Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions

IMF Working Papers, May 9, 2025

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Title: Preventing Fiscal Crises under Decentralization: Intergovernmental Policies and Institutions
Author: Ryota Nakatani
Date: May 9, 2025
Research question: What instruments can governments deploy to prevent fiscal crises in decentralized fiscal systems?
Core conclusion: Good public sector institutions, central controls over local fiscal balances and borrowing, and intergovernmental transfers can reduce the probability of a fiscal crisis under decentralization.

Institutional quality
- Strengthening good institutions mitigates the unwanted effects of devolution on fiscal unsustainability by inhibiting allocative inefficiencies caused by the moral hazard of governments.
Expenditure decentralization
- Expenditure decentralization to local governments increases the probability of a crisis only when local governments run large budget deficits.
- This indicates that controls by the center over the local budget balance or borrowing ability may help to avoid overspending and the resulting excessive indebtedness.
Controls and constraints
- Subnational fiscal rules and administrative constraints reduce the probability of a crisis.
Intergovernmental transfers
- Intergovernmental transfers are associated with a lower probability of a fiscal crisis because they can play a role in interregional risk sharing among subnational governments.

Strengthen public sector institutions to reduce moral hazard and allocative inefficiencies under devolution.
Implement central government controls over local fiscal balances or borrowing ability to limit the risk that expenditure decentralization produces large local deficits.
Adopt subnational fiscal rules and administrative constraints to lower crisis probability.
Design intergovernmental transfer systems to enhance interregional risk sharing among subnational governments and thereby reduce systemic fiscal vulnerability.

Subject: Expenditure; Fiscal federalism; Fiscal policy; Government asset and liability management; Government debt management; Public financial management (PFM); Revenue administration
Keywords: Administrative Constraints; borrowing ability; Corruption; Decentralization; expenditure decentralization; Fiscal Crisis; Fiscal federalism; Global; Government asset and liability management; Government debt management; Intergovernmental Transfers; probability of a crisis; revenue decentralization; Spending decentralization; Subnational Fiscal Rules