Fiscal Decentralization and Financial Condition

• Date: 01 June 2018
• Author: Samuel B. Stone,Akheil Singla
• DOI: 10.1177/0160323X18794014
• Published date: 01 June 2018
• Subject Matter: General Interests

General Interest
State and Local Government Review
2018, Vol. 50(2) 119-131
Fiscal Decentralization and
ª The Author(s) 2018
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Financial Condition: The
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DOI: 10.1177/0160323X18794014
Effects of Revenue and
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Expenditure Decentralization
on State Financial Health
Akheil Singla1
and Samuel B. Stone2
Abstract
Although there are strong theoretical arguments about both the benefits and costs of decen-
tralization in the federalism literature, there is little on how second-order fiscal decentralization
effects the financial health of state governments. This study examines this question and adds to the
understanding of state-and-local fiscal relations. Using financial indicators that measure several
dimensions of financial condition, the research estimates the effect of revenue and expenditure
decentralization on state fiscal health. It finds that while state financial condition is unaffected by
revenue decentralization, there is a curvilinear relationship between expenditure decentralization
and long-term state financial condition.
Keywords
fiscal federalism, financial condition, decentralization, devolution, financial health
Recent political gridlock at the federal level has
devolution, the empirical work on the subject
had an interesting effect on American federal-
does not demonstrate conclusive evidence
ism. States have stepped into the void created
about what other effects these trends might
by the absence of federal policy-making, taking
have on state or local governments. Devolution
the lead in a variety of policy arenas (Gamkhar
can improve programmatic outcomes but doing
and Pickerill 2012; Goelzhauser and Rose
so frequently requires moving resources from
2017). This first-order devolution from federal
one level of government to another, which can
to state government has dominated most con-
versations about federalism. A critical but less
1
covered development coming out of the Great
School of Public Affairs, Arizona State University, Phoenix,
AZ, USA
Recession has been the increased importance
2 Division of Politics, Administration & Justice, California
of local governments in the policy process.
State University, Fullerton, Fullerton, CA, USA
States have tasked local governments with
“a greater role as the true laboratories of
Corresponding Author:
Akheil Singla, School of Public Affairs, Arizona State
democracy” (Daigneau 2011).
University, 411 N. Central Ave., Suite #400, Phoenix, AZ
Although there are a large number of theore-
85004, USA.
tical arguments about the costs and benefits of
Email: akheil.singla@asu.edu

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120
State and Local Government Review 50(2)
erode the resource base of one level of govern-
relationship between states and their local gov-
ment. This is an important area of study
ernments. This relationship is known as
because the reassignment of responsibilities
second-order federalism and the shifting of
between one level of government and another
responsibility from states to local governments
can represent a massive transfer of obligations
is usually called second-order devolution.
and resources. For example, states experiencing
Studying state and local interactions poses dif-
fiscal crises respond by devolving responsibil-
ferent challenges from the federal–state inter-
ities down to local governments, which, in turn,
action, as local governments are the political
experience fiscal pressure of their own in order
creations of the states; for this reason, state–
to meet their new obligations (Reschovsky
local relations might be best described as pater-
2004). This study addresses this issue by exam-
nalistic (Berman 2003; Zimmerman 1995).
ining what effect fiscal decentralization (the
Recent literature on American federalism tends
fiscal result of devolution) to local govern-
to more closely address second-order federal-
ments within a state has on the financial health
ism and is correspondingly less certain about
of state governments.
the benefits of decentralization (Oates 2008;
Weingast 2009).
An example of this is the problem of the soft
Background & Theory
budget constraint. That is, in times of fiscal cri-
sis, lower-level governments can seemingly fall
Second-order Federalism
back on a higher level government to bail them
Fiscal federalism is “the vertical structure of
out (Kornai, Maskin, and Roland 2003). Rather
the public sector. It explores, both in norma-
than facing a hard ceiling on their budgets that
tive and positive terms, the roles of the differ-
would encourage more moderation in spending
ent levels of government and the ways in
or forecasting, local governments have a “soft”
which they relate to one another . . . ” (Oates
cap that might be lifted by the state via emer-
1999, 1120). American federalism, in particu-
gency assistance like extra intergovernmental
lar, has a more decentralized structure of
aid (Qian and Roland 1998). This system of
authority, as the Constitution gives all powers
intergovernmental grants in aid can result in
that are not specifically enumerated to the fed-
dependency by local governments on higher-
eral government to the states. The earlier liter-
level governments, which creates an incentive
ature on federalism contends that though
to defy fiscal discipline (Qian and Roland
centralized and decentralized systems can
1998). Empirical studies (Saxton et al. 2002;
both adequately provide public goods and
Kloha, Weissert, and Kleine 2005) note that
social welfare functions through redistribu-
diminishing intergovernmental aid from states
tion, decentralized systems are more efficient
to local governments often results in fiscal
at matching preferences to local public goods
stress for local governments, which, in turn, can
(Musgrave 1959, 1965; Olson 1969; Oates
require state intervention.
1972, 1977, 1991). Additionally, there are
Centralization, on the other hand, can force
strong historical, political, and cultural norms
the internalization of local jurisdictional
in favor of local self-government in the United
externalities, which may more equitably distri-
States (Ostrom, Bish, and Ostrom 1988; Bru-
bute welfare, but may be costlier for local gov-
nori 2007). Although there are some excep-
ernments (Goodspeed 2002; Kornai, Maskin,
tions (Mclure 1967), there seemed to be
and Roland 2003). Additionally, because the
general agreement that the American system
central government pays for grants with taxes
of fiscal decentralization more closely meets
levied across all lower level governments, the
these ideals (in theory if not always in
cost to a single local government using the
practice).
grants to pay back debt is less than the cost of
However, it is not clear whether this empha-
the higher-level tax on its own residents. Sub-
sis on decentralization always extends to the
national governments thus have a strong

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Singla and Stone
121
incentive to rely on intergovernmental grants.
which mandated that state and local govern-
The proposed solution to this problem is a sys-
ments produce government-wide (in addition
tem of independent local revenues.
to fund-based) financial statements using
There are a number of empirical studies that
accrual accounting (Government Accounting
deal directly with the centralization or decen-
Standards Board 1999). These statements have
tralization of the fiscal relationships between
led to a new body of research that describes dif-
states and their local governments. One contri-
ferent measures that capture financial condition.
buting factor to centralization within a state
Most of the current research uses ratios that
was the trend of state governments creating
measure financial condition as solvency (i.e.,
departments and agencies as corollaries to fed-
ability to meet obligations) in four areas: cash,
eral departments and agencies in order to man-
budget, long-term, and service (Wang, Dennis,
age federal aid (Stephens 1974; Fisher 2003).
and Tu 2007). Cash solvency captures the abil-
There is little evidence of regional trends in
ity to meet obligations in the immediate future;
centralization; in fact, centralization is highly
budgetary solvency focuses on the ability to
variable between states (Bowman and Kearny
meet obligations over a budgetary cycle of
2011). But there is a strong negative associa-
one-to-two years; long-term solvency focuses
tion between population and centralization
on the ability to meet long-range obligations
(Stephens 1974). The decades of the 1930s and
like pensions or municipal bonds that extend
1960s witnessed the most centralization from
out over multiple decades. Service solvency
local to state government, plateauing in the
focuses on a government’s ability to provide
1980s (Bowman and Kearny 2011). States that
essential services to citizens. These different
are geographically larger, more populous,
dimensions of solvency are independent, mean-
more urban, have lower per capita income, and
ing a government may be solvent in the near
are not located in the south will be less fiscally
term (e.g., be able to pay its employees) while
centralized (Wallis and Oates 1988). In an
being insolvent in the long term (e.g., be unable
exploration of the determinants of debt decen-
to make payments to bond holders). Others
tralization, Greer and Denison (2016) find
have built upon this framework, adding to or
political and institutional factors, rather than
subdividing these four areas, or suggesting
financial or economic ones, to be...