Safeguarding National Budgets: How Countries Can Prevent Crises in Decentralized Systems

In a landmark study published by the International Monetary Fund’s Fiscal Affairs Department, economist Ryota Nakatani investigates how countries can safeguard themselves from fiscal crises amid growing trends of fiscal decentralization. Utilizing data from global institutions such as the IMF, World Bank, Transparency International, and numerous academic sources, the working paper provides a sweeping, data-rich analysis of the policy frameworks and institutional conditions that either curb or accelerate fiscal instability. Spanning 59 countries from 1980 to 2019, this research offers crucial insights into how governance quality, central oversight, and intergovernmental cooperation interact with the architecture of decentralized fiscal systems.

Decentralization’s Hidden Danger

Decentralization is widely seen as a governance tool that empowers local governments to respond more effectively to local needs, but Nakatani’s research uncovers the darker side of this administrative shift. When local governments are granted autonomy without the institutional capacity or financial discipline to manage it, the entire fiscal system can become fragile. Local authorities often lack incentives to maintain balanced budgets if they expect the central government to rescue them during financial distress, a situation known as a soft budget constraint. This creates a “common pool” problem, where multiple layers of government draw on shared national resources with limited coordination or accountability. As a result, decentralized systems without adequate checks and balances tend to experience more frequent and severe fiscal crises, particularly when local governments are allowed to run sustained deficits.

Good Governance as a Fiscal Shield

One of the strongest findings of the study is that sound public sector institutions, those that are transparent, efficient, and corruption-free, greatly reduce the risk of fiscal crises in decentralized systems. The research draws on metrics such as the Corruption Perceptions Index from Transparency International and the World Bank’s Government Effectiveness scores to quantify the quality of governance. Countries with better institutional environments are less vulnerable to the moral hazards that decentralization can create. Local governments in such settings are more likely to use public funds responsibly, avoiding the reckless overspending that can destabilize national finances. Notably, improvements in governance were found to reduce the probability of a fiscal crisis by up to five percentage points, a substantial gain given the stakes involved. These findings suggest that building robust institutions is not only a matter of democratic governance but also a powerful tool for fiscal risk management.

Transfers and Controls: Two Sides of the Policy Coin

To mitigate the destabilizing effects of decentralization, governments have at their disposal two primary tools: intergovernmental transfers and administrative controls. Intergovernmental transfers allow central governments to redistribute revenue to subnational governments, offering critical support during local economic shocks. The study finds that such transfers are the most effective policy lever in preventing fiscal crises, capable of reducing crisis probability by as much as 19 percentage points. However, these transfers must be carefully designed. Without transparency and accountability, they risk deepening the common-pool problem by encouraging financial recklessness at the local level.

On the other hand, administrative controls, such as limits on subnational borrowing, mandatory balanced budgets, and subnational fiscal rules, act as a more direct form of risk containment. When local governments are subject to well-enforced borrowing constraints or fiscal rules, their propensity to overspend diminishes. Nakatani’s analysis shows that in countries where such controls are in place, the adverse impact of decentralization on fiscal health is significantly muted. While these mechanisms are effective, they come at the cost of reduced fiscal flexibility. In downturns, for example, rigid rules may prevent local authorities from enacting countercyclical spending, complicating economic recovery.

The Problem with Revenue Decentralization

Beyond spending powers, the research also scrutinizes the effects of revenue decentralization, when local governments are responsible for tax collection. This aspect of decentralization appears to have even graver implications. Revenue decentralization was found to be positively associated with higher crisis probability, largely due to inefficiencies and inequities it introduces. Local tax bases tend to vary widely, and tax competition among jurisdictions can distort policy and reduce overall tax collection. Moreover, small local governments often lack the administrative capacity to collect taxes efficiently, making centralized revenue systems not only more equitable but also more fiscally stable. The study confirms that economies of scale in revenue collection, along with central oversight, are critical in maintaining healthy public finances.

Striking the Balance: A Policy Blueprint

Nakatani’s findings suggest that decentralization, though valuable for responsive governance, must be handled with precision and care. Policymakers are encouraged to avoid allowing local governments to run persistent deficits, invest in improving institutional quality, and deploy intergovernmental transfers as strategic, rules-based tools. Moreover, they should retain centralized tax collection systems while considering the selective use of administrative controls over subnational borrowing. These approaches allow countries to reap the benefits of decentralization, greater efficiency, better service delivery, and enhanced local accountability, without incurring unsustainable fiscal risks. The broader implication is that decentralization is not inherently dangerous; it becomes so when pursued without adequate planning, oversight, and institutional readiness. The study makes a compelling case that the future of decentralization must be both empowered and disciplined, with good governance and thoughtful policy as its twin foundations.