## Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions — Introduction

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---

### Background and research question
- Many public services are provided by subnational governments because they know local needs better than the central government, but this may come at a cost to fiscal sustainability because local governments do not internalize the effect of their actions on the country-wide fiscal position.
- Recent studies find that fiscal decentralization may increase sovereign risk and raise the probability of a fiscal crisis.
- Central question: How can countries prevent fiscal crises in fiscally decentralized systems?
- Policy and institutional tools analyzed: intergovernmental transfers, controls by the central government (subnational fiscal rules and administrative constraints), and institutional governance.

### Data and methodology
- Sample: 59 advanced, emerging market, and developing countries from 1980 to 2019.
- Fiscal decentralization measures taken from the IMF’s Fiscal Decentralization Dataset.
- Macroeconomic controls taken from the IMF’s World Economic Outlook Database.
- Dates of fiscal crises taken from Moreno Badia et al. (2022); fiscal crises are identified if any of several criteria are met (examples preserved verbatim):
  - credit events larger than 0.5 percent of GDP and substantial nominal growth of the defaulted amount (by 10 percent);
  - exceptionally large official financing such as a high-access IMF financial arrangement larger than 100 percent of quota or EU program;
  - implicit domestic defaults such as high inflation (higher than 35 percent in advanced countries and 100 percent in developing countries) or a steep increase in domestic arrears (by at least 1 percentage point of GDP);
  - extreme market pressures including loss of market access or very large borrowing costs (level of spread higher than 1,000 bps) or sovereign yield spikes (annual change in spreads higher than 300 bps in advanced countries and 650 bps in developing countries).
- Main econometric approaches:
  - Binary choice models: probit and logit models.
  - Instrumental variable (IV) probit estimation using lagged decentralization and macro variables as instruments to address endogeneity concerns.
- Key regressors include: spending decentralization (spending share of local governments in the general government), transfer dependency ratio (net transfers to own revenue of local governments), revenue decentralization, government debt level, interest cost, inflation, GDP growth, ln(income per capita), current account balance, exchange rate depreciation, banking crisis dummy, currency crisis dummy, commodity terms of trade index.
- Spending decentralization and revenue decentralization are not included simultaneously due to a correlation of 0.8.

### Key findings and quantitative impacts
- Model performance:
  - Area under the receiver operating characteristic curve (AUROC) exceeded 0.8 for the baseline model.
- Spending decentralization:
  - Associated with a higher probability of a fiscal crisis in the baseline IV probit estimates.
  - At medians, "the median level of spending decentralization explains approximately 3 4 percent of the expected probability of a fiscal crisis" (preserved original phrasing).
  - A one standard deviation increase in spending decentralization increases the probability of a fiscal crisis by 22 percent (one standard deviation increase corresponds to moving spending decentralization from the median to the 79th percentile).
  - The adverse effect of spending decentralization is stronger in countries where local governments run budget deficits (state-dependent relationship).
- Intergovernmental transfers:
  - Transfer dependency ratio is negatively associated with the probability of a fiscal crisis (transfers act as inter-regional insurance and stabilization).
  - The negative impact of intergovernmental transfers on crisis probability is less than one-fifth of that of spending decentralization at medians.
  - One standard deviation increase in transfers corresponds to moving from the median to the 90th percentile.
  - Intergovernmental transfers could mitigate the probability of a fiscal crisis by 19 percentage points (policy discussion, right-panel charts of Figures 5 and 6).
- Institutional quality and governance:
  - Better public-sector institutions and lower corruption are associated with a lower probability of a fiscal crisis under spending decentralization.
  - Reducing corruption or improving government effectiveness can reduce the probability of a fiscal crisis by 5 percentage points (Figure 7, policy discussion).
  - Cross-terms of spending decentralization with Corruption Perceptions Index (CPI) and with World Bank government effectiveness show that good governance mitigates adverse effects of decentralization.
- Central control over subnational borrowing:
  - Central government controls (administrative constraints on subnational borrowing or subnational fiscal rules) reduce the adverse effect of spending decentralization on crisis probability.
  - In the presence of administrative constraints, spending decentralization ceases to raise the probability of a fiscal crisis (suggesting local governments internalize constraints).
  - Caveat: such controls reduce fiscal flexibility and can impair countercyclicality at the local level.
- Revenue decentralization:
  - Revenue decentralization is associated with a greater probability of a fiscal crisis in the IV probit and corroborated by logit estimates.
  - Nakatani (2024a) threshold: when approximately 16 percent of general government revenues are collected at the local level, countries are more likely to face a fiscal crisis (preserved exact phrasing).
  - One standard deviation impact of revenue decentralization is sizable in IV probit estimates (right-hand panel of Figure 8); the logit model shows smaller magnitudes but a similar ordering (one standard deviation moves to approximately the 81st percentile of revenue decentralization).
- Controls and robustness:
  - Logit models produce broadly similar results; banking crisis dummy becomes statistically significant in logit.
  - Probit without IV shows some coefficient changes (spending decentralization, GDP growth, banking crisis dummy), suggesting mild endogeneity — IV probit preferred.
  - Linear panel with country fixed effects changes some significance (e.g., government debt) but main findings on spending decentralization and transfers are robust.

### Policy implications and trade-offs
- Effective tools to prevent fiscal crises under decentralization:
  - Intergovernmental transfers: powerful countercyclical and inter-regional insurance role, but risk creating moral hazard, soft budget constraints, and common pool problems.
  - Strengthening public-sector institutions and reducing corruption: reduces probability of crisis by an estimated 5 percentage points and mitigates moral hazard and misappropriation risks.
  - Central controls over subnational borrowing (administrative constraints, subnational fiscal rules): effective at reducing crisis probability but reduce local fiscal flexibility and countercyclicality.
  - Revenue centralization: economies of scale in revenue administration and avoidance of tax competition externalities; revenue decentralization empirically associated with higher crisis probability.
- State-dependent recommendations:
  - If local governments run budget deficits, spending decentralization substantially raises crisis risk — enforcing balanced local budgets can help but at the cost of reduced flexibility.
  - Intergovernmental transfers are particularly important for countries with local budget deficits (stronger negative effect on crisis probability).
- Policymakers must weigh trade-offs:
  - Administrative constraints and fiscal rules reduce crisis risk but can limit fiscal flexibility and the ability of local governments to respond during downturns.
  - Intergovernmental transfers stabilize regions but encourage moral hazard and weaken local accountability.
  - Improving governance and government effectiveness is a complementary policy that reduces reliance on heavy-handed controls and transfers.

### Paper organization
- Literature survey on fiscal decentralization, moral hazard, revenue centralization, intergovernmental transfers, subnational fiscal controls, and fiscal crisis evidence.
- Data and methodology (definitions of decentralization measures, transfer ratio, and revenue decentralization provided).
- Empirical results and robustness checks (probit, logit, IV probit, fixed effects).
- Policy implications and conclusions.

---

### Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions — Conclusion

### Key empirical findings
- Increased spending decentralization to local governments correlates with a higher likelihood of fiscal crises; results are robust to changes in econometric methods.
  - Baseline estimates (Table 3): Spending Decentralization coefficients: 2.0702* (Binary Choice Model) and 2.9847** (IV Probit / Logit).
  - Robustness check (Table 4): Spending Decentralization coefficients: 1.5910** (Probit) and 0.7576** (OLS).
  - Heterogeneity by local budget balance (Table 5): Spending Decentralization coefficients: 3.4989*** for deficit (<0) countries and 2.0561* for surplus (≥0) countries.
- A high level of intergovernmental transfers (Transfer Dependency Ratio) is associated with a lower probability of a fiscal crisis.
  - Example coefficients: -0.0829** (Table 3, Binary Choice Model), -0.1412** (Table 3, IV Probit/Logit), -0.0812** (Table 4, Probit).
- Revenue decentralization is positively associated with the probability of a fiscal crisis.
  - Table 7: Revenue Decentralization coefficients: 3.7735*** (Binary Choice Model) and 4.7203*** (IV Probit/Logit).
- Conditional and interaction evidence:
  - Control by center mitigates the adverse effect of spending decentralization (Table 6): SD x Control by Center coefficient -1.5563**.
  - Better governance reduces the crisis risk associated with spending decentralization:
    - SD x Corruption Perceptions Index coefficient -0.0511*** (Table 6).
    - SD x Government Effectiveness coefficient -1.2476** (Table 6).
- Other robust correlates of lower fiscal crisis probability include higher GDP Growth and higher Income Per Capita.
  - Examples: GDP Growth coefficients significant and negative across models (e.g., -0.2381*** in Table 3; -0.0854*** in Table 4). Income Per Capita coefficients: -0.9465*** (Table 3), -0.8005*** (Table 4).

### Conditional and heterogeneous results
- The adverse association between spending decentralization and fiscal crises disappears when local governments do not persistently run budget deficits; however, requiring local governments to avoid persistent deficits reduces local fiscal flexibility.
- Revenue decentralization results align with theory on economies of scale in revenue administration, central role in countercyclical fiscal policy, and central government borrowing capacity; literature evidence is mixed and suggests potential nonlinearities depending on the degree of decentralization.

### Policy implications and recommendations
- Primary policy goal: improve governance and public financial management to prevent fiscal crises under decentralization.
  - Focus areas: reduce corruption, strengthen government effectiveness, and build sound public financial management systems at the subnational level.
- Intergovernmental transfers:
  - Transfers are an important redistribution tool to protect local and national economies from localized shocks.
  - Transfers should be transparent and rule-based to reinforce accountability and fiscal discipline and to avoid moral hazard (common pool problems and soft budget constraints).
- Local fiscal discipline:
  - Local governments should run budget operations responsibly and avoid large and persistent budget deficits because they usually have limited financing tools and often lack access to bond markets.
  - Controlling subnational borrowing is an effective policy instrument for maintaining local fiscal discipline when decentralizing; effectiveness depends on constitutional and legal underpinnings and differs across federal and unitary systems.
- Administrative constraints and subnational fiscal rules:
  - Impositions of administrative constraints or subnational fiscal rules are viable, if blunt, reform options and may face fewer obstacles than governance reforms but require central fiscal authority capacity for implementation.
- Trade-offs to consider:
  - Policymakers must weigh benefits of decentralizing fiscal power (better local public goods provision) against costs (weakened ability to implement countercyclical fiscal policy and cross-regional redistribution, and potential erosion of revenue-raising incentives at the local level).
  - Countries need to consider legal frameworks, competing fiscal goals, and the location of fiscal risks when choosing between decentralization and central control.

### Synthesis and final message
- Spending decentralization and revenue decentralization are empirically associated with higher fiscal crisis probability absent strong governance, transfer systems, and borrowing controls.
- The most effective and sustainable prevention strategy emphasized by the paper is improving governance (reducing corruption and strengthening public financial management), complemented by well-designed intergovernmental transfers and credible controls on subnational borrowing.
- Policy choice requires careful country-specific assessment of benefits, costs, and institutional capacity, both at introduction and after a few years when empirical outcomes are observable.

*Source: Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions — IMF Working Paper (Introduction and Conclusion sections)*

### Introduction ...........................................................................................................

### Introduction

### Document structure and main sections
- Introduction ......................................................................................................................................................... 3
- Literature Review ................................................................................................................................................ 4
- Data ...................................................................................................................................................................... 8
- Methodology ...................................................................................................................................................... 11
- Results ............................................................................................................................................................... 12
- Policy Discussion ............................................................................................................................................. 18
- Conclusion ......................................................................................................................................................... 19
- Annex ................................................................................................................................................................. 21
- References ......................................................................................................................................................... 29

### Figures (list and topics)
- Figure 1. Policy Tools and Institutions to Prevent Fiscal Crises under Decentralization
- Figure 2. Fiscal Crisis and Spending Decentralization
- Figure 3. Fiscal Crisis and Spending Decentralization in Countries with Local Budget Deficits
- Figure 4. Fiscal Crisis and Spending Decentralization in Countries without Control by Center
- Figure 5. Impact of Incremental Changes in Each Explanatory Variable
- Figure 6. Impact of Incremental Changes for Different Types of Countries
- Figure 7. Institutional Impact of Decentralization
- Figure 8. Impact of Spending Decentralization versus Revenue Decentralization

### Annex tables (list and contents)
- Annex Table 1. List of Sample Countries (59 Countries)
- Annex Table 2. Definitions and Data Sources of the Variables
- Annex Table 3. Baseline Estimation
- Annex Table 4. Robustness Check
- Annex Table 5. Deficit Countries Versus Surplus Countries
- Annex Table 6. Effects of Control by Center, Corruption, and Public Institutions
- Annex Table 7. Revenue Decentralization
- Annex Table 8. Subnational Fiscal Rules versus Administrative Constraints

### Document identification
- IMF WORKING PAPERS Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions
- INTERNATIONAL MONETARY FUND
- Page indicator shown: 3

*Source: wpiea2025087-print-pdf - Introduction.*

### Introduction

### Introduction

### Background and research question
- Many public services are provided by subnational governments because they know local needs better than the central government, but this may come at a cost to fiscal sustainability because local governments do not internalize the effect of their actions on the country-wide fiscal position.
- Recent studies find that fiscal decentralization may increase sovereign risk and raise the probability of a fiscal crisis.
- Central question: How can countries prevent fiscal crises in fiscally decentralized systems?
- Policy and institutional tools analyzed: intergovernmental transfers, controls by the central government (subnational fiscal rules and administrative constraints), and institutional governance.

### Data and methodology
- Sample: 59 advanced, emerging market, and developing countries from 1980 to 2019.
- Fiscal decentralization measures taken from the IMF’s Fiscal Decentralization Dataset.
- Macroeconomic controls taken from the IMF’s World Economic Outlook Database.
- Dates of fiscal crises taken from Moreno Badia et al. (2022); fiscal crises are identified if any of several criteria are met (examples preserved verbatim):
  - credit events larger than 0.5 percent of GDP and substantial nominal growth of the defaulted amount (by 10 percent);
  - exceptionally large official financing such as a high-access IMF financial arrangement larger than 100 percent of quota or EU program;
  - implicit domestic defaults such as high inflation (higher than 35 percent in advanced countries and 100 percent in developing countries) or a steep increase in domestic arrears (by at least 1 percentage point of GDP);
  - extreme market pressures including loss of market access or very large borrowing costs (level of spread higher than 1,000 bps) or sovereign yield spikes (annual change in spreads higher than 300 bps in advanced countries and 650 bps in developing countries).
- Main econometric approaches:
  - Binary choice models: probit and logit models.
  - Instrumental variable (IV) probit estimation using lagged decentralization and macro variables as instruments to address endogeneity concerns.
- Key regressors include: spending decentralization (spending share of local governments in the general government), transfer dependency ratio (net transfers to own revenue of local governments), revenue decentralization, government debt level, interest cost, inflation, GDP growth, ln(income per capita), current account balance, exchange rate depreciation, banking crisis dummy, currency crisis dummy, commodity terms of trade index.
- Spending decentralization and revenue decentralization are not included simultaneously due to a correlation of 0.8.

### Key findings and quantitative impacts
- Model performance: area under the receiver operating characteristic curve (AUROC) exceeded 0.8 for the baseline model.
- Spending decentralization:
  - Associated with a higher probability of a fiscal crisis in the baseline IV probit estimates.
  - At medians, "the median level of spending decentralization explains approximately 3 4 percent of the expected probability of a fiscal crisis" (preserve original phrasing).
  - A one standard deviation increase in spending decentralization increases the probability of a fiscal crisis by 22 percent (one standard deviation increase corresponds to moving spending decentralization from the median to the 79th percentile).
  - The adverse effect of spending decentralization is stronger in countries where local governments run budget deficits (state-dependent relationship).
- Intergovernmental transfers:
  - Transfer dependency ratio is negatively associated with the probability of a fiscal crisis (transfers act as inter-regional insurance and stabilization).
  - The negative impact of intergovernmental transfers on crisis probability is less than one-fifth of that of spending decentralization at medians.
  - One standard deviation increase in transfers corresponds to moving from the median to the 90th percentile.
  - Intergovernmental transfers could mitigate the probability of a fiscal crisis by 19 percentage points (policy discussion, right-panel charts of Figures 5 and 6).
- Institutional quality and governance:
  - Better public-sector institutions and lower corruption are associated with a lower probability of a fiscal crisis under spending decentralization.
  - Reducing corruption or improving government effectiveness can reduce the probability of a fiscal crisis by 5 percentage points (Figure 7, policy discussion).
  - Cross-terms of spending decentralization with Corruption Perceptions Index (CPI) and with World Bank government effectiveness show that good governance mitigates adverse effects of decentralization.
- Central control over subnational borrowing:
  - Central government controls (administrative constraints on subnational borrowing or subnational fiscal rules) reduce the adverse effect of spending decentralization on crisis probability.
  - In the presence of administrative constraints, spending decentralization ceases to raise the probability of a fiscal crisis (suggesting local governments internalize constraints).
  - Caveat: such controls reduce fiscal flexibility and can impair countercyclicality at the local level.
- Revenue decentralization:
  - Revenue decentralization is associated with a greater probability of a fiscal crisis in the IV probit and corroborated by logit estimates.
  - Nakatani (2024a) threshold: when approximately 16 percent of general government revenues are collected at the local level, countries are more likely to face a fiscal crisis (preserved exact phrasing from the source).
  - One standard deviation impact of revenue decentralization is sizable in IV probit estimates (right-hand panel of Figure 8); the logit model shows smaller magnitudes but a similar ordering (one standard deviation moves to approximately the 81st percentile of revenue decentralization).
- Controls and robustness:
  - Logit models produce broadly similar results; banking crisis dummy becomes statistically significant in logit.
  - Probit without IV shows some coefficient changes (spending decentralization, GDP growth, banking crisis dummy), suggesting mild endogeneity — IV probit preferred.
  - Linear panel with country fixed effects changes some significance (e.g., government debt) but main findings on spending decentralization and transfers are robust.

### Policy implications and trade-offs
- Effective tools to prevent fiscal crises under decentralization:
  - Intergovernmental transfers: powerful countercyclical and inter-regional insurance role, but risk creating moral hazard, soft budget constraints, and common pool problems.
  - Strengthening public-sector institutions and reducing corruption: reduces probability of crisis by an estimated 5 percentage points and mitigates moral hazard and misappropriation risks.
  - Central controls over subnational borrowing (administrative constraints, subnational fiscal rules): effective at reducing crisis probability but reduce local fiscal flexibility and countercyclicality.
  - Revenue centralization: economies of scale in revenue administration and avoidance of tax competition externalities; revenue decentralization empirically associated with higher crisis probability.
- State-dependent recommendations:
  - If local governments run budget deficits, spending decentralization substantially raises crisis risk — enforcing balanced local budgets can help but at the cost of reduced flexibility.
  - Intergovernmental transfers are particularly important for countries with local budget deficits (stronger negative effect on crisis probability).
- Policymakers must weigh trade-offs:
  - Administrative constraints and fiscal rules reduce crisis risk but can limit fiscal flexibility and the ability of local governments to respond during downturns.
  - Intergovernmental transfers stabilize regions but encourage moral hazard and weaken local accountability.
  - Improving governance and government effectiveness is a complementary policy that reduces reliance on heavy-handed controls and transfers.

### Paper organization
- Literature survey on fiscal decentralization, moral hazard, revenue centralization, intergovernmental transfers, subnational fiscal controls, and fiscal crisis evidence.
- Data and methodology (definitions of decentralization measures, transfer ratio, and revenue decentralization provided).
- Empirical results and robustness checks (probit, logit, IV probit, fixed effects).
- Policy implications and conclusions.

*Source: IMF Working Paper — Introduction section*

### Conclusion

### Conclusion

### Key empirical findings
- Increased spending decentralization to local governments correlates with a higher likelihood of fiscal crises; results are robust to changes in econometric methods.
  - Baseline estimates (Table 3): Spending Decentralization coefficients: 2.0702* (Binary Choice Model) and 2.9847** (IV Probit / Logit).
  - Robustness check (Table 4): Spending Decentralization coefficients: 1.5910** (Probit) and 0.7576** (OLS).
  - Heterogeneity by local budget balance (Table 5): Spending Decentralization coefficients: 3.4989*** for deficit (<0) countries and 2.0561* for surplus (≥0) countries.
- A high level of intergovernmental transfers (Transfer Dependency Ratio) is associated with a lower probability of a fiscal crisis.
  - Example coefficients: -0.0829** (Table 3, Binary Choice Model), -0.1412** (Table 3, IV Probit/Logit), -0.0812** (Table 4, Probit).
- Revenue decentralization is positively associated with the probability of a fiscal crisis.
  - Table 7: Revenue Decentralization coefficients: 3.7735*** (Binary Choice Model) and 4.7203*** (IV Probit/Logit).
- Conditional and interaction evidence:
  - Control by center mitigates the adverse effect of spending decentralization (Table 6): SD x Control by Center coefficient -1.5563**.
  - Better governance reduces the crisis risk associated with spending decentralization:
    - SD x Corruption Perceptions Index coefficient -0.0511*** (Table 6).
    - SD x Government Effectiveness coefficient -1.2476** (Table 6).
- Other robust correlates of lower fiscal crisis probability include higher GDP Growth and higher Income Per Capita.
  - Examples: GDP Growth coefficients significant and negative across models (e.g., -0.2381*** in Table 3; -0.0854*** in Table 4). Income Per Capita coefficients: -0.9465*** (Table 3), -0.8005*** (Table 4).

### Conditional and heterogeneous results
- The adverse association between spending decentralization and fiscal crises disappears when local governments do not persistently run budget deficits; however, requiring local governments to avoid persistent deficits reduces local fiscal flexibility.
- Revenue decentralization results align with theory on economies of scale in revenue administration, central role in countercyclical fiscal policy, and central government borrowing capacity; literature evidence is mixed and suggests potential nonlinearities depending on the degree of decentralization.

### Policy implications and recommendations
- Primary policy goal: improve governance and public financial management to prevent fiscal crises under decentralization.
  - Focus areas: reduce corruption, strengthen government effectiveness, and build sound public financial management systems at the subnational level.
- Intergovernmental transfers:
  - Transfers are an important redistribution tool to protect local and national economies from localized shocks.
  - Transfers should be transparent and rule-based to reinforce accountability and fiscal discipline and to avoid moral hazard (common pool problems and soft budget constraints).
- Local fiscal discipline:
  - Local governments should run budget operations responsibly and avoid large and persistent budget deficits because they usually have limited financing tools and often lack access to bond markets.
  - Controlling subnational borrowing is an effective policy instrument for maintaining local fiscal discipline when decentralizing; effectiveness depends on constitutional and legal underpinnings and differs across federal and unitary systems.
- Administrative constraints and subnational fiscal rules:
  - Impositions of administrative constraints or subnational fiscal rules are viable, if blunt, reform options and may face fewer obstacles than governance reforms but require central fiscal authority capacity for implementation.
- Trade-offs to consider:
  - Policymakers must weigh benefits of decentralizing fiscal power (better local public goods provision) against costs (weakened ability to implement countercyclical fiscal policy and cross-regional redistribution, and potential erosion of revenue-raising incentives at the local level).
  - Countries need to consider legal frameworks, competing fiscal goals, and the location of fiscal risks when choosing between decentralization and central control.

### Synthesis and final message
- Spending decentralization and revenue decentralization are empirically associated with higher fiscal crisis probability absent strong governance, transfer systems, and borrowing controls.
- The most effective and sustainable prevention strategy emphasized by the paper is improving governance (reducing corruption and strengthening public financial management), complemented by well-designed intergovernmental transfers and credible controls on subnational borrowing.
- Policy choice requires careful country-specific assessment of benefits, costs, and institutional capacity, both at introduction and after a few years when empirical outcomes are observable.

*IMF Working Papers — Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions — Conclusion*

### References

### References

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*Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions, Working Paper No. WP/2025/087*

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_Source: https://www.imf.org/-/media/files/publications/wp/2025/english/wpiea2025087-print-pdf.pdf_