Reviving Leviathan: Fiscal Federalism and the Growth of Government

TLDR

The Leviathan hypothesis suggests that tax competition restrains government spending growth in decentralized systems. The study uses panel data to examine how fiscal decentralization over time within countries differs between intergovernmental transfer‑funded and locally taxed decentralization. The analysis shows that decentralization limits spending when local governments control tax bases and rates, but that government growth accelerates when expenditures are funded by intergovernmental transfers. Decentralization is associated with smaller government in cases where local authorities set taxes, yet it leads to faster growth when funding relies on intergovernmental transfers.

Abstract

Abstract This article revisits the influential “Leviathan” hypothesis, which posits that tax competition limits the growth of government spending in decentralized countries. I use panel data to examine the effect of fiscal decentralization over time within countries, attempting to distinguish between decentralization that is funded by intergovernmental transfers and local taxation. First, I explore the logic whereby decentralization should restrict government spending if state and local governments have wide-ranging authority to set the tax base and rate, especially on mobile assets. In countries where this is most clearly the case, decentralization is associated with smaller government. Second, consistent with theoretical arguments drawn from welfare economics and positive political economy, I show that governments grow faster as they fund a greater portion of public expenditures through intergovernmental transfers.