Association for Public Policy Analysis & Management

In many developing countries, the national government has devolved many administrative and spending powers to local governments. The standard reasoning is that local governments may be more responsive to and more informed about local needs and barriers to economic development. However, since it is typically more efficient to collect taxes at the national level, a vertical fiscal imbalance arises– local governments cannot raise enough local revenues to cover spending responsibilities. This can hinder their ability to provide public goods and encourage economic development.

In response, national governments often institute a system of intergovernmental grants to fund local government projects. However, economic theory predicts that the effect of such transfers will be to crowd out local effort, raising the possibility that local governments will remain dependent on the transfers instead of taking steps to stimulate economic activity. Previous empirical studies that test these predictions generate mixed results on crowd-out and are unable to estimate the effect on long-run economic development.

In this paper, I examine the effect of increased intergovernmental transfers on local revenue generation, spending, and economic development using Philippine local budget data and nighttime light intensity data from 1992-2016. The latter is used in the development literature as a measure of economic activity at the subnational level. To identify effects, I exploit the revenue allotment formulas used for municipalities and cities in the Philippines based on a 1991 decentralization reform. This reform devolved many administrative and spending responsibilities to local governments, and instituted a system where cities get transfers that are effectively twice as large as those received by municipalities. I employ a difference-in-differences research design that compares outcomes over time in pre-existing cities to municipalities that were newly classified as cities after the 1991 reform. I show that transfers permanently increase in these newly classified cities following cityhood, and that spending rises dramatically. Contrary to the crowding out prediction, I find that locally generated revenues increase following the reclassification. This is noteworthy because in this context, newly classified cities declare a moratorium on tax rate increases, so increased revenues must come from an increase in collection effort and/or higher economic activity.

Using luminosity data, I provide evidence that the jump in transfers led to greater economic activity. Specifically, I find that newly classified cities exhibit an increased nighttime light intensity of about 10 percent. This effect manifests after two years of receiving higher transfers. My estimates are robust to controlling for regional shocks and town-specific time trends, and to controlling for population changes over time.

These findings have important policy implications. They imply that transfers need not crowd out local revenue generation and spending. Because of this, transfers can succeed in their goal of stimulating economic development away from the center. Thus, national governments can continue to collect the bulk of taxes, which they likely do more efficiently than local governments, and transfer it back to local governments, who are likely to be more effective at spending the money.