Political Decentralization and Fiscal Management of Local Governments:

Evidence and Lessons from Korea

No-Wook Park

Center for Fiscal Analysis

Korea Institute of Public Finance

Purpose of the Presentation

Share Korean experiences by examining the effects of political decentralization (resumption of local elections) on the fiscal management of local governments– Resumption of Korean local elections in 1995– Identify differences in fiscal managements

before and after the resumption of local elections

– Derive lessons and implications from Korean experiences

Decentralization Process

Decentralization is a globally popular since 1990s– Many developing countries have experimented

with decentralization reforms– Decentralization reforms are in full swing with

the initiatives of the current administration in Korea

What is Decentralization?

Devolution of various authorities (powers) to the lower level of governments– Fiscal decentralization

• More fiscal decision making authority and economic resources in local governments

– Political decentralization• Local governments are formed by local residents

– Administrative decentralization• More administrative decision making authority in local

governments

Why Decentralization?

Expected benefits of decentralization– Increase in efficiency

• Local governments have better local information• Competition among local governments improves the

performance of local governments

Expected benefits of centralization– Realization of economies of scale– Internalize externalities across local governments

Recent trend reflects the perception that movement towards decentralization may bring in benefits.

How to Decentralize?

Proper assignment of various authorities between central and local governments

Capacity consideration is important.– Capacity for decentralization needs to be

developed.– Local governments tend to lack capacity to

cope with various issues.• Administrative capacity• Restraining corruption

Supporting Institutions for Decentralization

Intergovernmental Fiscal Institutions– Intergovernmental Transfers– Transfer Dependency and Local Revenue Raising– Expenditure Assignment and Local Autonomy

Political Institutions Capital Markets Factor Mobility and Land Market Hierarchical Mechanisms

Political Decentralization

How to select local officials– Election: Politicians– Appointment: Bureaucrats

Resumption of local elections– Appointment Election

Why Do Local Elections Matter? Different Incentives

– Politicians• Winning Elections

– Bureaucrats• Career Concerns

Local Elections as an Issue-Unbundling Mechanism– Elected Local Officials

• Mainly Care for Local Issues

– Appointed Local Officials• Care for both of Central and Local Issues

The Korean Case

Resumption of Local Elections in 1995– Opportunity to examine the effects of political

decentralization– No significant devolution of economic resources

to local governments– Appointed officials Elected Officials

Research Questions

Do elected officials manage differently in their fiscal issues?

In addition to elections as a way of selecting local officials, do other political factors matter?– Political competition in each district– Alignment with the incumbent president

Summary of Results 1

More fiscal independence – Exert efforts in increasing internal revenues

Raising revenues through non-tax revenues as opposed to through local taxes– Minimize political costs associated with raising

internal revenues

Summary of Results 2

Do not face harder budget constraints– Rely more on intergovernmental transfers than

local borrowings Political competitive districts receive more

intergovernmental grants– Political decentralization may activate

distributive politics

Institutional Backgrounds

Political decentralization Regional identity based voting and imperial

president

Political decentralization 1

Resumption of local elections for the head of local governments in 1995– Suspended since 1961– 3 year term and term-limit is 3 times– Higher level local governments

• 7 Metro-cities and 6 provinces

– Lower level local governments• 232 cities, counties and districts in 2000

Political decentralization 2

No significant fiscal decentralization during 1991-1999

Local tax revenue– 20 percent of total tax revenue

Local government’s budget share– 35-43 percent of total government revenue

Ratios of Local Budget Share and Local Tax Revenue Share

05

101520253035404550

1992 1993 1994 1995 1996 1997 1998 1999 2000

Year

Per

cent

Local Tax/(National Tax+Local Tax)

Local Budget/(National Budget+Local Budget)

Voting Behavior and Imperial Presidency

Regional identity-based voting Imperial presidency Importance of Swing Voters (Districts)

– Expected to be important given strong regionalism

Importance of Alignment with president– May not be important

Regional Identity-Based Voting

0

10

20

30

40

50

60

70

80

90

100

1987Prez

1988Nat'l

1992Nat'l

1992Prez

1995Local

1996Nat'l

1997Prez

Per

cen

tag

e

Gwangju Jeonnam Buasn Gyoungnam

Empirical Strategy

Devise Fiscal Indices Test significance of decentralization dummy

which is 1 after decentralization Test significance of political variables in

explaining differences of indices pre and post decentralization

Indices of Fiscal Management 1

Internal-revenue vs. external-revenue– Fiscal independence index– FI1 = (local tax+non-tax)/total expenditure– FI2 = (local tax+non-tax)/total revenue

Indices of fiscal management 2

Revenue raising through non-tax vs. local tax– Source of raising internal revenue– RI1 = current non-tax/(local tax+current non-tax)– RI2 = non-tax/(local tax+non-tax)– Non-tax revenues tend to carry less political

costs.

Indices of fiscal management 3

External financing through subsidy vs. local borrowing– Source of external funding– SI1 = National subsidy/(national subsidy+local

borrowing)– SI2 = All intergovernmental

transfers/(intergovernmental transfers + local borrowing)

– Transfers tend to be soft money.

Data 1

Local government fiscal year book during 1991-1999– No significant change in fiscal rules related to

local governments Cities, counties, and district level data

– 232 cities, counties, and districts in 2000– Due to administrative boundary changes in

1995, 123 local governments are analyzed.

Regional Identity-Based Voting

0

10

20

30

40

50

60

70

80

90

100

1987Prez

1988Nat'l

1992Nat'l

1992Prez

1995Local

1996Nat'l

1997Prez

Per

cen

tag

e

Gwangju Jeonnam Buasn Gyoungnam

Results - Break of Trend 1

Significant break of trend after the resumption of local elections

Unconditional average– Fiscal independence indices increase by 1-2%– Subsidy indices decrease by 1-2%– Non tax revenue indices increase by 6-9%

Table 1 Average Indices of Pre and Post Decentralization

Index

Pre-Decentralization (1991-1995) Post-Decentralization (1996-1999)

MeanStandardDeviation

Number of Observation

sMean

StandardDeviation

Number of Observation

s

Independence Index 1

0.6231 0.4304 615 0.6547 0.2779 492

Independence Index 2

0.4817 0.3178 615 0.4925 0.1734 492

Non-tax Revenue Index 1

0.2946 0.0697 615 0.3529 0.0665 492

Non-tax Revenue Index 2

0.6098 0.1019 615 0.6988 0.1001 492

Subsidy Index 1

0.9351 0.1072 615 0.9213 0.1092 492

Subsidy Index 2

0.9660 0.0750 612 0.9554 0.0721 492

Results - Break of Trend 2

Controlling for district fixed effect and year effect

Significantly positive decentralization dummy (=1 after local elections) for every category of indices– Independence indices increase 3-5%– Subsidy indices increase 0.56-0.35%– Non tax indices increase 5-8.4%

Table 2 Comparison of Indices between Pre and Post Decentralization(Weighted Least Squares Logit Estimates)

 

IndexDecentralization Dummy

Estimated Pre-decentralization

Fiscal Index

Estimated Post-decentralization

Fiscal IndexR2 Number of

Observations

Independence Index 1

0.2524 (0.040)

0.4657 (0.1710) 0.4954 (0.1671) 0.9031 1228

Independence Index 2

0.2724 (0.055)

0.5525 (0.1652) 0.6023 (0.1577) 0.7416 1107

Non-tax Revenue Index

1

0.3074 (0.032)

0.2998 (0.0552) 0.3499 (0.0575) 0.7000 1107

Non-tax Revenue Index

2

0.5410 (0.043)

0.6178 (0.0932) 0.7014 (0.0822) 0.7532 1228

Subsidy Index 10.2886 (0.147)

0.8400 (0.1117) 0.8456 (0.1067) 0.539 761

Subsidy Index 20.3650 (0.145)

0.9117 (0.0920) 0.9152 (0.0893) 0.626 760

Results – Political determinants 1

Robust results– Political competition have a negative impact on

fiscal independence index 2– Political variables do not matter for non-tax

revenue indices– Political competition has a positive correlation

with subsidy index 1

Table 3 Average Political Factors Affecting Changes in Fiscal Management 

 Independence Index

1

Independence Index

2

Revenue Index 1

Revenue Index 2

Subsidy Index 1

Subsidy Index 2

Alignment-0.001(0.021)

-0.066(0.072)

0.002(0.024)

-0.006(0.029)

-0.017(0.038)

-0.037**(0.019)

Competition0.001

(0.064)-0.505**(0.208)

-0.096(0.065)

-0.063(0.077)

0.199**(0.076)

0.064*(0.037)

Alignment*Competition

-0.029(0.012)

0.028(0.052)

-0.020(0.19)

-0.020(0.022)

-0.083***(0.025)

-0.022*(0.013)

Population Density-0.003***

(0.000)-0.010***

(0.002)-0.000(0.001)

-0.004***(0.001)

0.009***(0.002)

0.004***(0.001)

Number of Observations

89 89 89 89 89 89

R2 0.3866 0.264 0.049 0.2374 0.2968 0.2388

Summary 1

Fiscal management changed after the resumption of local elections– More fiscal independence– More non-tax revenue raising efforts– More dependence on subsidy for external

funding

Summary 2

Political characteristics of districts matter for attracting subsidy from the central government after political decentralization.

Internal revenue raising efforts through non-tax revenues are significant regardless of political characteristics.

Efficiency implications

Increased revenue raising through non-tax– Efficiency implication depends on how local

governments use increased revenues Active political factors

– May have negative implications Decentralization itself does not guarantee

efficiency gains.– Supporting institutions are important.

Other Implications Political institutions are important in realizing

benefits of decentralization. Political environments shaping incentives of

local officials are crucial.– Can local residents (voters) discipline local

officials?– Availability of Information on the fiscal

management of local governments – How to avoid a possibility of collusion between

local officials and powerful local interest groups

Thank you!