ABSTRACT Title of Dissertation: ON THE EFFECTS OF INTER- GOVERNMENTAL TRANSFERS ON MACROECONOMIC STABILITY Gustavo Axel Radics, Doctor of Philosophy, 2012 Dissertation directed by: Professor Phillip L. Swagel, School of Public Policy, University of Maryland This dissertation explores the effects of inter-governmental transfers on macroeconomic stability, evaluating the case of Peru, which experienced a large increase in transfers to local governments from 2001 to 2010, linked to the fiscal revenue from the development of natural resources. The findings indicate that, although the surge in transfers in Peru is not an imminent threat on macroeconomic stability, it created a fiscal risk through two main channels. First, the reduction in the fiscal space of the central government to conduct counter-cyclical fiscal policy, since it shares with sub-national governments an increased proportion of its revenue from corporate income tax on extractive industries, which is the tax that grew most in Peru over the last decade and is also the most volatile. And second, the high increase of local expenditures due to increased transfers from the central government, which is a manifestation of the flypaper effect. This increased local expenditure contributed to a larger share of local government participation in the general government. In turn, this increased participation contributed to put pressure on the central government to allocate more funds to local governments when transfers fell. Contrary to conventional wisdom, the results also show that local governments in Peru do not reduce their fiscal effort in terms of own taxation in response to the high increase in transfers. This dissertation builds on the literature on the link between decentralization and macroeconomic stability, with particular reference to the allocation of the fiscal revenue from the development of natural resources among levels of government, which is an important issue in many countries around the world, in the context of the high rise in commodity prices of the last decade. It provides lessons related to the consequences of sharing a large proportion of the fiscal revenue from the development of natural resources with sub-national governments, as well as policy options for Peru to improve its decentralization process. ON THE EFFECTS OF INTER-GOVERNMENTAL TRANSFERS ON MACROECONOMIC STABILITY By Gustavo Axel Radics Dissertation submitted to the Faculty of the Graduate School of the University of Maryland, College Park, in partial fulfillment of the requirements for the degree of Doctor of Philosophy 2012 Advisory Committee: Professor Phillip L. Swagel, Chair Professor Madiha Afzal Professor Carol Graham Professor Allen Schick Professor Carlos Vegh © Copyright by Gustavo Axel Radics 2012 Dedication To my wife Kelly, whose patience and support allowed me to complete this dissertation. ii Acknowledgements My doctorate degree would not have been possible without the continuous encouragement and generosity of Professor I. M. “Mac” Destler. Professors Reinhart, Graham, Schick and Sprinkle have also been an important source of support at different stages of my degree. With respect to this dissertation, I am thankful to my advisor and my panel members for their useful guidance. I am also indebted to my supervisors at the Inter-American Development Bank, Ana María Rodríguez, Fidel Jaramillo and especially Vicente Fretes- Cibils, who constantly encouraged me to complete my dissertation. In Peru, I would like to thank Gloria León, Hugo Oropeza, Brigitt Bencich, Luis Bernal, Oscar Pajuelo, Ángel Pascual, Celia Mejía and Julio Mejía, from the Ministry of Economics and Finance, who provided me with essential data and explanation of the accounting standards of Peru´s subnational governments. Thank you also to Demian Pouzo for helpful ideas on how to introduce the empirical analysis. Lastly, completing a doctorate degree as a part-time student has not only been taxing on my leisure time, but also on that of my family. In this regard, thank you to my mother, my brother and my sister for their understanding and support. My infinite gratitude goes to my wife Kelly, who fully shared the effort that allowed me to earn this degree. iii Table of Contents Dedication .......................................................................................................................... ii Acknowledgements .......................................................................................................... iii Table of Contents ............................................................................................................. iv List of Tables .................................................................................................................... vi List of Figures ................................................................................................................. viii List of Abbreviations ....................................................................................................... xi Chapter 1: Introduction ................................................................................................... 1 Motivation ..................................................................................................................... 3 Decentralization and macroeconomic stability ............................................................. 5 The assignment of revenue from natural resources ...................................................... 6 Decentralization in Peru ................................................................................................ 8 Latest push for decentralization .................................................................................. 11 Leading research questions ......................................................................................... 18 Chapter 2: Literature review ......................................................................................... 25 What is decentralization? ............................................................................................ 25 Why do countries decentralize? .................................................................................. 26 Dimensions of analysis of decentralization ................................................................ 27 Decentralization and macroeconomic stability – Literature review ........................... 32 The flypaper effect ...................................................................................................... 35 Decentralization of fiscal revenue from natural resources ......................................... 41 Chapter 3: Key features of Peru’s latest fiscal decentralization process ................... 48 Initial focus on Regional Governments ...................................................................... 49 Developments with LLGG .......................................................................................... 53 iv Chapter 4: Studies on decentralization and macroeconomic stability in Peru ......... 74 Introduction ................................................................................................................. 74 Review of studies on Peru........................................................................................... 77 Chapter 5: Leading research questions and methodology ........................................ 101 Introduction ............................................................................................................... 101 Effects of transfers on Peru’s general government ................................................... 102 Effect of transfers on fiscal decisions of LLGG ....................................................... 103 Classification of LLGG .................................................................................. 104 Inquiries related to fiscal decisions of LLGG ................................................. 109 Chapter 6: Results......................................................................................................... 113 Effect of transfers on Peru’s general government ..................................................... 113 Analysis of the effect of transfers on fiscal decisions of LLGG ............................... 122 Fiscal response of LLGG to transfers according to their different characteristics ... 128 A tale of two provinces ............................................................................................. 148 Do LLGG reduce their fiscal effort in response to transfers? ................................... 151 Descriptive analysis of the evolution of LLGG own revenue collection ....... 151 Econometric assessment of the response of local tax collection to transfers . 157 Regression model ............................................................................................ 177 Effect of transfers on LLGG expenditures ................................................................ 185 Descriptive statistics ....................................................................................... 185 Regression model ............................................................................................ 202 Chapter 7: Conclusions, policy implications and recommendations ....................... 227 Conclusions ............................................................................................................... 227 Policy implications and recommendations ..............................................................