Information transmission within federal fiscal architectures: Theory and evidence (discussion paper)

Abstract

This paper explores the role of information transmission and misaligned interests across levels of governments in explaining variation in the degree of decentralization across countries. We analyze two alternative policy-decision schemes—‘decentralization’ and ‘centralization’— within a two-sided incomplete information principal-agent framework. The quality of communication depends on the conflict of interests between the government levels and on which government level controls the degree of decentralization. We show that the extent of misaligned interests and the relative importance of local and central government knowledge affect the optimal choice of policydecision schemes. Our empirical analysis confirms that countries’ choices depend on the relative importance of their private information. Importantly, results differ significantly between unitary and federal countries, in line with our theory.