Revisiting the Nexus between Fiscal Decentralization and Government Size - the Role of Ethnic Fragmentation

This study analyses a possible reason behind the ambiguous relationship between fiscal decentralization and government size by introducing the mediating factor of ethnic fragmentation. It is postulated that the heterogeneous needs and preferences of an ethnically fragmented region would lead to an increase in the demand for public goods and services provision, thereby increasing the level of aggregate government spending through fiscal decentralization. It is tested by employing a panel dataset of 68 developed and developing countries spanning over the time period of 1972-2013, which is estimated using Feasible Generalized Least Squares model with heteroscedastic panels. The results support the postulated hypothesis and establish that fiscal decentralisation is associated with a decrease in the government size. However when ethnic fragmentation comes into the picture, it dilutes the negative association, which is suggestive of the fact that fiscal decentralization leads to an increase in the overall public spending in regions having higher degree of ethnic fragmentation. This result stays robust when System GMM and instrumental variable method with Two Stage Least Squares is used to account for potential endogeneity between the key variables. Furthermore, the robustness stays intact across various possible alternate econometric specifications, indicators of key variables and sample dimensions. Thus our study establishes ethnic fragmentation as a potential determining factor of the ambiguous relationship which fiscal decentralization and government size share