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 Local tax revenue –20 percent of total tax revenue Local government’s budget share –35-43 percent of total government revenue

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

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 –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.

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 ( )Post-Decentralization ( ) Mean Standard Deviation Number of Observation s Mean Standard Deviation Number of Observation s Independenc e Index Independenc e Index Non-tax Revenue Index Non-tax Revenue Index Subsidy Index Subsidy Index

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 % –Non tax indices increase 5-8.4%

Table 2 Comparison of Indices between Pre and Post Decentralization (Weighted Least Squares Logit Estimates) Index Decentralizati on Dummy Estimated Pre- decentralization Fiscal Index Estimated Post- decentralization Fiscal Index R2R2 Number of Observations Independence Index (0.040) (0.1710) (0.1671) Independence Index (0.055) (0.1652) (0.1577) Non-tax Revenue Index (0.032) (0.0552) (0.0575) Non-tax Revenue Index (0.043) (0.0932) (0.0822) Subsidy Index (0.147) (0.1117) (0.1067) Subsidy Index (0.145) (0.0920) (0.0893)

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 Independe nce Index 1 Independe nce Index 2 Revenue Index 1 Revenue Index 2 Subsidy Index 1 Subsidy Index 2 Alignment (0.021) (0.072) (0.024) (0.029) (0.038) ** (0.019) Competition (0.064) ** (0.208) (0.065) (0.077) 0.199** (0.076) 0.064* (0.037) Alignment*Competitio n (0.012) (0.052) (0.19) (0.022) *** (0.025) * (0.013) Population Density *** (0.000) *** (0.002) (0.001) *** (0.001) 0.009*** (0.002) 0.004*** (0.001) Number of Observations 89 R2R

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

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