Fiscal Federalism and Decentralization in Mongolia Inaugural Dissertation zur Erlangung der Würde eines Doktors der Wirtschafts- und Sozialwissenschaften Eingereicht an der Wirtschafts- und Sozialwissenschaftlichen Fakultät der Universität Potsdam von Ariunaa Lkhagvadorj Dekan: Prof. Dr. Norbert Gronau Gutachter: 1. Prof. Dr. Hans-Georg Petersen 2. Prof. Dr. Ulrich Basseler Published online at the Institutional Repository of the University of Potsdam: URL http://opus.kobv.de/ubp/volltexte/2010/4119/ URN urn:nbn:de:kobv:517-opus-41196 http://nbn-resolving.org/urn:nbn:de:kobv:517-opus-41196 Abstract Fiscal federalism has been an important topic among public finance theorists in the last four decades. There is a series of arguments that decentralization of governments enhances growth by improving allocation efficiency. However, the empirical studies have shown mixed results for industrialized and developing countries and some of them have demonstrated that there might be a threshold level of economic develop- ment below which decentralization is not effective. Developing and transition coun- tries have developed a variety of forms of fiscal decentralization as a possible strat- egy to achieve effective and efficient governmental structures. A generalized princi- ple of decentralization due to the country specific circumstances does not exist. Therefore, decentralization has taken place in different forms in various countries at different times, and even exactly the same extent of decentralization may have had different impacts under different conditions. The purpose of this study is to investigate the current state of the fiscal decentraliza- tion in Mongolia and to develop policy recommendations for the efficient and effec- tive intergovernmental fiscal relations system for Mongolia. Within this perspective the analysis concentrates on the scope and structure of the public sector, the expendi- ture and revenue assignment as well as on the design of the intergovernmental trans- fer and sub-national borrowing. The study is based on data for twenty-one provinces and the capital city of Mongolia for the period from 2000 to 2009. As a former socialist country Mongolia has had a highly centralized governmental sector. The result of the analysis below revealed that the Mongolia has introduced a number of decentralization measures, which followed a top down approach and were slowly implemented without any integrated decentralization strategy in the last dec- ade. As a result Mongolia became de-concentrated state with fiscal centralization. The revenue assignment is lacking a very important element, for instance significant revenue autonomy given to sub-national governments, which is vital for the efficient service delivery at the local level. According to the current assignments of the ex- penditure and revenue responsibilities most of the provinces are unable to provide a certain national standard of public goods supply. Hence, intergovernmental transfers from the central jurisdiction to the sub-national jurisdictions play an important role 1 for the equalization of the vertical and horizontal imbalances in Mongolia. The criti- cal problem associated with intergovernmental transfers is that there is not a stable, predictable and transparent system of transfer allocation. The amount of transfers to sub-national governments is determined largely by political decisions on ad hoc basis and disregards local differences in needs and fiscal capacity. Thus a fiscal equaliza- tion system based on the fiscal needs of the provinces should be implemented. The equalization transfers will at least partly offset the regional disparities in revenues and enable the sub-national governments to provide a national minimum standard of local public goods. 2 This thesis is dedicated to my daughters, Namuun and Khaliun. 3 Acknowledgments First of all I would like to express my sincere gratitude to my supervisor Professor Hans-Georg Petersen, for helping me to complete the dissertation. He has been an exceptional mentor with his extensive knowledge and experiences in the field of pub- lic economics and provided enormous support and enabled me to overcome difficul- ties in every step of my research toward the completion of the dissertation. Without his guidance and inspiration, it would have been an impossible task. I am also grate- ful to him for providing funding for my doctoral research. I also would like to ex- press my deep appreciation to Professor Ulrich Basseler from the Free University of Berlin, for his warm and frank advice in the final stage of the doctoral research. I am really grateful to Professor Dieter Wagner for his help and support in the very first phase of my doctoral study at Potsdam University. I also would like to express my gratitude to Professor Malcolm Dunn for his critical and valuable comments in the early stage of my dissertation, which helped to shape the thesis. I would also like to thank Tanja Kirn for her valuable assistance and comments in the progress of my dissertation, Yvonne Gruchmann and Doris Gericke for their help and assistance in organizing my social life during my stays in Potsdam, and their assistance to submit the thesis for the final defense. I would like to thank all the local governors, head of the assemblies and chief of the governor offices of the Aimags and Soums I have in- terviewed in Mongolia. I wish to thank the management of the Academy of Management the government agency of Mongolia for the financial support. I also would like to thank my friends and colleagues from the Academy of Management for their encouragement and con- cern about the progress of my work. I would also like to express my thanks to the Global Supplementary Grant Program of the Network Scholarship Program of the Open Society Foundation for their financial support. 4 My special thanks go to my parents, for their unconditional love and encouragement throughout my school career, to my brothers and sisters for their concern and sup- port. I would like to thank husband and dear daughters, Namuun and Khaliun, for their immeasurable love, sacrifice, support and understanding, which has been a mo- tivation for me to complete the PhD degree. I finally express my deepest thanks and hope that the accomplishment of this degree will make each of you proud. Ulaanbaatar and Potsdam, October 2009 Ariunaa Lkhagvadorj 5 Contents Abstract.................................................................................................................. 1 Acknowledgments ................................................................................................. 4 Contents ................................................................................................................. 6 List of Tables ......................................................................................................... 8 List of Figures........................................................................................................ 9 Abbreviations ...................................................................................................... 10 Chapter 1 Introduction......................................................................................................... 11 1.1 Background ............................................................................................... 11 1.2 Research Content and Importance of the Study........................................ 12 1.3 Research Goal and Expected Result ......................................................... 13 1.3.1 Research Goal and Questions ................................................... 13 1.3.2 Expected Result of the Study.................................................... 13 1.4 Literature on Fiscal Federalism................................................................. 14 1.5 Research Methodology............................................................................. 16 1.6 The Organization of the Thesis................................................................. 17 Chapter 2 Theoretical Review on Fiscal Decentralization ................................................ 18 2.1. The Theoretical Background for Fiscal Decentralization ......................... 19 2.1.1 Definition and Assessment of Decentralization........................ 19 2.1.2 Problems of Fiscal Federalism in Some Socialist Countries .... 22 2.2 Theory of Public Goods ............................................................................ 23 2.2.1 Provision of Public Goods ........................................................ 23 2.2.2 Efficient Jurisdictional Structure .............................................. 25 2.2.3 Citizen’s Mobility ..................................................................... 25 2.3 Centralized versus Decentralized Government......................................... 26 2.3.1 Advantages of a Federal System of Government...................... 26 2.3.2 Public Choice and Fiscal Policy................................................ 28 2.4 Theory of Taxation in Decentralized System............................................ 30 2.4.1 Tax Competition ....................................................................... 31 2.4.2 Tax Exporting........................................................................... 33 2.5 Theory of Grants ....................................................................................... 34 2.5.1 Matching versus Non-matching Grants .................................... 35 2.5.2 Tax Sharing and Grants............................................................