Fiscal Decentralization and Structural Involution in Developing Countries

Fiscal decentralization has been labeled as the silent change in the world's development. The main purpose of this policy is to increase growth and equality in country's sub-national level as well as promote openness and accountability. This in turn would lead to productive structural transformation when combined with industrial policy. However, my finding suggests that the reversal is true. Using data derived from IMF's Government Financial Statistics for the period between 1995 and 2017, it is found that fiscal decentralization has led to structural involution where the output share of agriculture increased at the cost of declining share of other sectors, particularly the industry sector. The result is particularly robust for low and lower-middle income country groups as well as under different estimation method. The phenomenon goes in line with premature decentralization narrative. These findings call, among others, for the prior need of a strong institutional capacity at the local level in order to mitigate local elite capture and rent-seeking. With stronger central-local collaboration, vertically-coordinated industrial policy between multi-level of governments could kick in to support productive transformation. JEL: E26, H50, H72, O11