Fiscal Decentralization, Political Heterogeneity and Welfare

This paper contributes to the literature on fiscal decentralization by presenting a formal model of the interaction between the central and local governments (CG and LGs, respectively) where LGs may differ in their degree of political alignment with CG. The non-cooperative optimal behavior of the agents reveals that optimal tax increases with the extent of FD, political unison and spillovers across localities; while LGs' optimal tax collection effort is negatively associated with all of these parameters. The first novel finding of our study is that both welfare peaks and income distribution is more equitable at a lower level of FD in case of spillovers than the case of no spillovers, which supports the decentralization theorem. The second novel finding is that both the amount of redistributable income and central government utility increases with the degree of political unison