Political Decentralization and Fiscal Management of Local Governments: Evidence and Lessons from Korea

1. Political Decentralization and Fiscal Management of Local Governments: Evidence and Lessons from Korea No-Wook Park Center for Fiscal Analysis Korea Institute of Public Finance

2. Purpose of the Presentation • Share Korean experiences by examining the effects of political decentralization (resumption of local elections) on the fiscal management of local governments • Resumption of Korean local elections in 1995 • Identify differences in fiscal managements before and after the resumption of local elections • Derive lessons and implications from Korean experiences

3. Decentralization Process • Decentralization is a globally popular since 1990s • Many developing countries have experimented with decentralization reforms • Decentralization reforms are in full swing with the initiatives of the current administration in Korea

4. What is Decentralization? • Devolution of various authorities (powers) to the lower level of governments • Fiscal decentralization • More fiscal decision making authority and economic resources in local governments • Political decentralization • Local governments are formed by local residents • Administrative decentralization • More administrative decision making authority in local governments

5. Why Decentralization? • Expected benefits of decentralization • Increase in efficiency • Local governments have better local information • Competition among local governments improves the performance of local governments • Expected benefits of centralization • Realization of economies of scale • Internalize externalities across local governments • Recent trend reflects the perception that movement towards decentralization may bring in benefits.

6. How to Decentralize? • Proper assignment of various authorities between central and local governments • Capacity consideration is important. • Capacity for decentralization needs to be developed. • Local governments tend to lack capacity to cope with various issues. • Administrative capacity • Restraining corruption

7. Supporting Institutions for Decentralization • Intergovernmental Fiscal Institutions • Intergovernmental Transfers • Transfer Dependency and Local Revenue Raising • Expenditure Assignment and Local Autonomy • Political Institutions • Capital Markets • Factor Mobility and Land Market • Hierarchical Mechanisms

8. Political Decentralization • How to select local officials • Election: Politicians • Appointment: Bureaucrats • Resumption of local elections • Appointment  Election

9. Why Do Local Elections Matter? • Different Incentives • Politicians • Winning Elections • Bureaucrats • Career Concerns • Local Elections as an Issue-Unbundling Mechanism • Elected Local Officials • Mainly Care for Local Issues • Appointed Local Officials • Care for both of Central and Local Issues

10. The Korean Case • Resumption of Local Elections in 1995 • Opportunity to examine the effects of political decentralization • No significant devolution of economic resources to local governments • Appointed officials  Elected Officials

11. Research Questions • Do elected officials manage differently in their fiscal issues? • In addition to elections as a way of selecting local officials, do other political factors matter? • Political competition in each district • Alignment with the incumbent president

12. Summary of Results 1 • More fiscal independence • Exert efforts in increasing internal revenues • Raising revenues through non-tax revenues as opposed to through local taxes • Minimize political costs associated with raising internal revenues

13. Summary of Results 2 • Do not face harder budget constraints • Rely more on intergovernmental transfers than local borrowings • Political competitive districts receive more intergovernmental grants • Political decentralization may activate distributive politics

14. Institutional Backgrounds • Political decentralization • Regional identity based voting and imperial president

15. Political decentralization 1 • Resumption of local elections for the head of local governments in 1995 • Suspended since 1961 • 3 year term and term-limit is 3 times • Higher level local governments • 7 Metro-cities and 6 provinces • Lower level local governments • 232 cities, counties and districts in 2000

16. Political decentralization2 • No significant fiscal decentralization during 1991-1999 • Local tax revenue • 20 percent of total tax revenue • Local government’s budget share • 35-43 percent of total government revenue

18. Voting Behavior and Imperial Presidency • Regional identity-based voting • Imperial presidency • Importance of Swing Voters (Districts) • Expected to be important given strong regionalism • Importance of Alignment with president • May not be important

20. Empirical Strategy • Devise Fiscal Indices • Test significance of decentralization dummy which is 1 after decentralization • Test significance of political variables in explaining differences of indices pre and post decentralization

21. Indices of Fiscal Management 1 • Internal-revenue vs. external-revenue • Fiscal independence index • FI1 = (local tax+non-tax)/total expenditure • FI2 = (local tax+non-tax)/total revenue

22. Indices of fiscal management 2 • Revenue raising through non-tax vs. local tax • Source of raising internal revenue • RI1 = current non-tax/(local tax+current non-tax) • RI2 = non-tax/(local tax+non-tax) • Non-tax revenues tend to carry less political costs.

23. Indices of fiscal management 3 • External financing through subsidy vs. local borrowing • Source of external funding • SI1 = National subsidy/(national subsidy+local borrowing) • SI2 = All intergovernmental transfers/(intergovernmental transfers + local borrowing) • Transfers tend to be soft money.

24. Data 1 • Local government fiscal year book during 1991-1999 • No significant change in fiscal rules related to local governments • Cities, counties, and district level data • 232 cities, counties, and districts in 2000 • Due to administrative boundary changes in 1995, 123 local governments are analyzed.

26. Results - Break of Trend 1 • Significant break of trend after the resumption of local elections • Unconditional average • Fiscal independence indices increase by 1-2% • Subsidy indices decrease by 1-2% • Non tax revenue indices increase by 6-9%

27. Index Pre-Decentralization (1991-1995) Post-Decentralization (1996-1999) Mean Standard Deviation Number of Observations Mean Standard Deviation Number of Observations Independence Index 1 0.6231 0.4304 615 0.6547 0.2779 492 Independence Index 2 0.4817 0.3178 615 0.4925 0.1734 492 Non-tax Revenue Index 1 0.2946 0.0697 615 0.3529 0.0665 492 Non-tax Revenue Index 2 0.6098 0.1019 615 0.6988 0.1001 492 Subsidy Index 1 0.9351 0.1072 615 0.9213 0.1092 492 Subsidy Index 2 0.9660 0.0750 612 0.9554 0.0721 492 Table 1 Average Indices of Pre and Post Decentralization

28. Results - Break of Trend 2 • Controlling for district fixed effect and year effect • Significantly positive decentralization dummy (=1 after local elections) for every category of indices • Independence indices increase 3-5% • Subsidy indices increase 0.56-0.35% • Non tax indices increase 5-8.4%

29. Index Decentralization Dummy Estimated Pre-decentralization Fiscal Index Estimated Post-decentralization Fiscal Index R2 Number of Observations Independence Index 1 0.2524 (0.040) 0.4657 (0.1710) 0.4954 (0.1671) 0.9031 1228 Independence Index 2 0.2724 (0.055) 0.5525 (0.1652) 0.6023 (0.1577) 0.7416 1107 Non-tax Revenue Index 1 0.3074 (0.032) 0.2998 (0.0552) 0.3499 (0.0575) 0.7000 1107 Non-tax Revenue Index 2 0.5410 (0.043) 0.6178 (0.0932) 0.7014 (0.0822) 0.7532 1228 Subsidy Index 1 0.2886 (0.147) 0.8400 (0.1117) 0.8456 (0.1067) 0.539 761 Subsidy Index 2 0.3650 (0.145) 0.9117 (0.0920) 0.9152 (0.0893) 0.626 760 Table 2 Comparison of Indices between Pre and Post Decentralization(Weighted Least Squares Logit Estimates)

30. Results – Political determinants 1 • Robust results • Political competition have a negative impact on fiscal independence index 2 • Political variables do not matter for non-tax revenue indices • Political competition has a positive correlation with subsidy index 1

31. Independence Index 1 Independence Index 2 Revenue Index 1 Revenue Index 2 Subsidy Index 1 Subsidy Index 2 Alignment -0.001 (0.021) -0.066 (0.072) 0.002 (0.024) -0.006 (0.029) -0.017 (0.038) -0.037** (0.019) Competition 0.001 (0.064) -0.505** (0.208) -0.096 (0.065) -0.063 (0.077) 0.199** (0.076) 0.064* (0.037) Alignment*Competition -0.029 (0.012) 0.028 (0.052) -0.020 (0.19) -0.020 (0.022) -0.083*** (0.025) -0.022* (0.013) Population Density -0.003*** (0.000) -0.010*** (0.002) -0.000 (0.001) -0.004*** (0.001) 0.009*** (0.002) 0.004*** (0.001) Number of Observations 89 89 89 89 89 89 R2 0.3866 0.264 0.049 0.2374 0.2968 0.2388 Table 3 Average Political Factors Affecting Changes in Fiscal Management

32. Summary 1 Fiscal management changed after the resumption of local elections More fiscal independence More non-tax revenue raising efforts More dependence on subsidy for external funding

33. Summary 2 • Political characteristics of districts matter for attracting subsidy from the central government after political decentralization. • Internal revenue raising efforts through non-tax revenues are significant regardless of political characteristics.

34. Efficiency implications • Increased revenue raising through non-tax • Efficiency implication depends on how local governments use increased revenues • Active political factors • May have negative implications • Decentralization itself does not guarantee efficiency gains. • Supporting institutions are important.

35. Other Implications • Political institutions are important in realizing benefits of decentralization. • Political environments shaping incentives of local officials are crucial. • Can local residents (voters) discipline local officials? • Availability of Information on the fiscal management of local governments • How to avoid a possibility of collusion between local officials and powerful local interest groups

36. Thank you!