted if government responsibilities for taxes and expenditures are decentralized. We study the effect of decentralization on public sector growth for a panel of twenty-nine countries over the 1978—2003 period. The major purposes of this study are twofold. First, we examine the decentralization hypothesis using two different proxy variables of fiscal decentralization: a measure of expenditure and revenue decentralization based on government financial statistics and an index of fiscal federalism that incorporates the fiscal and administrative autonomy that constitutional and statutory law grants to subnational governments. Second, and relatedly, we also explore the hypothesis that direct democracy at the local level has a dampening effect on government growth.