FISCAL DECENTRALIZATION IN EASTERN EUROPE: AN EXAMINATION OF ECONOMIC GROWTH PATTERNS KAITLIN VON HOFFMANN

KAITLIN VON HOFFMANN graduated from Notre Dame in 2011 with honors from the Department of Political Science. As part of the now-closed Central and Eastern European Study Abroad Program, she spent her junior year studying at the Universitt Franz-Leopold in Innsbruck, Austria. The program director, Gernot Guertler, and his wife Anita organized a trip to Hungary as part of the spring program. The things Kaitlin experienced in the course of that trip inspired her to abandon a previously-chosen topic for her senior thesis in favor of exploring development patterns in Eastern Europe. She would like to thank her advisor, Professor Guisinger, as well as Gernot and Anita Guertler, without whom this never would have been written.

2 Introduction Village-wide Wi-Fi networks in poverty stricken towns suffering from high unemployment and rickety ox-drawn carts on newly opened highways are just two examples of high-cost, European Union-supported infrastructure investments ridiculed by the Eastern European populaces whose lives they were intended to improve. The apparently large disjunction between real needs and governmental provisions throughout much of the region provokes the question of why the institutional structure, namely the level of fiscal decentralization, has not adapted to the shifting needs in the region. Locals argue that they could do a better job than the central government or Brussels,1 and that the decentralization of fiscal policy would significantly reduce the discrepancy between the type of support they need and the type that they receive. The specific effects of the institutional structure in Eastern Europe on growth and development have not been adequately addressed to date. The current body of literature on fiscal decentralization is largely theoretical, and many existing empirical studies neglect to account for important variations within the chosen sample. Consequently, studies seem either to be contradictory or to offer results that are not as valid as they first appear. In addition, studies that examine the causal linkages between decentralization and economic growth tend to focus on the overall countrywide efficiency of growth without delving into the nature of the growth within countries themselves. The idea that efficient growth might come at the expense of expanded inequality is both a theoretical concern of scholars such as Kuznets, as well as a potential political concern. His hypothesis claims that increases in income are correlated with increases in inequality (Stiglitz and Squire 1998). Growth equality as well as efficiency should be considered possible policy goals, especially in countries accustomed to a more equitable distribution of income. This paper explores the different relationships between fiscal decentralization and two economic growth 1 Many of the European Unions principle organizations have headquarters in Brussels.

3 patterns using a homogenous sample, which by its very nature controls for geo-political conditions and various structural factors often not included in previous studies. The first analysis focuses on the efficiency of economic growth, while the second examines inequality in the form of regional disparities. Since the fall of communism and the recognized failure of the command economy as a model conducive to growth and development, the countries of Eastern Europe have sought to decentralize authority as part of a broader institutional transition. I argue that the devolution of fiscal authority allows local governments to have the autonomy to pursue those policies that contribute most efficiently to local growth, resulting in a higher national growth rate than would occur if the countrys government retained its centralized structure. Additionally, the means through which fiscal decentralization promotes growth, specifically the close proximity of decision-making authority to the populace, should not increase regional inequalities as predicted by Kuznets and Prudhomme, but rather serve as a mitigating factor which decreases disparities as regions pursue policies addressing their specific needs. This paper undertakes a two-part analysis to gauge the relationship between fiscal decentralization and economic growth,. First, a multivariate fixed effects regression model illustrates how efficiently fiscally decentralized systems promote economic growth in comparison to their more centralized counterparts . Such a model measures total growth without accounting for its geographic distribution, and therefore a separate regression incorporating the dispersion of GDP per capita at an EU-recognized regional level (so-called NUTS 2) is also used. This second test shows how economic growth impacts the levels of regional inequality within a country. The analysis results support the contention that in the case of Eastern Europe, increasing the level of fiscal decentralization led to increased growth rates and, contrary to the Kuznets Hypothesis and

4 Prudhommes concerns, decreased the gap between rich and poor regions within countries. This demonstrates that decentralization facilitates economic development both efficiently and equitably.

Background and Review of Literature Decentralization can be most broadly described as the delegation of decision-making authority to lower levels of government. In a decentralized system, local government officials are authorized to make decisions that otherwise would require the involvement of the national government. Although many of the same decision-making processes are involved, a decentralized system saves the time needed to relay information and form a consensus in a larger group, thus making the system more responsive. Having fewer people involved in the decision-making process also serves to increase transparency and accountability. The theorized results of decentralization span a wide spectrum: proponents such as Oates (1993) tout increased efficiency and economic growth as benefits, while authors such as Prudhomme (1995) highlight potential pitfalls including the danger of local capture and conflicting budgetary goals. One significant point of divergence is the nature of the relationship between fiscal decentralization and economic growth. While theoretical arguments have been made for a variety of direct and indirect effects of fiscal decentralization on economic growth patterns, there is a lack of conclusive empirical research on the subject. One of the strongest and most frequently cited arguments in favor of decentralization states that fiscal subsidiarity promotes greater allocative efficiency. In other words, when decisions are made at the lowest level possible without jeopardizing effectiveness, funds are used more efficiently. This is the argument informally referenced by caf regulars reciting a Hungarian saying concerning Brussels decisions on the construction of the new highway system: They create hills

5 so they can dig tunnels and make valleys to build bridges. This argument hinges on the assumption that local governments have more accurate information about the needs of the populace, that they are capable of successfully implementing policies consistent with those needs, and that they are more directly accountable to voters as a result of closer interaction (Oates 1993). When expenditure assignments occur closer to the revenue source, fewer people are involved overall, hopefully reducing bureaucratic red tape and reaction time. Additionally, streamlining the public sector means money travels through fewer hands and is easier to track. Proponents argue that this streamlining promotes transparency and accountability, encouraging the efficient, responsible use of funds. As far as it creates an atmosphere of accountability, decentralization is seen as a tool for building the foundations of democracy and good governance (Huther and Shah 1998; ODwyer and Ziblatt 2006; Dunn and Wetzel 2000). To the extent that subsidiarity leads to allocative efficiency, countries should theoretically be able to address a wider range of projects. If countries operate more efficiently, fewer funds and overall resources are needed to accomplish the same goals. Funds previously used for nonproductive uses, such as debt servicing, can be reallocated toward policies and programs that promote growth. The benefits reaped are two-fold: fiscally decentralized countries not only have fewer debt and macroeconomic stability problems, but they also have higher growth rates when the new-found funds are put to alternate uses (Prudhomme 1995). These arguments depend on local governments successfully promoting greater efficiency, which opponents argue should not be assumed in all cases. The first test conducted here measures the relationship between these two variables. If proponents rely on a correlation between decentralization and efficiency as the cornerstone of their macroeconomic arguments, their opponents presume that the loss of central

6 government control allows local governments the policy freedom to make poor decisions, favoring short-term benefits over the long-term needs of the country. Most of the arguments follow the general pattern that policy freedom allows latitude for government elites to make decisions that benefit their own private interests, not those of the country or region. They take advantage of the freedom to pursue personal gain or pork-barrel policies that help them win re-election, but will ultimately damage the countrys overall economic prospects. Decentralization opponents further argue that the proximity of local governments to their constituency fuels corruption as politicians use their allocative jurisdiction not to channel funds toward the most productive, efficient use, but to direct it towards key constituents with whom they have personal relationships. They use similar arguments to refute the proponents theorized connection between subsidiarity and efficiency, while voicing arguments that the loss of control can lead to macroeconomic instability through a variety of causal mechanisms. The same autonomy that can be used to customize policies to regions specific needs can also allow regions to engage in a variety of less productive policies. In his widely cited article The Dangers of Decentralization, Prudhomme argues that decentralization increases regional disparities as states concentrate their resources in a few urban areas, and may lead to destructive competition between regions as they compete to provide the most favorable business climate. While decentralization may lead to short-term growth, he maintains that it sabotages long-term production capacity. De Mello contends that decentralization may decrease the size of the central budget to the extent that the state is unable to finance stabilization programs needed during times of crisis (2000). Tanzi (1995) and Wonnacott (1972) argue that decentralization allows lower levels of government to circumvent federal policy objectives and undermine the states macroeconomic stability. Huther and Shah (1998) report that sub-national governments often

7 pursue beggar-thy-neighbor policies and undermine national unity in pursuit of narrow interests. The extension of several of these arguments is that pursuing divergent sub-national policies would increase disparities between regions. Regional inequalities of this nature would be consistent with Kuznets hypothesis that growth indiscriminately leads to higher levels of inequality. The presence of such inequalities would be a logical outcome of the type of macroeconomically unstable policy choices highlighted above. Alternatively, Shah (1994) argues that fiscal decentralization offers the potential for better management if countries are able to realize it. A certain level of experience and knowledge among policy makers and administrators is often cited a necessary criteria for successful management. . An additional concern voiced by the opponents of decentralization focuses on the capacity of governments to adequately address the issues specific to decentralized systems. Unlike the previous arguments, which assume that politicians and bureaucrats are intentionally manipulating the system, these arguments speak more to the absence of knowledge and experience. Dethier contends that a lack of qualified personnel, unclear definition of roles and responsibilities, and poorly designed incentives to improve transparency and accountability all hamper the success of decentralized systems (2000). De Mello argues that a combination of actor and coordination problems in developing countries leads to poor use of funds when expenditure and revenue assignments occur at a local level (2000). He holds that these problems can largely be remedied through a mode of transfer payments in which the receipt of future sums is contingent on the local government using funds according to prescribed guidelines. Conditional agreements allow the central government to retain some measure of control, and are debated within the literature. While de Mellos solution remedies some of the problems highlighted by Prudhomme, Oates, and others, sub-national governments whose bureaucrats hands are effectively tied may not

8 be as autonomous as they appear when decentralization is measured by pure expenditure or revenue ratios. While de facto autonomy depends on the conditions themselves and how they are implemented, imposing any measure of conditionality potentially compromises sub-national autonomy; the central government could threaten to withhold vital funds if sub-national governments act incongruously with the agenda of the central government. Additionally, Shah argues that intergovernmental transfers undermine fiscal discipline and accountability while building transfer dependencies that cause a slow economic strangulation of fiscally disadvantaged regions (Shah 1999, 35). The problems associated with conditionality, intergovernmental transfers, and how decentralization should be measured constitute significant divisions within the literature and are further discussed in the methodology section. Much of the literature to date has focused on growth efficiency as the metric of measurement without examining any resulting changes in equality. A study correlating the nations overall GDP growth with its level of fiscal decentralization will fail to capture how that growth is distributed geographically across the country; it may be concentrated in one industrialized region, with little development occurring in other parts of the country. That would be an efficient use of funds in that the countrys GDP is increasing very quickly, but it would hardly be an equitable one. As mentioned previously, Prudhomme argues that fiscal decentralization is likely to increase regional disparities. Within the broader body of economic literature, this prediction is aligned with the famous Kuznets Hypothesis, which claims that increases in income are correlated with increases in inequality (Stiglitz and Squire 1998). While a number of papers discuss theoretical mechanisms in which decentralization leads to increasing regional disparities (Prudhomme 1995), the hypothesis has not been tested empirically in a study free from the sampling concerns

9 mentioned below. Testing this hypothesis in the context of fiscal decentralization is the second objective of this study. Literature to date has not reliably differentiated between several key characteristics of countries, among them the level of development, development path, and particular geo-political conditions. Using a wide-reaching sample, ODwyer and Ziblatt (2006) argue that the simple correlation between decentralization and efficiency disappears when controlling for structural variables such as socio-economic development, integration in the world economy, and regime type. However, they find that distinct trends emerge when their sample is divided into developed and developing countries. Generally, a consensus has been reached that the positive and negative externalities of decentralization differ significantly between developing and developed countries. Literature on developed countries seems to conclude more often than not that decentralization is largely positive. Studies that examine developing countries, as well as studies that do not differentiate between the two categories, are more contradictory. Utilizing data from 46 developed and developing countries, Davoodi and Zou (1992) found a negative relationship between fiscal decentralization and economic growth in developing countries and no significant relationship for developed countries, though Akai and Sakata argue that they fail to account for significant historical, cultural, and institutional differences within their sample (2002). Differing geo-political conditions within a sample are often given as a reason to disregard study results. Yet even when the sample does not contain both developing and developed countries, and geo-political factors are controlled for, the results are often unclear. Scholarship typically falls into one of two categories: either mixing non-like states or relying on a single case study. While a case study avoids some of the danger of omitted variable bias present when using a sample of non-like states, the applicability of a single country case study is limited since it is so closely tied to the

10 particular historical conditions within that country. However, the fact that studies differ so dramatically in their findings makes case studies interesting from a methodological perspective. For example, Akai and Sakata use state-level cross-section data for the United States to show that fiscal decentralization contributes to growth (2002), while Xie et. al. use data from the United States to show it as detrimental to growth (1999). Additionally, Zhang and Zou (1998) use data from China following the 1970s reforms to demonstrate that the increased fiscal decentralization actually reduced provincial economic growth. To avoid the trade-off between a poor sample and limited applicability, I look at a region with a similar composition of states in terms of geopolitical, historical and cultural conditions, as well as comparable development paths. While this study focuses on Eastern Europe for methodological reasons, the causal mechanisms hypothesized here are in no way specific to that region. As a result, the findings are applicable to a wider variety of cases.

Regional Description This sample encompasses those 12 Central and Eastern European countries that ascended to the European Union in 2004 and 2007: Cyrus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, Slovenia, Bulgaria and Romania. Following World War II, these countries were part of the United Soviet Socialist Republics (USSR) sphere of influence, during which their national governments and policies were largely replaced with Muscovites and ideologically driven programs (Stokes 1996). Until the fall of the Berlin Wall and the subsequent dismantling of the communist satellite states, the regimes in place were characterized by the centralization of authority in a single office or set of offices and a command economy firmly removed from the influences of free market forces and concentrated on promoting

11 industrialization. Emphasis was placed on conformity, adherence to the official party doctrine, and obedience to the state. The destruction of the Iron Curtain renewed contact between what had previously been two sides of an intensely bipolar international arena, and with the rejection of the command economy and communism as development methods, many Eastern European countries turned to western European models of democracy and free market economy. The depth and breadth of the transition can scarcely be exaggerated as the paradigm shifts required for the successful transformation affected every conceivable aspect of citizens lives. On the most basic level, it necessitated the introduction and consolidation of new norms of behavior in both the private and public spheres. Accomplishing such fundamental changes is the work of years and decadesthe ideological legacies of communism and its structural effects will likely only disappear with the generations that knew their realities. As Crawford and Lijphart summarize in their 1995 article, the historical legacy of the Soviet system interacts with present circumstances to impact the direction of each regimes change. They highlight six key remnants of the communist system: backwardness and peripheral status in the world economy, the absence of a successor elite, a weak party system, the reemergence of nationalism, the persistence of communist-era institutions, and the lasting impact of the centralized state and command economy. The final point is the most important for this discussion. While political elites used their strongly centralized authority to create social and economic infrastructure targeting high growth rates, the system was wasteful at best and led to a marked decline in living standards as the state misappropriated its resources. Firm control of the media reduced the availability of information needed to make sound policy decisions, further contributing to the downward spiral. Recognizing the need to change, the regime focused on

12 building a professional elite and an educated workforce, both of which remained separate from the party apparatus by necessity. While the states had these resources at their disposal, the command economies had exhausted their growth capacity. While the dissolution of the Soviet bloc marked the beginning of the wholesale political and economic transition throughout Eastern Europe from authoritarian systems to more open governing institutions, the nature of reform differed significantly among countries. Crawford and Lijphart suggest the specific historical legacies and then-current circumstances of each country played a significant role in their reforms (1995). As Timothy Frye writes in his book, Building States and Markets After Communism: The Perils of Polarized Democracy, If the watchword of the communist era was conformity, the watchword of the post-communist world is diversity the hardwiring of the planned economy cannot be easily replaced, but the scope of change across countries in a relatively brief period is remarkable. (1) Exchanging the centralized institutions and Soviet-era patterns of behavior with more transparent democratic ones necessitated changing the very anatomy of the decision-making structure. Given the single powerful locus of power under the prior regime, decentralization was an important characteristic of the democratic transition. Most countries have undergone dramatic change, while outliers still operate under an institutional structure remarkably similar to the one established at the time of transition. Romania and Slovakia, for example, had a total percentage change of 17.2 and 12.8 respectively in governmental revenues collected by the local government relative to the total government. On the other end of the spectrum, Malta only changed by 0.8 of a percent. The average level of expenditure decentralization, as well as the total range, is reported by country in Table 1.2 While the variance is typical of the regions governing structures and changes 2 In this sample, expenditure and revenue decentralization are highly correlated. Both are accepted methods of calculating decentralization.

13 in the degree of centralization are seen in many policy areas, I focus specifically on fiscal policy. As seen in Figure 2, the general trend within the sample is toward greater fiscal decentralization, although perhaps the most noticeable characteristic of the change is its lurching, uneven nature.3 The myriad of simultaneous political and economic reforms only further complicated the process. The 12 countries began their ascension negotiations with the European Union in the midto-late 1990s. As a condition for joining the Union, candidate countries must demonstrate that they have met certain economic and institutional criteria domestically as specified by the 35 chapters of the acquis communautaire. During the years of negotiation, the EU helped the candidate countries prepare for their eventual membership through a pre-accession strategy that encompassed various types of trade and aid measures, general assistance and a structured dialogue (Nello 2009). After evaluating the countries against the conditions for membership specified by the 1993 Copenhagen European Council, the EC Commission published opinions on the readiness of each candidate country in July of 1997. In December of 1999 the European Council opened official negotiations with Cyprus, the Czech Republic, Estonia, Hungary, Poland, and Slovenia, and in 2000 Bulgaria, Latvia, Lithuania, Romania, the Slovak Republic, and Malta were invited to negotiate. All of the countries ascended to the Union in 2004, except Bulgaria and Romania who joined in 2007. The Maastricht criteria specify that a country must maintain an exchange rate within a given range of the Euro for two years without depreciation to be eligible to join the monetary union. Slovenia adopted the Euro in 2007, Cyprus and Malta in 2008, and the Slovak Republic in 2009. The remaining countries faced economic difficulties that forced them to postpone their plans to join the Eurozone, even prior to the latest financial crisis.

3 Hellman (1998) and Frye (2010) offer the presence of partial reform equilibrium and high political polarization respectively as reasons for the pace and consistency of reforms.

14 Theory The core of the classic arguments in favor of fiscal decentralization can be summarized simply with the hypothesis that systems incorporating greater fiscal autonomy are more efficient. The arguments I advance in favor of this hypothesis are not new so much as they are applications of previously advanced hypotheses to the sample, as well as an extension of several fiscal decentralization arguments that address the question of whether the inequality resulting from effective economic growth is as automatic as Kuznets theorizes. The majority of arguments for fiscal decentralization focus on either the systems smaller decision-making apparatuses or the greater proximity of those processes to the people they are intended to serve. The combination of greater knowledge of the populaces needs and the various benefits stemming from fewer people being involved in the decision-making process serve to decrease the overall cost of fixing any given problem or executing any specific project. One of the greatest strengths of a decentralized system is the ability to tailor policies and programs to the specific needs of that regions economy. If the nature of the particular need is known, the government can easily target it. Instead of simply throwing large amounts of money at a problem, the regional government can spend money where it is most likely to make a difference and have the largest impact. Critics of decentralization argue that sub-national governments will not benefit more from the knowledge gained as a result of their closer proximity than the national government would if it had that same knowledge. At both levels of government, if officials are not held accountable to the populace or choose not to act in its best interests, the fact that they have access to the knowledge to do so is immaterial. The pro-decentralization arguments assume that the national government does not have access to this knowledge, would not use it if it did, or is not able to effectively implement

15 the course of action supported by the knowledge. I argue that even if the national government had access to the knowledge and was able to implement the appropriate policies, decentralization is still more efficient by virtue of the number of people involved: with a smaller response loop there is less red tape. Government can react more quickly, making it more responsive. With fewer hands involved in the transfer of funds, it is easier to hold individuals accountable.4 Additionally, the overhead cost of a smaller government is lower, saving more funds for the programs themselves. These rebuttals are not specific to Eastern Europe, but rather address concerns raised regardless of the samples context. Even assuming the accuracy of the argument that decentralized systems have the capacity to be more efficient, there are factors that could keep institutions from reaching that full potential. Prudhomme and others cite the small size of the decision-making hierarchy and resulting proximity of allocation decisions to the populace as creating a greater potential for corruption and local capture (1995). However, that same proximity makes it more likely that the populace will be aware of corrupt politicians and hold them accountable. A voter is more likely to notice the hallmark discrepancies between policies and actions if those policies are being made in their town or region, as opposed to in the capitol across the country. They may not be aware enough of national policies to know that certain programs should have been put in place or that some program was supposed to be executed in a different manner. The proximity to the decision-making bodies makes it more likely they will notice corruption. In keeping with this idea, Dwyer and Ziblatt find that fiscal decentralization is correlated with good governance (2006), further suggesting the proximity and its resultant transparency would allow citizens to better scrutinize politicians choices. While the particular circumstances of a country may lessen the benefits of what in essence 4 In a broad study indexing 80 countries, Huther and Shah show a strong positive correlation between fiscal decentralization and governance quality, which incorporates citizen participation, government orientation, social development and economic management (1998).

16 should be a more streamlined and effective model, these factors can be mitigated institutionally or otherwise offset. I argue that many of the characteristics which hamper decentralized systems success in less developed countries are either not present in this sample for historical reasons or are being addressed. In the case of Eastern Europe, there are multiple reasons to believe that the problems associated with proximity are not troublesome enough to negate the benefits. As mentioned earlier, the criteria for joining the European Union mandate that all candidate countries adopt the acquis communautaire (Nello 2009). As part of the negotiations they must show that they are in compliance with the EUs previously adopted treaties and legislation. Given their history, this criterion necessitated a comprehensive reform of the then-candidate countries governing structures. Throughout the process they were held accountable to an outside body that they had every incentive to please. The pressure of negotiations and multiple vetting procedures would predictably have led countries to be less tolerant of corruption than is likely the norm in countries in their stage of development. Moreover, the transparency required by the EU made it more likely that corrupt policies would be exposed to the populace, so politicians and bureaucrats would be less likely to engage in them in the first place. The involvement of the EU had a broad impact on the system. Crawford and Lijphart argue that influences such as the level and kind of foreign aid and investment, capital flows, openness to imports from various sectors, and the role of foreign experts and expatriates in designing new institutions and administering privatization and reform plans had a dramatic effect on the trajectory and speed of the post-communist transformation (1995).5 Despite similar historical circumstances, the EU had a much more significant role in these 12 countries than in countries belonging to the 5 Shah (1997) argues a countrys EU status spurred changes in the level of centralization. Dunn and Wetzel (2000) contend that the role of the EU predisposed countries toward adopting a decentralized model and increased their preparedness to benefit from it.

17 Commonwealth of Independent States. It played an active role in aiding their transformation through sizeable aid and technical assistance packages even prior to the official beginning of ascension procedures. The involvement of the EU also helps mitigate concerns arising from a lack of experience with the new institutional arrangement and the quality of the bureaucrats they are able to attract. Critics argue that by virtue of their smaller size, sub-national governments are not able to attract the same quality of politicians and bureaucrats as the central government and this dearth of experience will hamper the quality of their governance. Working for the national government is seen as more prestigious, and the national government generally offers better employment benefits. As a result, more highly qualified individuals will choose to work for the national rather than subnational government. As a result, personnel employed by sub-national governments do not have the same level of institutional knowledge or experience. The scarcity of experience may exist to such a degree that sub-national governments, despite their best intentions, are simply not able to design and implement successful policies. In a region like Eastern Europe, where the previous economy was based on a highly centralized command structure so different from the models adopted after the transition, this is a highly relevant concern (Dethier 2000). Although the saliency of this argument wanes with each passing year, many political elites were educated under the communist system and simply have different basic policy instincts. While only a few individuals had been in charge of designing policy, and thus had the advantage of that experience, the shift to using an entirely new set of rules and norms may have been large enough to counter the experiential knowledge they gained under the prior system. It is far more likely that, to the extent that unfamiliarity is a problem, it is a problem at all levels of government.

18 The central government presumably faced the same deficit of institutional knowledge regarding capitalism, free market dynamics, and democratic institutions that the sub-national governments did. Since the transition, development efforts undertaken by the European Unions regional and cohesion policy programs may be enough to offset any differences.6 This is not to say that all levels of government have skilled, adept politicians and bureaucrats, but rather that there is not likely to be a significant discrepancy between the national and sub-national levels. If my hypothesis that these concerns are outweighed by the benefits of allocative efficiency is correct, increases in fiscal decentralization will correlate positively with higher GDP growth rates on a national level. However, while this provides a measure of how efficiently a system is operating, it neglects to capture how equitably that system distributes its resources. The Kuznets Hypothesis states that one of the externalities of economic growth is increasing inequality resulting from some individuals being left behind because of their inability to compete in the modern economy. On a regional level, one could imagine this dynamic occurring as the national government concentrates resources in those areas where they would see the highest return. In contrast to Prudhomme, I argue that growth in a fiscally decentralized system does not necessarily make regional disparities worse because regions are free to pursue growth in those areas that are most beneficial. While there may be variances in what type of sector the economy is based or in the overall level of development, I argue that fiscal decentralization actually serves as a mitigating factor in the regional application of the Kuznets Hypothesis as explained below. As each sub-national region gains more fiscal autonomy, it has greater authority over how government funds are utilized to develop its economy. Whereas policies created at the national 6 For example, during the 2007 to 2013 budgetary cycle, the European Regional Development Fund will finance programs addressing general infrastructure and investments, including research and innovation, telecommunications, energy and water supply, information society, education and professional training and health services (Nello 2009).

19 level may be of the one-size-fits-all variety, policies formed at the sub-national level are more closely attuned to the particular conditions of that region. In countries where there is a large variation between different sub-national regions geographically, economically, or demographically increasing sub-national fiscal autonomy would be expected to increase variance in policies and types of economic development. Specialization means that regions are not necessarily left behind as the country develops, but rather they pursue the development path that is most efficient for them. As a result, although it appears that regions are becoming more distinct from each other, the overall level of economic inequality is not necessarily increasing. Growth according to comparative advantage is cyclical in that it builds on itself, as theorized below, but it does so in such a way as to maximize the production capabilities of each region. I theorize that this will decrease the inequalities found between regions in more centralized states where ill-fitting policies hamper the growth of some regions while focusing on the needs of others.7 Autonomy allows for great policy diversity that regions can use to design policies to suit their specific needs. If a particular sub-national policy is based on the specific conditions and circumstances present in that region, pre-existing differences between regions would logically lead to differences in policies. Each sub-national government would be able to tailor its policies to develop those sectors of the economy where it has the greatest comparative advantage. For example, a region rich in natural resources would probably devote a large portion of its budget toward building the infrastructure needed to transport minerals and other raw materials from mines

7 For this analysis, the aspect of inequality under examination is specifically the discrepancies in production capacity as measured by GDP per capita. This has the additional benefit of providing a rough measure of the variation in wealth distribution across the country, although this statistic should not be used to generalize too broadly about the level of development.

20 to factories. Alternatively, a region that has one or two heavily populated cities, but is otherwise undeveloped, is unlikely to spend money building an extensive highway network. While fiscal decentralization allows each region to develop according to its comparative advantage, the magnitude of the resulting regional disparities is compounded by a cyclical growth pattern that accentuates the pre-existing differences. In a country where different comparative advantages exist, each region will pursue distinct development goals. As regions make use of their autonomy to tailor policies, the direction of development becomes path dependent. When both public and private sectors pursue policies that effectively promote growth in a particular economic sector or industry, that industrys importance in that region increases, and both sectors will continue to emphasize its growth. This cycle can lead to the concentration of different economic sectors in different regions of the country. For example, Romania has a highly diversified terrain. While fertile plains occupy much of the country, the eastern regions near the Danube are hilly and the major mountain ranges that comprise the Carpathians run through the northern and western portions of the country. The countrys work force is almost evenly divided between agriculture (3 million), industry and construction (2.8 million), and services (3.3 million). Given the geography, one would expect the agriculture to be in the middle and southern portions and for those regions governments to take more interest in agricultural policies than the regional governments in the Carpathians. Given the autonomy to pursue independent development agendas, the central region will promote agriculture. They might do this by creating educational programs, instituting tax incentives, or providing subsidies for this discussion the means are not important. As the regional economies become

21 more focused on their specific sectors, the government has more incentives to further promote productivity.8 This path-dependent development can be thought of as a virtuous cycle, the counterpart of the vicious cycle of poverty and stagnation. For example, mines in a certain area of a country could lead businesses to establish processing plants for raw ore and minerals in the area to avoid the added cost of transporting them over long distances. Perhaps manufacturing plants will be built there for the same reason. The creation of such a hub will attract more industrial workers, further developing the region as an industrial center. Conversely, areas seen as innovative centers are likely to attract people with higher levels of education, building their human capital while potentially contributing to a brain drain of other areas. This cyclical development pattern applies to more than the migration of workers and relocation of private firms. Sectorial concentration also has a drastic impact on the regions government, whose policies allowed the creation in the first place. As prosperous areas become more prosperous they attract more businesses, more qualified people, and more investment funds, all of which further contribute to their development. More prosperous areas will have higher tax revenues than less prosperous areas, assuming a similar tax structure. The larger budget allows for additional government expenditures, and almost regardless of the type of program they are allocated to support, they will impact the regions development. With a larger operating budget, the governments of these regions will be able to provide more extensive or higher quality services. These regions would be expected to have higher levels of government spending than less developed areas in the absence of intergovernmental transfers. 8 Assuming the government collects a business tax, the more productive these companies are, the more tax revenue the government collects. Increasing the size of their budget is a strong, if cynical, reason for them pursuing sector-specific policies that focus the regions economy on its comparative advantage.

22 The rate at which this cyclical, path dependent growth occurs depends on a number of factors: the governments success in pursuing the regions comparative advantage, the pre-existing degree of differentiation between regions, and the populaces willingness and ability to relocate.9 First, each regional government must pursue its comparative advantage.10 While this is the logical course of action in the abstract, there are some circumstances in which a government would not institute these policies. For example, if the sub-national government received high transfers from the central government, they would have less of an incentive to develop their own tax base. The issues associated with intergovernmental transfers are complex due to the constraints on policy decisions they may place on sub-national governments and are discussed more in depth in the methodology section. Another influential factor is the level of pre-existing demographic differences between subnational regions. The argument assumes that the regions are sufficiently different from one another that distinct comparative advantages exist. If an entire country is best suited for agriculture, then fiscal decentralization within that country will not lead to differentiation according to comparative advantage.11 The degree to which one region is economically distinct from another could also be 9 The European Federations 2006 Mobility in Europe Report states that in 2005, 2.7% of respondents in EU15 countries reported an intention to move within the EU within 5 years, compared to 5.1% of respondents from the 2004 ascension countries. While this disguises large differences between the 2004 countries in the willingness to move, a 2006 Dutch study showed that if the Netherlands opened its borders to these countries, an estimated 53,000 to 63,000 workers would move there within a year (Ecorys 2006). The country limited work permits to 30,000 in 2005. The report found that job and geographic mobility are closely interrelated. 10 The law of comparative advantage refers to the ability of an individual, group or country to produce a particular good, or deliver a particular service, with a lower opportunity cost than their competitors would incur producing the same good. It is more efficient for them to produce that good than others. The concept was explained in David Ricardos 1817 book On the Principles of Political Economy and Taxation, where he concluded that countries benefit from trading with each other when each specializes in goods where they have the comparative advantage. 11 Within the sample, the difference in the percent of the labor force employed by the largest sector and the smallest sector ranges from 29 to 40 percent. This suggests that the dominant sector does not monopolize the economy.

23 influenced by government policies such as tax incentives or subsidies rather than the natural comparative advantages of that region. The willingness of businesses and individuals to relocate also impacts the cyclical nature of sectorial development. If neither is willing to relocate, then the growth of a particular industry is dependent upon the capability of the region to build its own human resources and capital stock specialized to that industry. Training programs must be established to educate workers and incentives must be provided to foster entrepreneurship. While both of these things would occur eventually in the course of development, not having imported knowledge and resources would slow down the growth rate. The actions of the national government also bear mentioning with regard to the impact of fiscal decentralization on equality. There are two main types of policies it can enact that could theoretically have a substantial impact on the differentiation of economic development, the first of which has already been mentioned briefly. That is, they could supply sub-national governments with large transfers, which may create dependencies in a similar way to how some world systems theorists argue interactions between core and periphery countries have a long-term detrimental impact on the peripherys independence and development The second central government policy influencing the growth pattern is the size (or existence of) a national social program that redistributes wealth between sub-national regions. As Shah, Oates, and others argue, the national government is the most logical level to enact and carry out redistributive policies. Since sub-national governments are only able to effect change within their jurisdiction, even if all sub-national governments pursued communist-style redistributive policies that gave each of their residents the exact same level of wealth, the citizen of one region would still have a different level of prosperity than that of another region because of differences in

24 each regions population, cost of living, social expectations, and other non-quantitative factors. Regional disparities could be remedied either through transfers negotiated between the regions themselves or by the national government. Since direct transfers among regions would not be politically advantageous to the politicians at the sub-national levelthey would not win any points with the electorate for funneling funds away from their constituencypolicies seeking to redistribute capital are most effectively conducted by the national government. One consequence of this is that in a country with a strong redistributive system on the national level, a low level of variance would be expected regardless of the level of sub-national fiscal autonomy. This last factor can be excluded from the model depending upon the choice of metrics. If the measurement metric used to gauge equality is the variance in gross national income per capita at a regional level, then factors such as income redistribution policies would have a direct impact. While this encompasses a set of inequalities primarily relating to the relative quality of life and purchasing power of consumers in different regions, it says little about the dispersion of the means of production across a country that has a significant redistributive program. To shift the focus to production dispersion, this study uses gross domestic product per capita instead. Eastern Europe presents a unique backdrop: forced industrialization and farm collectivization required countries to pursue development in sectors outside of where comparative advantage lay. If my hypothesis that fiscal decentralization will allow regions to more efficiently pursue their comparative advantages is correct, I would expect the disparity in GDP per capita between regions to decrease. Following the transition, the economy would have been exposed to free market forces. Those regions that had been forced to produce products where they did not have the comparative advantage would suffer as their competitors undercut their prices, decreasing sales and resulting in declining production. The decline would lower the regions GDP per capita

25 until the economy began to shift to those areas where they did have comparative advantage, at which point I would expect GDP per capita to rise and narrow the gap between their level of production and that of regions that had not been so negatively affected.

Empirics To test my hypotheses, I first examine the relationship between fiscal decentralization and GDP growth rate, my proxy for efficiency, before investigating its connection with the dispersion of GDP per capita between NUTS 2 regions within each country.12 The sample covers 12 Central and Eastern European countries from 1997 to 2007. Before explaining the methodology used for each of the standards, some remarks on the specific features of the sample and on the definition of fiscal decentralization are necessary.

On the sample: Due to the similar geo-political circumstances of these Eastern European countries, even accounting for differences in the nature of reforms, the sample countries share more in common than many samples used by previous studies. This is an important feature of the sample, as variances in historical, political, economic, or geographic conditions within the chosen sample are one of the primary reasons cited as grounds to discount the findings of fiscal decentralization 12 NUTS is the legal framework formally established in Regulation (EC) No 1059/2003 that provides for the common classification of territorial units into 3 different hierarchical levels (Europa: Summaries of EU Legislation). NUTS regions of each level are of comparable size in terms of population, and are defined in terms of the existing administrative units in the member countries. Administrative units are defined as geographic areas for which an administrative body has authority to make policy decisions as defined by the countrys legal and institutional framework. Due to the classification requirements, most Eastern European sub-national governments fall into the NUTS 2 or NUTS 3 categories. The NUTS 2 level figures most prominently in sub-national governing.

26 studies. Previous empirical studies have often used samples containing countries at different stages of development, countries from around the globe, countries with drastically opposed regime types, or countries with different levels of institutional consolidation. While some variance will always occur within a sampleno two countries are exactly alikethe differences within some of the previous samples are large enough to influence the results and may be why contradicting studies exist. This sample offers a unique opportunity to examine the effects of evolving institutions. In most prior time-series studies, the authors examined a single country as a case study. Since few countries pursue similar development paths, this is a logical method to use to study institutional evolution. In the case of these 12 Central and Eastern European countries, however, decades of communism, the fall of the Iron Curtain, and the events leading to their inclusion in the European Union provide a series of exogenous shocks. In the context of the bigger picture, the countries all were at the same level of development, with similar disadvantages in terms of experience with the capitalist systems they would adopt and the democratic systems they would institute. While the democratic transition was more or less complete by 1996 in the majority of the sample countries, depending on how it is defined, institutional consolidation is still an on-going process to this day. That the patterns of behavior under which the new system will operate were not yet norms in 1996 adds a new dimensionthis is common in developing countries, but by the World Bank definition, most of these 12 countries do not fall into that category.13 While this sample offers a unique perspective on this question, it also has several important disadvantages that should be noted. By nature of its unique homogeneity, the sample controls a 13 Bulgaria, Romania and Lithuania are categorized as developing by the World Bank using 2009 data. That label refers to countries or regions with low- or middle-income economies. Low-income economies have a Gross National Income (GNI) per capita of $995 or less, while middle-income economies are calculated as having a GNI per capita between $996 and $12,195.

27 number of factors, allowing a clear, new perspective on the topic. The immediate consequence of this is a small sample size. While initially the sample only included those countries that ascended in 2004, due to the small sample size and other factors that will become apparent, the sample was expanded to include Bulgaria and Romania. This concession seems reasonable, as their ascension negotiations followed roughly the same timeline and trajectory, even if the decision to delay their ascension was made for primarily economic reasons (Nello 2009). The number of possible observations was further limited by the availability of data. Prior to 1997 data is not consistently available due to historical circumstances. As an important aspect of this study is the evolution of transitioning institutions, data from the intervening years would have been desirable, and would have been incorporated had it seemed credible and been consistently available. Even the data from the period included in this study must be analyzed in light of its source. Much of this data was self-reported by the sample countries to Eurostat. While Eurostat and national statistic offices operate using common quality standards as stated in the European Statistics Code of Practice and applied through the European Statistics System (ESS), adopting a set of broadly defined definitions uniformly to each specific country is not without challenges. This issue of inconsistency is a concern with any group of self-reported data, and the reason why one of Eurostats key tasks is to ensure the comparability of data across countries. Many of the same features that make this sample desirable also limit its future applicability. The experiences of these twelve countries are unique; there are few other places in the world where similar geo-political circumstances exist. That said, many countries belonging to the Commonwealth of Independent States (CIS) experienced similar communist regimes in the course of the last century and, for the most part, tend to follow the development path taken by their

28 more western-oriented neighbors. Their political situation is fraught with complexities and uncertainties, but the same could be said about these 12 countries in the mid-to-late 1990s.

On the Measurement of Decentralization: The theoretical and empirical literature to date lacks consensus on how fiscal decentralization should be measured, and studies using different indicators have yielded conflicting results. In general, studies employ two modes of measurement: the tax revenues collected by the local government as a percentage of the total government tax revenues, and local government expenditures as a percentage of total expenditures. While Oates presents an argument for the separate treatment of revenues and expenditures in decentralized systems (1993), in the chosen sample expenditure and revenue decentralization ratios are highly correlated with an R square value of .969. Given that the two are so highly correlated, for the sake of simplicity, I use the tax revenue ratio as a proxy for general fiscal decentralization. Although there are arguments for the inclusion of inter-governmental transfers, how they should be treated currently remains undecided by economic theorists. Some argue that transfer payments distort the numbers to overestimate decentralization if included. De Mello includes transfer payments from the central to the sub-national governments as part of sub-national revenues, while others such as Oates argue that a scheme of pure revenues and expenditures should be the basis for research. While the latter group acknowledges that intergovernmental transfers occur, both with and without conditions, it does not include them in theoretical or empirical models. No one disputes that how intergovernmental transfers factor in will have a negligible impact on the results. They at least imply some level of dependence, of conditionality, on the

29 central government, which may curtail the de facto level of fiscal decentralization. Transfers may also create dependencies by discouraging the sub-national governments from developing their own independent tax bases. At the same time, the sub-national governments do have some level of jurisdiction over how that money is spent, and good arguments can and have been made for the inclusion of transfers in the calculation of how decentralized a system is. In incorporating transfers the research would more closely reflect the actual circumstances, but given the differences of opinion on what levels of conditionality are inconsistent with the principles of decentralization and on how transfers themselves should be viewed, I will use Oates model, which excludes transfers. Analysis The empirical analysis focuses on two different regression models. The first tests the relationship between fiscal decentralization and growth, using a countrys national GDP growth rate as the dependent variable. The second test examines the nature of that economic growth by comparing the level of fiscal decentralization to the variance in regional GDP per capita, which is the dependent variable in that regression. Coupled with anecdotal data about the region, these regressions provide an in-depth picture of the relationship between fiscal decentralization and economic growth. According to the first portion of my hypothesis, higher degrees of fiscal decentralization led to more efficient government and, as a result, higher overall GDP growth rates. To summarize, using linear regression with fixed effects while controlling for variables such as the rule of law, gross national income per capita, and size of the labor force, the model found a strong positive relationship between fiscal decentralization and the dependent variable of GDP growth rate. The model as a whole and most individual variables14 were significant beyond the p-value standard of . 05. 14 Rule of Law was not statistically significant.

30 In designing a model, I faced a trade-off between using one of the full growth models found in economic literature and the need for parsimony, recognizing the special circumstances of Eastern Europe. The choice of control variables reflects the peculiarities of the region and its socio-economic make-up; some variables traditionally used in economic growth models do not apply to the region. In his paper prepared for the 2001 Conference on Institutions in Transition, Lucian Cernat explains that while models typically use education as a proxy for human capital in economic growth models (Barro 1991, 1997), the region is very homogenous in this regard. As a result, using education as a proxy for human capital adds little to the models explanatory power. In Cernats study , trade as a percent of GDP, exports to the EU as a percent of total exports (a proxy for regional integration) and country population did not have a significant impact on the economic growth model in the case of Central and Eastern European countries (2001). Given the importance of a parsimonious model, variables of this sort have been excluded. Many economic studies include a measure of regime type, with the justification that some regimes are better at protecting the rights of their citizens and establishing the type of society that is attractive to investors (ODwyer and Ziblatt 2006). Such a regime would benefit from a higher growth rate than one run by, for example, an unpredictable tyrant with a history of changing policies. Given that all of the countries in the sample are consolidating democracies of one degree or another, a simple measure of regime type does not capture this disparity. To control for this effect, I included the Rule of Law estimate developed by the World Bank as part of its Worldwide Governance Indicators project. The projects authors describe the indicator as capturing perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence (Kaufmann et al). Countries with a higher score have

31 more predictable governments, which decreases the transactions costs of doing business in that country and creates a more desirable business environment. Some measure of general economic prosperity is usually taken into account in both fiscal decentralization and economic growth studies (Barro 1991; ODwyer and Ziblatt 2006; Cernat 2001). In many cases, poor countries will have higher growth rates than their more prosperous counterparts when they undertake similar development initiatives. When a country is very poor, even a small amount of aid will cause a dramatic change, whereas that same amount of aid is not, proportionally speaking, as important to the more prosperous country and does not prompt the same response. In this case, the gross national income per capita is used as a proxy for general prosperity. Given the variables skewed distribution, the natural log was used in the model. The third control variable is the size of the labor force relative to the countrys total population, which serves a dual purpose. As mentioned above, education levels are often used as a proxy for human capital in economic growth models (Barro 1991, 1997). The education ratios throughout the Eastern Europe region are very similar due to the effects of the Soviet system and therefore insignificant (Cernat 2001). Given that education cannot be used to control for this disparity, the size of the labor force has been used as a proxy instead: the larger the labor force, the greater the potential. This statistic primarily reflects the size of the dependent sector. The dependent sector is made up of all individuals outside of the official labor force, and, while some of these individuals may have illicit revenue streams, in general they must be supported by the labor force or by government programs. The larger the dependent sector, the more money the government must spend on social programs, and the lower the expected growth rate. Figure 2 highlights the need to consider decentralization as a factor in the growth model. The figure represents the relationship between decentralization (as measured by the percent of total

32 government revenues collected by local governments) and the residuals, that is, the portion of growth not predicted by the control variables alone (rule of law, GNI per capita, labor force). As can be observed, this relationship is strongly positive and increases monotonically, but appears limited to changes at low levels of decentralization (0 to approximately 30 percent). The sample contains few observations in which decentralization is above this level, and those are limited to one or two countries. Regressing countries GDP growth rates against their level of fiscal decentralization, while holding rule of law, GNI per capita, and labor force constant revealed an intriguing relationship. As shown in Table 2, the model generated a surprisingly strong R-squared value of .4587 when the data is grouped by country. The coefficient for the decentralization variable is positive, which means that in those countries where a change in decentralization took place, there was a strong, positive impact on the efficiency of their growth. A one-standard deviation change in decentralization (from, for example, the regions mean value of 0.2 to 0.3) results in a 151% increase in the predicted annual growth rate for that country. While the direction of the relationship between the variables is as hypothesized, the strength of the association is remarkable and heightened concerns that outliers may be exaggerating the effect. There is a wide variance in decentralization ratios within the sample, ranging from 0.015 (Malta) to 0.34 (Poland) with a standard deviation of 0.094. The lack of fiscal decentralization in Malta and Cyprus is strong enough that those data points could have biased the model. By excluding each of these countries from the sample in turn, I tested the robustness of the model and found that eliminating these outliers only strengthened the results. See Appendix 2 for detailed results. As expected, there is a correlation between the GNI per capita and the GDP growth rate. Since more prosperous countries have more resources at their disposal with which they can

33 encourage further growth, it is not surprising that these two variables would be positively correlated. This correlation refutes the idea that, within the sample, countries with lower prosperity experienced a catch-up effect relative to the more prosperous ones. While studies show that this dynamic exists within broader samples, it is likely that the variance in prosperity level is not enough for this effect to be observed within the sample. The other significant control variable, the size of the labor force, is deceptively important to the model despite its small coefficient. Leaving this variable out entirely, or taking its log to even out the distribution, drastically impacts the models predictions for the other controls and for the dependent variable. The second test of the influence of decentralization on growth equity did not find support for Kuznets Hypothesis that economic growth is inextricably linked with increasing inequality, but instead provides evidence that fiscally decentralized systems decrease some regional disparities. To capture the complexities of what it means to have equal growth, I used a fixed effects multivariate regression model in which the distribution of GDP per capita15 is the dependent variable. Holding country size,16 prosperity, and population density constant, fiscal decentralization is negatively correlated with the standard deviation of GDP per capita between NUTS 2 regions. In other words, the more decentralized a country is, the lower the standard deviation. As a lower standard deviation signifies that the data points are more tightly grouped, countries with a lower standard deviation have regions whose GDP per capita are more similar to each other than is the case in countries with higher standard deviations. Given the negative correlation, more decentralized countries have more equitable levels of development. This test reveals nothing about 15 The standard deviation of GDP per capita between NUTS 2 regions within a country was used as a proxy for this variable. 16 Larger countries are more likely to benefit disproportionately from decentralization, whereas small countries can adequately govern without it. Cyprus and Malta have very low levels of fiscal decentralization, but it does not seem to have had the same negative impact on their overall growth level that would probably have been observed in Poland if that government had the ratio of either of the smaller countries.

34 how developed the country is or what kind of economic development has taken place, only that the development is more even in the more decentralized countries. Differences between the models three R-squared values reveal an important dynamic in the region. The models overall R-squared value is a miniscule 0.0185, but the R-squared value within groups when observations are sorted by country is 0.8553, as reported in Table 3. This means comparisons should not be made across countriesa certain level of decentralization does not necessarily correspond to a particular degree of equality or inequalitybut rather, in those countries that undertook decentralization programs, the variation seen in regions respective GDP per capita values decreased. It is important to note that this does not mean regional inequalities are not present within countries, but rather that decentralization decreases them.

Conclusion One of the concrete changes predicted by the causal mechanism of fiscal decentralization allowing governments to pursue policies that foster their regions comparative advantage is that the composition of the economy will shift over time. Hypothetically, in an agricultural region where Soviet rule mandated an economy based on heavy industry, the successful introduction of a capitalist economy would necessitate a period of transition in which the size of the heavy industry sector decreased while the agricultural sector grew. Empirically, this would appear as a decrease in variance of sector size if the time studied corresponded to those first years, after which the variance would begin to increase once again as sector size more accurately reflected each regions comparative advantage and each regions economy becomes more specialized. In the general sense, this notion is confirmed by evaluating the net change in sector size between the largest and

35 smallest sectors between 1999 and 2008. During this time period, all of the countries experienced change in the range of sector size, with the change in any particular country between 1% and 4%.17 With the exceptions of Bulgaria and Romania, all of the countries experienced an increase in sector size range. These two countries are unique within the sample in that they ascended to the EU in 2007 instead of 2004 and are classified as developing by the World Bank, whereas the majority of the rest of the sample are classified as developed economies.18 The reasons cited for postponing their ascension were mainly economic and institutionalthey had not progressed as far developmentally as the 2004 ascension countries. That the difference in magnitude of importance of their largest and smallest sectors is narrowing, while it is increasing in the remainder of the sample, is consistent with the idea that the composition of the economy is affected by the transition stage as described above. In both Bulgaria and Romania, the variance in sector size decreases yearto-year, with a net change of over one standard deviation during the time period considered.19 Although the sector data is not conclusive proof, it lends credibility to a hypothesis that only time can test. The transition from Soviet command economies to the free market is not a simple or quick change. It requires a fundamental restructuring of the basic governing framework and the successful institutionalization of principles inherently absent from the communist model. Although great strides have been made, much remains still to be done. Until the economic and political structures are consolidated into a new system of norms, the composition of both arenas will remain in flux. It will be difficult to definitively state that one system promotes more 17 The range of sector size is calculated as the percent of the labor force employed by the largest sector minus the percent of the labor force employed by the smallest sector. Values ranged from 28% (Romania in 2007) to 41% (Malta in 2007 and 2008). 18 Lithuania is also classified as developing, but is significantly more prosperous than the other two countries. According to the World Bank, in 2009 Bulgaria and Romania had GNI per capita evaluations of $6,060 and $8,330 respectively, while Lithuania is listed with $11,410. $12,196 is the lower limit a country must achieve to be considered developed. 19 The time period considered is 2000 to 2007 for Bulgaria and 1999 to 2008 for Romania.

36 equitable growth than another until the countries have reached a new equilibrium. Given the substantial costs of changing a countrys economic base to the degree that it would be reflected in these statistics, it is not surprising that a significant lag time is involved. The sector composition of a countrys economy is slower to react to institutional changes than other economic indicators. Despite this, the data available supports the hypothesis that decentralization allows for development according to comparative advantage, seen as a convergence in GDP per capita and an increase in variance of various sectors importance in the long-term. In the case of the Eastern European countries that ascended to the European Union in 2004 and 2007, when controlling for the rule of law, general economic prosperity and human capital, there is a direct causal correlation between the level of government where allocation decisions are made and how efficiently the economy operates, as reflected by a higher GDP growth rate. Higher levels of fiscal decentralization led to more efficient growth and decreases inequalities between regions. The existence of strong relationships between these variables is consistent with the broader body of economic literature citing the importance of the institutional settings as a growth factor (North 1990; Cernat 2001; Huther and Shah). In countries with comparable socio-economic environments, namely the candidate countries of Eastern Europe and CIS members hoping to ascend to the EU in coming years, adopting a fiscally decentralized institutional arrangement will aid them in the pursuit of efficient economic growth and development.

37 Table 1: Expenditure Decentralization by Country, 1996-2009 Expenditure Decentralization Mean .185 .044 .254 .268 .249 .244 .271 .015 .302 .184 .187 .127 Rang e .054 .011 .068 .055 .033 .099 .083 .006 .119 .162 .034 .129 Standard Deviation .016 .003 .024 .018 .010 .026 .023 .002 .036 .058 .011 .051

Country Code

B G C Y C Z E E H U L T L V M T P L R O SI S K

38

39 Table 2: Efficiency Regression Output

Fixed-effects (within) regression Group variable: country_nu~r R-sq: within = 0.4587 between = 0.0461 overall = 0.0445 F(4,78) corr(u_i, Xb) wdi_gro | loc_gen_rev | = -0.6015 Coef. 16.00694 Std. Err. 7.72855 1.90452 .5620409 .0078365 4.736211 t 2.07 -0.13 6.01 -2.86 -3.70 Prob > F P>|t| 0.042 0.895 0.000 0.006 0.000 Number of obs Number of groups avg = max = = = = = 94 12 7 7.8 8 16.52 0.0000

Obs per group: min =

-----------------------------------------------------------------------------[95% Conf. Interval] .6205792 -4.044734 2.257305 -.0379761 -26.96429 31.3933 3.538481 4.49518 -.0067737 -8.106148 -------------+---------------------------------------------------------------wbgi_rle | -.2531265 ln_wdi_gnipc | 3.376242 labor_pop | _cons | sigma_u | sigma_e | rho | -.0223749 -17.53522 2.8497521 1.6877987 .74031642 (fraction of variance due to u_i) F(11, 78) = 10.30 Prob > F = 0.000

-------------+----------------------------------------------------------------

-----------------------------------------------------------------------------F test that all u_i=0:

40

41 Table 3: Regional Equality Regression Output

Fixed-effects (within) regression Group variable: country_nu~r R-sq: within = 0.8553 between = 0.0260 overall = 0.0185 = -0.9998 Number of obs Number of groups = = 53 5 9 10.6 11 65.00 0.0000

Obs per group: min = avg = max = F(4,44) Prob > F = =

corr(u_i, Xb)

-----------------------------------------------------------------------------sd_gdppc2 | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------loc_gen_rev | -4143.351 1610.341 -2.57 0.014 -7388.78 -897.9219 nuts_area | -.9723793 1.53145 -0.63 0.529 -4.058813 2.114055 gdp_pc | .4578983 .0306512 14.94 0.000 .3961248 .5196717 pop_dens | 97.16602 63.42023 1.53 0.133 -30.64905 224.9811 _cons | 108153.3 191702.2 0.56 0.576 -278197.2 494503.8 -------------+---------------------------------------------------------------sigma_u | 102053.94 sigma_e | 331.53846 rho | .99998945 (fraction of variance due to u_i) -----------------------------------------------------------------------------F test that all u_i=0: F(4, 44) = 41.57 Prob > F = 0.0000

42 Figure 1: Changing Expenditure Decentralization by Country, 1996-2009

43 Figure 2: Predicted Residuals for Efficiency Regression

44 Appendix 1: Definition of Variables and Summary Table Fiscal Decentralization (loc_gen_rev): the ratio of local government revenues to total government revenues; own calculation from Eurostat data Economic Growth (wdi_gro): the gross domestic product growth rate as reported by the World Banks World Development Indicator database Rule of Law (wdgi_rle): a composite score with more positive values reflecting better governance; created as part of the World Banks Worldwide Governance Indicators database Prosperity (ln_wdi_gnipc): the log of the Gross National Income per capita; own calculation from World Banks World Development Indicator data Labor Force (labor_pop): the size of the labor force relative to the total population; own calculations from Eurostat data Inequality (sd_gdppc2): standard deviation of the Gross Domestic Product per capita values for each NUTS 2 region within a country; own calculation form Eurostat data NUTS 2 Area (nuts_area): geographic area under the jurisdiction of a sub-national government classified as NUTS 2; data reported by Eurostat Development (gdp_pc): Gross Domestic Product per capita reported by Eurostat Population Density (pop_dens): population density reported by Eurostat

45 Variable Statistics Summary

Variable | Obs Mean Std. Dev. Min Max -------------+-------------------------------------------------------wdi_gro | 94 5.237513 2.749158 -4.789061 12.2351 loc_gen_rev | 94 .2059905 .0944025 .0150785 .3483936 ln_wdi_gnipc | 94 8.807415 .6792525 7.146772 10.12423 wbgi_rle | 94 .5661434 .4270248 -.2433605 1.53541 labor_pop | 94 452.1678 45.41214 290.1836 518.1159

46 Appendix 2: Efficiency Robustness Tests Malta

Fixed-effects (within) regression Group variable: country_nu~r R-sq: within = 0.5036 between = 0.0523 overall = 0.0367 = -0.6848 Number of obs Number of groups = = 87 11 7 7.9 8 18.26 0.0000

Obs per group: min = avg = max = F(4,72) Prob > F = =

corr(u_i, Xb)

-----------------------------------------------------------------------------wdi_gro | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------loc_gen_rev | 15.44159 7.437653 2.08 0.041 .6149039 30.26829 wbgi_rle | .6787901 1.877793 0.36 0.719 -3.064523 4.422103 ln_wdi_gnipc | 3.428616 .5444969 6.30 0.000 2.343181 4.514051 labor_pop | -.0218004 .0075515 -2.89 0.005 -.036854 -.0067467 _cons | -18.40589 4.615105 -3.99 0.000 -27.60593 -9.205847 -------------+---------------------------------------------------------------sigma_u | 3.1319507 sigma_e | 1.6202518 rho | .78887358 (fraction of variance due to u_i) -----------------------------------------------------------------------------F test that all u_i=0: F(10, 72) = 12.17 Prob > F = 0.0000

47 Cyprus
Fixed-effects (within) regression Group variable: country_nu~r R-sq: within = 0.4709 between = 0.0294 overall = 0.0595 = -0.5900 Number of obs Number of groups = = 86 11 7 7.8 8 15.79 0.0000

Obs per group: min = avg = max = F(4,71) Prob > F = =

corr(u_i, Xb)

-----------------------------------------------------------------------------wdi_gro | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------loc_gen_rev | 16.09458 7.916801 2.03 0.046 .3089293 31.88023 wbgi_rle | -.2342822 1.959802 -0.12 0.905 -4.142016 3.673451 ln_wdi_gnipc | 3.394828 .5785097 5.87 0.000 2.241313 4.548344 labor_pop | -.0221873 .0081408 -2.73 0.008 -.0384197 -.005955 _cons | -17.57073 4.994428 -3.52 0.001 -27.52934 -7.612126 -------------+---------------------------------------------------------------sigma_u | 2.8729739 sigma_e | 1.7273343 rho | .73449248 (fraction of variance due to u_i) -----------------------------------------------------------------------------F test that all u_i=0: F(10, 71) = 10.65 Prob > F = 0.0000

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