Sovereign Debt Crisis and Fiscal Devolution

Abstract

How is the probability of a sovereign debt crisis affected by fiscal devolution? Using annual cross-country panel data from 82 advanced and developing countries, the association between fiscal decentralization and the sovereign debt crisis is investigated. We adopt an instrumental variable probit model to address potential endogeneity. The research distinguishes between tax policies and spending policies. The results reveal that local tax autonomy reduces the probability of a sovereign debt crisis. In contrast, expenditure devolution is found to increase the probability of a sovereign debt crisis. These favorable and unfavorable effects of fiscal devolution are more evident in the case of decentralization to local governments than in the case of decentralization to subnational governments. In terms of relative magnitudes, our discrete choice analysis demonstrates that the undesirable effects of expenditure decentralization are greater than the desirable effects of tax revenue decentralization. Therefore, countries should be cautious about the risks associated with fiscal devolution, particularly the contrasting impact of tax revenue and spending decentralization on the likelihood that sovereign debt crises occur.