Tax Decentralization and Local Government Size

This paper investigates the relationship between fiscal federalism and the sizes of local governments. While many empirical studies emphasized that grants encourage the growth of local public spending and local taxes constrain it, they are more silent regarding the effects of different types of tax autonomy. The paper addresses this issue by arguing that tax decentralization as organized on tax bases used only by local governments (tax-separation), rather than on tax-base sharing, would restrain local public expenditures. Using an unbalanced panel of OECD countries, the key finding is that only property taxes – mostly based on a “tax-separation” scheme – seem to favor smaller local governments. Thus, while tax decentralization is a necessary condition for limiting the growth of local governments, it does not appear sufficient, as tax-separation schemes among government levels would in fact be required.