State Corroding Federalism

Competition among local governments in a decentralized political system is often thought to discipline lazy or corrupt officials, improving public good provision and increasing welfare. Some scholars note possible distortions due to spillovers or a race-to-the-bottom, but suggest that central transfers or regulations can remedy these. Both arguments take for granted a framework of constitutional order in which the central government can collect taxes, allocate transfers, and enforce regulations autonomously. But what if it can't? We show that if central enforcement capacity is endogenous, interjurisdictional competition may itself erode the center's ability to channel competition in welfare-enhancing directions. Regional governments may compete for capital by shielding firms from central tax collectors, bankruptcy courts, or regulators. The equilibrium result is weaker central law enforcement and usually lower welfare: interjurisdictional competition corrodes the state. We illustrate with three examples - from Russia, China, and the US - of cases in which such competition apparently encouraged subnational politicians to help firms evade central taxes or regulations