Masters research report. Decentralization and Economic Growth: A Case Study for Canada. Prepared by: Philippe Wingender WINP

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1 Masters research reort Decentraization and Economic Growth: A Case Study or Canada Preared by: Phiie Wingender WINP Research director: François Vaiancourt Université de Montréa Tuesday, Juy 2th 2005

2 Tabe o contents List o igures and tabes... iii Summary... iv Introduction... Chater Theoretica ramework...3. Decentraization: deinitions Theoretica aroaches Endogenous growth mode Review o revious studies...0 Chater 2 Emirica anaysis The Canadian ederation Econometric seciications The data...27 Chater 3 Emirica resuts...33 Concusion...40 Bibiograhy...43 Annex Growth mode cacuations...46 Annex 2 Provincia time-series regressions...49 Annex 3 Deendant and contro variabes mean and standard-deviation

3 List o igures and tabes Tabe. Three asects o three tyes o decentraization...3 Figure.2 Decentraization and growth: review o existing studies...6 Figure 2. Evoution o revenue shares by eve o government Figure 2.2 Evoution o exenditure shares by eve o government Figure 2.3 Evoution o rovincia government revenue Figure 2.4 Evoution o oca government revenue Tabe 2. Demograhic, economic and geograhic eatures o Canada and its rovinces, Tabe 2.2 Variabes deinition...26 Tabe 2.3 CANSIM II tabes...27 Tabe 2.4 Fisca decentraization by rovince and indicators or seected years 3 Tabe 2.5 Correation coeicients o isca decentraization indicators, Tabe 3. Statisticay signiicant resuts on decentraization indicators rovincia timeseries rovincia time-series Tabe 3.2 Regression resuts or rovincia ane data, Tabe 3.3 Regression resuts or rovincia ane data (6 rovinces), Tabe 3.4 Regression resuts or nationa data Tabe A. Regression resuts or Newoundand Tabe A.2 Regression resuts or Prince-Edward-Isand Tabe A.3 Regression resuts or Nova Scotia Tabe A.4 Regression resuts or New Brunswick Tabe A.5 Regression resuts or Québec Tabe A.6 Regression resuts or Ontario Tabe A.7 Regression resuts or Manitoba Tabe A.8 Regression resuts or Saskatchewan Tabe A.9 Regression resuts or Aberta Tabe A.0 Regression resuts or British Coumbia Tabe A. Deendant and contro variabes mean and standard-deviation

4 Summary This aer uses time-series and ane data regressions to investigate the imact o decentraization on economic growth in Canada or the eriod. Evidence suggests that decentraization has contributed ositivey to growth in some rovinces, but aggregated data do not resent cear evidence o a signiicant imact. The aer irst resents a theoretica ramework or decentraization and growth by exaining dierent aroaches and detais a theoretica mode o endogenous growth, with outut growth rate exressed as a unction a goba tax rate and subnationa government share o tota exenditure. This is oowed by a review o revious studies. Ater a brie historica, oitica and economic overview o the Canadian ederation, econometric seciications, variabes and data are then exained, oowed by the resentation and discussion o the regressions resuts. Exanations are oered as we as a discussion or uture research ossibiities. 4

5 Introduction The urose o this research aer is to determine the imact isca decentraization has had on economic growth in Canada or the eriod. This question is o interest since decentraization is seen as a way to romote eiciency in the ubic sector, to increase cometition between subnationa governments and thereore contribute to economic growth. The debate on devoution and isca subnationa autonomy has aso been revived in deveoed ederations ike the United States, Austraia Germany and Canada. 2 However, emirica investigations have not yet given a deinitive answer to the question o the imact o decentraization on deveoment and economic growth. For these reasons, this research toic is imortant and it sti needs to be a concern or researchers and governments aike. In order to rovide an answer to our initia question, the aer is set u as oows: chater rovides the theoretica ramework in which decentraization and its reation and imact on growth are to be understood. In order to do so, we wi review the dierent schoos o thought on the beneits and drawbacks on decentraization. We wi then review the current state o the iterature on decentraization and growth by examining ive revious studies reated to our subject o interest. Chater 2 introduces a brie summary o the Canadian ederation, its history and economic, demograhic and oitica characteristics and an overview o the evoution o subnationa government inance. We aso detai emirica investigation and anaysis. Starting with our econometric seciications, estimation technique and variabe deinitions, we then describe the data we used or our anaysis. Severa imortant remarks are made on the source and content o our data which wi he in rocessing correcty the inormation retrieved rom Statistics Canada s CANSIM II data bank. Chater 3 rovides the resentation and discussion o our regressions resuts and inks them to the theoretica redictions made in the revious section o our aer. The See or exame, Xie, Zou & Davoodi(999) Word Bank(200) and Bah & Linn(992) 2 Xie & a.(999).229 5

6 concusion is oowed by Annex which gives the cacuus detais o our endogenous growth mode, and Annex 2, which detais the resuts o our rovincia time-series regressions. 6

7 Chater Theoretica ramework. Decentraization: deinitions Decentraization, ike intergovernmenta reations is a comex henomenon. It invoves many oitica and ega arrangements and it is no easy task to quantiy eves o resonsibiity and decision-ower. In order to cariy the subsequent discussion about decentraization, it is useu to distinguish between the usua broad institutiona arrangements ound in most ederations. The oowing tabe resents an overview o three tyes o decentraization arrangements. Tye Deconcentration Deegation Devoution Tabe. Three asects o three tyes o decentraization Imementing Poitica authority Funding authority authority Nationa eected Centra government Nationa budget reresentatives oicias Nationa and oca eected reresentatives Loca eected reresentatives Source: Gauthier and Vaiancourt (2002). Loca government oicias suervised by centra government oicias Loca government oicias (incuding grous o centra government oicias) Loca budget, with or without contractua ayments by centra government, taken rom the nationa budget Loca budget, taxes or centra government transers rom the nationa budget Whie deconcentration is simy the resence o administrative agencies or oices o the centra government ocated in the regions, deegation occurs when the centra government retains authority and resonsibiity o unding and service deivery, but deegates the imementation and administration to ower eves o government. Finay, the term devoution which is regarded as true decentraization is used when the centra government retains no rights to oversee and monitor the quaity, quantity and mode o deivery o ubic services. Subnationa eected governments are entirey resonsibe to 7

8 their own eectorate or a asects o these services. Rosembaum deines devoution as oows: genuine decentraization consists in the deegation o resonsibiities and resources to reativey indeendent and autonomous inra-nationa authorities which are answerabe not to centra government but to the citizens o the region or community 3. With these deinitions in mind, we wi consider or the remainder o this aer devoution when taking about decentraization. The next section wi resent dierent theoretica aroaches to decentraization..2 Theoretica aroaches The reationshi between decentraization and growth rests on the remise that decentraization may or may not ead to a more eicient ubic sector. Indeed, there are two theoretica aroaches to the imact o decentraization on eiciency. The normative ubic economics aroach, which incudes the work o authors such as Musgrave(997) and Zodrow and Mieszkowski(986), hods that decentraization eads to ineicient aocation o resources, regressive taxes and inadequate ubic service eves or the oorest members o society 4. The view is that the oss o economies o scae and the externaities inherent in the decisions taken by oca and subnationa governments resut in inadequate budgets. Furthermore, isca cometition and a highy mobie tax basis at subnationa eves orces governments to reduce their suy o goods and services and to use beneit taxes. These taxes are considered regressive in that they don t rest in taxayers abiity to ay, which are more redistributive. A second aroach termed the ubic choice aroach hods that governments ursue their own interests and seek to maximize their revenue, and that cometition between governments is a necessary constraint designed to imose disciine. According to Tiebout(956) and Brennan and Buchanan(980), cometition is seen as an imortant mechanism to encourage eiciency in taxation, reguation and suy o goods and services. Moreover, decentraization rovides society with such a mechanism. 3 Rosenbaum (998), Oates and Schwab (99),

9 However, when it comes to actua governance and oicy imementation, the question is not as much shoud we decentraize, but rather how, how much and what shoud we decentraize. To this question, two authors have rovided answers sti regarded today as sound rincies in the isca ederaism iterature. Richard A. Musgrave in his 959 book The theory o ubic inance distinguished three tyes o government interventions and indicated which eve o government shoud be resonsibe or their imementation. These were macroeconomic actions, redistributive actions and microeconomic actions. Oates(972) imroved on these rincies by urther deining the scoe o microeconomic interventions and roosed rues or the distribution o authority. First, macroeconomic actions which consist o isca and monetary oicies shoud be taken care o by the centra government because o the need or coordination and stabiity. Furthermore, macroeconomic actions are beieved to be ineective at the subnationa eve because o economic eakages associated with oca and rovincia exenditure. 5 However, subnationa governments coud act as agents on request o the centra government by taking measures to stimuate investment or exame. Second are the redistributive actions, or which it is considered more eicient or the centra government to be resonsibe, eseciay when there is imortant ouation mobiity. For the third tye o government action, microeconomic interventions, it is considered aroriate or subnationa governments to ay a roe in their suy and it was Oates who set the rues, known as the decentraization theorem, 6 that shoud ay to the sharing o resonsibiities in this area. Microeconomic actions, which consist o a the other ubic services and goods rovided by governments, rom roads, to arks, to hositas and schoos, shoud be the resonsibiity o the center or the subnationa eves deending on 4 actors: the otentia economies o scae, the heterogeneity o the ouation, the externaities rom one jurisdiction to the other and on the ossibiity o cometition and emuation between governments. In the resence o economies o scae, it is naturay considered to be more eicient or the centra government to suy the articuar good. The more variety in reerences or quantity, quaity and tye o goods in 5 Martinez-Vazquez(2003) Meoche & a.(2004).2 9

10 the ouation or geograhicay concentrated grous, the more decentraization in ubic services rovision shoud occur. Canada is a ine exame with the resence o Québec, a redominanty French-seaking and historicay cathoic rovince in a redominanty Engish-seaking and rotestant country. The third rue on externaities says that the more we ind externaities in the roduction o ubic services, the more roduction shoud be centraized in order to internaize them to ensure an otimum eve. Finay, the ourth rue in determining the eve o resonsibiity o microeconomic actions is the otentia or innovation in roduction. The greater the ossibiity to roduce dierent tyes o ubic goods and services or to roduce them in dierent ways, the more roduction shoud be decentraized. From these rues, it aears that each government intervention must be evauated distincty in order to determine which eve o government shoud be resonsibe, thus the questions o how and what in decentraization. Ater reviewing the existing theory on decentraisation, the next section wi address the issue o its imact on economic growth, by setting u a mode o endogenous growth..3 Endogenous growth mode Foowing Barro(990) and Xie, Zou & Davoodi(999), we wi setu a theoretica mode o isca decentraization and economic growth in order to rame our emirica investigation or Canada. Whie Barro s mode introduced government exenditure in the roduction unction o an endogenous growth mode, Xie & a. imroved it by detaiing three eves o government. We wi do the same here by deining these eves as the edera, rovincia and oca eves. Decentraization wi thereore be reresented as a higher share o subnationa (rovincia and oca) government sending on tota government sending. The roduction unction is Cobb- Dougas, with k reresenting the eve o rivate caita stock, which can be considered as a measure o both human and hysica caita. Tota government sending g is divided in the three comonents, and, edera, rovincia and oca government sending on goods and services resectivey (we ony consider sending that enters in the roduction unction, thereore ignoring transers and debt-service). The variabes are a measured on a er caita basis. 0

11 with,,, ω ( 0,) and ω ω y k (.) g (.2) Tota government sending is aocated as oows where and ( 0,) g, g, g, (.3) or i,,. i We have thereore the edera government s share o tota exenditure, rovincia government s share and oca government's share. Consoidated government sending is inanced by a at income tax at a rate τ, which we wi assume constant. We aso make the urther assumtion o a baanced growth ath, i.e. the government wi not run any deicits or suruses. g τy (.4) To determine the ong-run growth rate o the economy, we need to anayze the consumtion and investment decisions made by the individuas. We consider one reresentative agent acing an ininite anning horizon who maximizes his discounted utiity subject to his dynamic budget constraint (.6) and the government s budget aocation (.4). He takes as given the government s announcement o the ix tax rate and the sending by the dierent eves o governments. The reresentative agent s reerences have the oowing orm U 0 σ c e σ where c is er caita rivate consumtion and ρ is a ositive time discount rate. ρt dt (.5) The dynamic budget constraint is given by the equation dk k & ω ( τ ) y c ( τ ) k c dt (.6)

12 The individua chooses his otima consumtion ath { c () t : t 0} and his investment ath to determine the eve o caita stock { k ( t) : t 0} aocation o resources by the individua, we write down the Hamitonian 7 σ c H e σ ρt λ where λ is a dynamic Lagrange mutiier. ω [( τ ) k c]. To ind this otima By dierencing on c and k we ind the irst order conditions H σ ρt 0 c e λ 0 c (.7) H ω ( τ ) k & λ & λ 0 λ (.8) k Using the transversaity condition im ρt kλ e 0, the budget constraint (.6) and t by ixing the initia caita stock to k ( 0 ), we can ind the growth rate o the economy. 8 y& y ( )( ) ( τ τ ) ω ρ σ σ (.9) Equation (.9) shows that the ong-run growth rate o er caita outut is a unction o the tax rate and the sending shares o the dierent eves o government. Thus, we see that the government can inuence the growth rate o the economy by choosing among dierent sending shares or the edera, rovincia and oca eves. I the government s objective is to maximize this growth rate, it wi do so by choosing the sending shares that maximize (.9). They are determined by the otimization o equation (.9) under the constraint (.0) By setting u the Lagrangian 7 See Barro & Saa-i-Martin(2004).604 or a derivation o irst-order conditions in a dynamic otimization robem 8 See Annex or cacuus detais 2

13 3 ( ) ( ),,, L λ σ ρ λ ω with ( )( ) ( ) σ τ τ we ind the irst-order conditions 0 0 λ ω L (.) 0 0 λ ω L (.2) 0 0 λ ω ω L (.3) 0 0 L λ (.4) From these, we can deduce the growth-maximizing sending shares o the edera, rovincia and oca governments. ω, ω, ω ω Foowing Xie & a., we interret these ratios as measures o the roductivity o ubic sending by each eve o government on aggregate roductivity o edera, rovincia and oca government sending. 9 Hence, growth can be increased with a reaocation o government exenditure i the shares by the dierent eves are not those corresonding to the ratios above. It is to be noted that tota government exenditure as a share o GDP needs not to be increased or decreased to do so. This resut rovides an interesting ramework or the anaysis o our emirica data by showing that the reationshi between decentraization and growth is not a cear one and thus we coud ind either a ositive association between the two, when sending assignment corresond to these theoretica growth-maximizing ratios, but aso negative correation when they dier rom them. Knowing that exenditure resonsibiities are determined by many oitica, historica and cutura actors other than strict economic eiciency, we cannot 9 Xie & a.(999).232

14 redict the sign o our decentraization coeicients or our regression. It can be exected to ind both resuts in our emirica investigation deending on the eve o decentraization. From the revious discussion, it aears that no cear theoretica redictions can be made in regards to the imact o decentraization on growth. Some authors woud argue that it is detrimenta to economic growth, because o the oss o coordination and economies o scae, whie some others woud consider that the resence o intergovernmenta cometition shoud ositivey contribute to eiciency in ubic service deivery and thus, to ong-term growth. Simiary, whie we have exressed the growth rate o the economy as a unction o the shares o aggregated government sending, we know that these shares are determined by many non-economic actors and thereore, may not be at otima eves. The oowing section wi cover the iterature review on the subject o decentraization and growth and how it has been studied in other countries o the word..4 Review o revious studies Interest in the imact o decentraization on growth is recent in the iterature on isca ederaism. However, there have been many attemts in the ast ew years to quantiy this reationshi, but no ina consensus has been reached among seciaists. We wi review here ive o those studies who have investigated the subject. These were chosen based on the simiarities between the method and subject o their investigation and the urose o this aer. 0 Aying a Sime Measure o Good Governance to the Debate on Fisca Decentraization, Huther and Shah(998) Beore reviewing the work done directy on the question o decentraization and growth, we wi cover a aer by Huther and Shah(998) on decentraization and quaity 0 This section is not a comrehensive review on the question o decentraization s imact on economic growth. For a more comete review see Martinez-Vazquez & McNab(2003). 4

15 o governance. In their cross-country study the authors devised a comosite index o governance or a same o 80 countries, deveoed, deveoing and in transition. They controed or a arge number o governance eatures ike oitica reedom and stabiity, judicia and bureaucratic eiciency, absence o corrution, human deveoment, equaity o income distribution, oenness to internationa trade, centra bank indeendence and inverted debt to GDP ratio. Their data on decentraization used subnationa government exenditure. The authors used correation anaysis to evauate the reationshi between decentraization and good governance. Among their resuts, they ound that decentraization was signiicanty and ositivey correated with bureaucratic eiciency, ower corrution, a higher Human Deveoment Index (HDI) score and a ositive ink between the invert o debt to GDP ratio, athough this ast resut, using a Pearson correation coeicient was not statisticay signiicant. Athough the authors did not measure the correation between decentraization and growth, the study is interesting in that it hes us to understand how decentraization may contribute to economic growth. It seems rom their resuts that it has been a ositive actor in the deveoment o sound socia, judicia, oitica and economic institutions, which are imortant actors or ongterm growth. However, some robems arise with their aroach as they used somewhat very broad measures taken rom imited surveys and invoving subjective judgments. The choice o the weights associated with each measure is aso subject to debate. In using correation anaysis instead o regression anaysis, the authors did not contro or imortant variabes that aect decentraization and quaity o governance. Their resuts might thereore be biased, in addition to not caturing the causaity ink between the two variabes. Finay, their data on isca decentraization ais to reresent the comexity o the many institutiona arrangements ound in such a diverse same o countries. Thereore, we need to be careu in interreting their resuts. Fisca Decentraization and Economic Growth: A Cross-Country Study, Davoodi and Zou(998) Huther & Shah(998).3 5

16 In the second study reviewed, Davoodi and Zou(998) use a ane data to directy determine the eect o decentraization on economic growth. They coected data on 46 deveoed and deveoing countries over the eriod. Their decentraization indicators used subnationa share o tota government exenditure. Using regression anaysis, the authors controed or the tota tax burden on the economy, ouation growth, human caita, initia er caita GDP and investment. They did ind signiicant coeicients or their decentraization variabes, but ony or deveoing countries and those coeicients were reativey ow and negative. Athough the authors used a arge same o countries or a reativey ong eriod o time, one robem with their aroach is the strong heterogeneity o their same. The great divergences between countries ike the United States and Maawi or Germany and Boivia make comarisons diicut and robaby induce major variabe omissions. Another robem with their study is the onedimension o their decentraization indicator, which ais to cature the comexity o the henomenon. Thereore this research aer makes use o 6 dierent decentraization indicators, measured with dierent aroaches ike revenue, overa and categories o sending as we as autonomy. Fisca decentraization and economic growth in the United States, Xie, Zou and Davoodi(999) Xie, Zou and Davoodi(999) used or their research time-series data or the United States on decentraization and GDP growth. Using variabes such as the goba tax burden, abor growth rate, investment, a measure o the economy s oenness to internationa trade, an average tari rate, the ination rate, the Gini coeicient and an index o energy rices, they ran 6 regressions over the 949 to 994 eriod. Their decentraization measures consisted o state and oca government sending shares or subnationa (state and oca) government sending share. They ound ony one signiicant coeicient associated with oca sending in a o their 6 seciications. Athough ocus on one country has enabed them to isoate more accuratey the eects o decentraization on growth, it seems that their measure o decentraization sti ais to cature the comexity o the henomenon. Government isca data in the United States, contrary to 6

17 most deveoing countries are very detaied and reiabe. Faiing to measure more recise indicators o rea subnationa government autonomy and eve o authority, or exame by taking into account edera grants to states and municiaities, has ket the authors rom ushing their investigation urther. Decentraization or Fisca Autonomy? What Does Reay Matter?, Meoche, Vaiancourt and Yimaz(2004) 2 In this aer, the authors evauated the imact o decentraization on growth or 0 Euroean transition countries using new data made avaiabe by the OECD. This data imroves on the Government Finance Statistics rovided by the IMF by incuding inormation on the eve o autonomy o oca governments in terms o both revenue and exenditure. The GFS statistics had been used or most studies on decentraization and growth, but the authors caimed it did not rovide adequate inormation on actua oca government autonomy and resonsibiity eves. They incuded in their anaysis 8 measures o decentraization and subnationa autonomy on both the revenue and sending sides. Controing or initia eve o GDP er caita, ouation growth, schoo enroment and investment, they ound a ositive and signiicant imact o subnationa non-tax autonomy and tota revenue autonomy on growth. They aso ound a negative and signiicant reationshi between subnationa isca deendency and growth, which is an indication o the beneits o decentraization. They aso ran regressions o the size o the ubic sector on their measures o decentraization and ound ositive and signiicant reationshi between autonomy and ubic sector size. The authors did imrove on revious studies by their use o more accurate decentraization and autonomy indicators. However, their imited same, both in terms o number o countries and observations, did not roduce very robust resuts. Fisca decentraization contributes to economic growth: evidence rom state-eve crosssection data or the United States, Akai and Sakata(2002) 2 This aer is an extension o a revious study by Robert D. Ebe and Serdar Yimaz(2002), On the Measurement and Imact o Fisca Decentraization. 7

18 Foowing Davoodi and Zou(998) in their cross-country and ane aroach, but ocusing ike Xie & a.(999) on the United States data, Akai and Sakata(2002) measured the imact o isca decentraization on state economic growth. They ran a cross-section regression or the 50 states with the deendant variabe being the average er caita state GDP growth over the eriod. Their contro variabes were the average annua growth rate o the state s GDP over the receding 4-year eriod, the ercentage o high schoo graduates in tota 8-24 years ouation, a variabe indicating the share o seats in state egisature hed by Democrats in 992, the Gini coeicient, a dummy variabe indicating i the state was in the southern region, the state s share o tota US atents, an oenness to trade indicator. An interesting innovation on their art was the act that they used 5 indicators o decentraization. Aong with the usua measure o oca government exenditure as a share o tota government exenditure in the state (anaogue to subnationa exenditure on tota exenditure ound in nationa studies), they aso used a revenue indicator, the ratio o oca government revenue to oca and state government revenue. Another indicator was the average o both receding variabes aong with two indicators o oca government isca autonomy. These were comuted as the ratio o oca government s own revenue to tota revenue, both with and without edera grants. This ast distinction was not very reevant, the indicators showed a correation coeicient and it did not yied any interesting emirica resuts. The authors did ind statisticay signiicant and ositive coeicients associated with their decentraization indicators. Both their revenue and exenditure indicators had signiicant coeicients between 0.4 and 0.22 deending on the seciication. However, their autonomy indicators did not have statisticay signiicant resuts. Desite their resuts and concusions, one draw-back in the authors aer is the act that they imited themseves to cross-section anaysis and a 2-eriod ane, thereore missing vauabe inormation on the evoution and ong-term imact o decentraization on growth. Ater reviewing these studies which give us a good overview o the current state o our knowedge on the imact o decentraization on economic growth, we are abe to 8

19 oint to the shortcomings o the resent iterature and imrove on what s been done aready. From what we ve seen, the major weaknesses o revious studies have been the use o sime measures o decentraization aiing to cature the comexity o the henomenon. Most studies have simy used the share o subnationa exenditure on tota government exenditure, but this indicator may ai to cature actua authority and resonsibiity over the sums sent. Another robem with cross-country studies is the act that it is very diicut to contro or historica, cutura and institutiona dierences which have an imortant imact on a country s ong-term growth rate. Most studies using crosssectiona data aso ai to cature the ong-term reationshi between decentraization and growth and this might rove to be quite imortant. Institutiona variabes may take some years to actuay imact on the economy s growth rate and this cannot be detected in cross-section studies. Finay, no study has comrehensivey investigated the reationshi between decentraization and growth at both the nationa and subnationa eve or a singe country. Thereore, there is sti a need to resent a u account o this imortant institutiona characteristic. Foowing is a tabe summarizing the studies and resuts described above. 9

20 Tabe.2 Decentraization and growth: review o existing studies Study Descrition Concusions Huther et Shah(998) Davoodi et Zou(998) Xie, Zou and Davoodi (999) Meoche, Vaiancourt et Yimaz(2004) Decentraization and governance, cross-section (980-83) same o 80 countries Decentraization and growth, ane o 46 countries or the eriod Decentraization and growth, time-series or the United States or the eriod Decentraization, economic growth and ubic sector size, cross-section (o 0 Euroean transition countries, ) Akai and Sakata(2002) Decentraization and state economic growth, cross-section and 2-eriod ane or the United States (988-96) Source: comiation by the author Decentraization is correated with bureaucratic eiciency, absence o corrution and higher score on the Human Deveoment Index Negative reation between decentraization and economic growth our deveoing countries No statisticay signiicant reation between decentraization and growth Signiicant imact o subnationa isca autonomy on growth and ubic sector size, but no imact o exenditure decentraization Positive and signiicant imact o revenue and exenditure decentraization on state economic growth Ater reviewing the current state o the iterature, the next section wi resent the theoretica ramework o our research question by resenting dierent aroaches and modes o decentraization and intergovernmenta cometition and by setting u a theoretica mode o endogenous growth. In the next section, we wi try to rovide an answer to the question o the imact o decentraization on growth or the Canadian context during the eriod. We wi resent the econometric seciications and the data used to do our regressions. 20

21 Chater 2 Emirica anaysis 2. The Canadian ederation Since this research aer wi ocus on decentraization in the Canadian ederation or the eriod rom 96 to 2004, it is imortant in order to better understand the imications o our question to have a broad understanding o the Canadian context in its economic, oitica, demograhic and historica comonents. Canada is a ederation o 0 rovinces and three territories. Its Constitution, the British North American Act, dates back to 867 and the country was ounded on the remise o a strong centra government. 3 The edera government was given access to the most imortant revenue source in use then, custom duties and had resonsibiity over economic deveoment aairs ike rairoads, the banking sector, commerce and taris, etc. Provinces were et with areas o resonsibiity that were not very imortant then, namey matters such as heath care, education and socia services. Imortant socia changes and a growing imication o government in a areas o society have been behind the much more active art ayed by rovincia governments in the ast century. On the revenue side, rovinces were given by the Constitution and its judicia interretation the right to tax anything they wanted excet internationa and inter-rovincia trade. 4 They have done so increasingy in the ast century. In 93, the edera government had 3.5 times the tota revenue rovinces had. In 92, ater Word War I and in great art because o the imortant wartime exenditures, Ottawa coected 4.3 times as much as the rovincia governments. Ater the Second Word War however, rovincia governments started catching u with the centre and their share steadiy cimbed unti the 70 s, where it has remained stabe at aroximatey 50% o tota government revenue, more than 2.5 times the edera share. 5 As or oca governments, they mainy consist o municiaities and schoo boards. Whie schoo boards have constitutiona status, municia governments have aways been under rovincia contro since they are not mentioned in the Constitution. Provinces thus have tota reedom to determine their boundaries, their taxing owers and areas o 3 Vaiancourt & Wingender(2005).4 4 Ibid..5 5 Bird(983) series H75-9 and H92-2 and CANSIM II, tabe

22 resonsibiities. Figures 2. and 2.2 give the shares o revenue and sending by a eves o government since 96. We can see that whie oca governments in Canada have maintained a stabe share o both revenue and exenditure around 8% and 30% resectivey, since 96 the edera shares have decined rom 40 to 20% or revenues and rom a near 50% to 38% in 2004 or sending. In contrast, rovincia revenue has increased rom 30% to more than 45% and rovincia sending went rom 30% in 96 to 55% now. Figure 2. Evoution o revenue shares by eve o government % o tota government revenue Source: CANSIM II, tabe Year Loca governments Provincia governments Federa government Figure 2.2 Evoution o exenditure shares by eve o government % o tota government exenditure Source: CANSIM II, tabe Year Loca governments Provincia governments Federa government 22

23 The comosition o rovincia revenue has aso changed signiicanty since 96. Intergovernmenta transers, mosty rom the edera government, reresented 30% o rovincia revenues in 96, but in 2004 these transers amounted to ony 5% o tota revenue. Provinces have mainy reied on their own-tax revenue to kee u with exenditure growth. Loca governments, which are much more deendant on transers, have seen those increased in terms o share o tota revenue whie their own-tax revenue decined during the same eriod. Foowing in igure 2.3 and 2.4 are the evoutions o rovincia and oca government revenue comosition or the eriod. Figure 2.3 Evoution o rovincia government revenue % o tota revenue Gov transers Other revenue Own-tax revenue Year Source: CANSIM II, tabe Figure 2.4 Evoution o oca government revenue % o tota revenue Gov transers Other revenue Own-tax revenue Year Source: CANSIM II, tabe

24 Whie it is straightorward to cover dierent asects o decentraization or Canada, it is more diicut to do so or individua rovinces. Provinces have very diverse municia structures and they vary greaty in terms o the number o municiaities and their ega status. Thereore, we wi kee the discussion on rovincia decentraization or a subsequent section o this aer, when we wi resent the data. We now end this section with an overview o Canada s current situation. Key economic, demograhic and geograhic variabes are resented in tabe 2. and rovide us with a useu background or evauating the imortance and imact o decentraization o the country s and its rovinces economic growth. As we can see, Canadian rovinces are very diverse in terms o size, ouation and er caita GDP. Whie Prince-Edward-Isand is the smaest and oorest rovince in the ederation aong with the other Atantic rovinces, Ontario and Aberta are the richest. These two rovinces are aso the ones receiving rom Ottawa the east transers, with.7% and 8.7% resectivey o tota rovincia revenue. The next section resents our emirica modes and the data used. 24

25 Tabe 2. Demograhic, economic and geograhic eatures o Canada and its rovinces, 2003 Canada NFD PEI NS NB QUÉ ONT MAN SASK ALTA BC Area (km²) 9,984, ,22 5,660 55,284 72,908,542,056,076, ,797 65,036 66, ,735 Pouation ( 000) 3, ,487 2,238, ,54 4,47 Pouation density GDP ($000,000),24,60 8,05 3,883 28,83 22, , ,46 38,078 36,778 70,63 42,48 GDP er caita 38,400 34,644 28,38 30,783 29,77 33,96 40,38 32,74 36,963 54,00 34,342 Tota rovincia government revenue ($000,000) 235,032 4,68,079 7,025 5,953 63,488 77,887 9,243 8,522 25,933 29,0 % revenue rom own sources % transers Tota oca government revenue ($000,000) 84, ,62,6 6,05 32,593 2,452 2,098 8,03 8,263 % revenue rom own sources % transers Number o municiaities Number o schoo boards Sources: Vaiancourt and Wingender(2005), Finance o the Nation 2003 and comiation rom CANSIM II by the author 25

26 2.2 Econometric seciications For the urose o our research, the imact o decentraization on Canadian economic growth has been anayzed with three dierent aroaches. Data gathered or the 0 Canadian rovinces or the eriod was evauated using 0 time-series regressions and 2 ane data regressions, one incuding a 0 rovinces and a second using a subset o the 6 argest rovinces (with the excusion o the 4 Atantic rovinces). A time-series anaysis has aso been conducted or aggregated Canadian data. The ordinary east squares technique was used in order to evauate the imact o decentraization o outut growth. Our irst set o rovincia regressions used the oowing equation yt 0 n decentraization X ε, t,, 39 (5.) t t t where t is a time index. Deinitions o the variabes o the equation are given in tabe 5.. Decentraization is a measure o decentraization catured by one o the 6 indicators used or our rovincia data, with higher vaues associated with higher eves o decentraization. We chose our dierent indicators based o the work done in revious studies. Deinitions o these indicators are given in tabe 5.. Two imortant seciications need to be made. First, we chose to use data on government sending or goods and services ony because we wanted to kee in ine with our theoretica mode and cature the imact o roductive sending ony. This way, government sending did not contain transer ayments or debt service. Second, data or schoo board exenditure was the tota sending, because cassiications by Statistics Canada did not have the same goods and services series as or governments. X t is a vector o contro variabes tyicay used in growth studies to catured rovince-seciic characteristics. 6 The arameters 0 and are scaars, reresents a arameter vector and ε t is the error term, which may be seriay correated and/or correated with some o the indeendent variabes. However, because o the imited size o our same and the diicuty o inding aroriate 6 See or exame Devarajan & a.(996) or Levine & Renet(992) 26

27 instrumenta variabes, we chose to ignore this otentia correation/autocorreation and use a sime basic OLS. In our rovincia time-series regression, data or outut growth rate has been coected rom 965 to 2003 whie a the other variabes have been comied starting in 96 and ending in 999. This 4 year ag was chosen because o the avaiabiity o the data and because it roduces the best resuts in terms o exanatory ower. In addition, this 4-year ag ensures us that the reationshi between growth and the indeendent variabes is unidirectiona, i.e. that economic growth as we measured it did not aect the indeendent variabes used in our anaysis. It aso aows us to cature more ong-term eects that changes in the institutiona variabes may have on growth. 7 A second set o regression anaysis has been done with the aggregated rovincia data using a ane orm. We comuted two aternative regressions, the irst one using a 0 rovinces and the second one using ony the 6 argest rovinces (excuding the our Atantic rovinces). The seciication diers sighty rom the revious one in individua rovincia data. The regression equations are as oow ( ) δ yeart t n y it 0 decentraisationt X t δy 0 3 µ (5.2) i,, 0 and,, 6 and t,, 8 where i reers to one o the 0 rovinces in the irst ane and to the 6 argest rovinces (Québec, Ontario, Manitoba, Saskatchewan, Aberta and British Coumbia) in the second regression sets and t reers to the 8 5-year eriods seected. For these regressions, the deendant variabe is no onger the annua growth rate o rovincia er caita GDP, but is a 5-year orward-ooking average o this variabe. This 5-year average is interesting to use because it aows us to cature both short-term and ong-term eects o our institutiona and macroeconomic variabes on growth. We were abe to construct 8 suberiods rom 962 to 2004 with a indeendent variabes measured in the base year. The 7 It woud be an interesting extension o this aer to test or the resence o unit root or cointegration in the variabes used in our rovincia time-series regressions. 27

28 5-year average deendant variabe and the indeendent variabes were comuted as oow n y n y t 4 n y t with decentraizationt and X t measured at time t We aso added in the regression the og o the initia eve o rovincia GDP n y ( 0) and (8-) time dummy variabes year t. Using Hausman s test which tests the nu hyothesis o random-eects or ane variabes against ixed-eects, we aied to reject the nu hyothesis in a but one ane regressions. We thereore did not incude any rovincia dummy variabes in the ane regressions, considering a random-eect seciication. Resuts o these Hausman tests are given in tabe 3.2 and 3.3. Finay, the error term µ t is assumed to be seriay uncorreated and uncorreated to the exanatory variabes. It is to be noted that or each o the regressions, we incuded aternativey the dierent indicators o isca decentraization. Decentraization is a comex henomenon which invoves many ega and oitica arrangements between dierent eves o government. Sime quantitative budgetary measures cannot easiy cature true resonsibiity and decision-making over imortant governance questions, ike ower to tax, exenditure resonsibiity and reguation or exame. Our ive indicators can thereore rovides us with a more accurate icture o the imact decentraization has had in Canada in the ast 40 years. We aso anayzed aggregated data or Canada over the eriod. The econometric seciication is simiar to what we did with rovincia data. Treating Canada as one jurisdiction, we used a time-series anaysis to run the oowing regression 8 yt 0 n decentraisation X ε, t,, 43 (5.3) t t t 8 As noted by one o our readers and simiar to the rovincia regressions, urther tests on the resence o unit root and cointegration woud be required in order to veriy the imicit assumtions o stationarity made here. 28

29 Whie we incuded a measure o the economy s oenness to internationa trade in this regression, a key variabe in most growth anaysis aers, we coud not use the same measure or our rovincia data. The reason was the unreiabiity o rovincia exort data in CANSIM. Because interrovincia borders are not monitored in Canada, Statistics Canada is not abe to comie accurate data. For Canadian data however, it was imortant to incude this measure as a contro variabe. The decentraization indicators dier rom the rovincia case. Unike the revious anaysis, subnationa decentraisation can either be rovincia or oca. It was thereore imortant to searate measures o revenue and sending between the two eves, aong aggregated indicators. Another dierence between rovincia and nationa regressions was the use o an indicator o the economy s oenness to trade. Whie it was straightorward or the nationa eve, we simy used the ratio o goods and services exorts on GDP; we had to use a dierent indicator or rovincia eve. The reason or this is that data or rovincia exorts is comied in CANSIM as a residua category o GDP cacuations; it is thereore not comuted directy. This introduces error in exorts data, we thereore decided to use as a roxy the share o rovincia GDP to nationa GDP by making the assumtion that the arger the rovince, the ower are its exorts share o GDP. Foowing in tabe 2. are given the variabes descrition and the regressions in which they were used. Means and standard-deviations or the deendant and contro variabes are ound in Annex 3. The reader may reer to tabe 2.4 and section 2. or the evoution o decentraization indicators at the rovincia and nationa eves. 29

30 Tabe 2.2 Variabes deinition Variabe Deinition Provincia Provincia Nationa time-series ane time-series n y t Annua growth rate o rea er caita outut n y t 5-year orward-ooking average annua growth rate o rea er caita outut n y (0) Logarithm o rea er caita rovincia outut or initia year TXRT Ratio o tota consoidated government revenues to GDP EXPEND Ratio o tota government exenditure in goods and services to GDP POP Annua growth rate o ouation EDUC Share o ost-secondary education exenditure on tota government exenditures INV Ratio o tota rivate investment to GDP OPEN Ratio o goods and services exorts to GDP OPEN(2) Share o the rovincia GDP to nationa GDP Fisca decentraisation indicators RI Ratio o tota oca government revenue to oca and rovincia government revenue PROVREV Ratio o rovincia government revenue to tota government revenue LOCREV Ratio o oca government revenue to tota government revenue SNREV Ratio o subnationa government revenue to tota government revenue PI Ratio o oca (municia schoo board) government exenditure in goods and services to oca and rovincia government exenditure PRI Arithmetic average o RI and PI indicators PROVEXP Ratio o rovincia government exenditure in goods and services to tota government exenditure LOCEXP Ratio o oca government exenditure in goods and services to tota government exenditure SNEXP Ratio o subnationa government exenditure in goods and services to tota government exenditure MUNI Ratio o municia government exenditure in goods and services to tota government exenditure SCHOOL Ratio o schoo boards tota exenditure to tota government exenditure (goods and services) AI Ratio o oca government s own revenue to tota revenue Source: comiation by the author 30

31 2.3 The data Data were taken rom Statistics Canada s CANSIM II database. Tabe 2.2 ists the tabes used rom CANSIM II to retrieve the data necessary or this aer. Tabe 2.3 CANSIM II Tabes Tabe number Tabe Tite Provincia data Estimates o Pouation, Canada, Provinces and Territories Gross domestic roduct (GDP), Income-based, Provincia Accounts Gross domestic roduct (GDP), exenditure-based, rovincia economic accounts Government sector revenue and exenditure, rovincia economic accounts Provincia Gross Domestic Product (GDP), Exenditure-based Federa Government and Government Sector Revenue and Exenditure Provincia Government Revenue and Exenditure Loca Government Revenue and Exenditure Tota Exenditure on Education, by Direct Source o Funds and Tye o Education Schoo Board Revenues, by Direct Source o Funds Schoo Board Exenditures, by Economic Cassiication Nationa data Gross Domestic Product (GDP), Exenditure-based Sector Accounts, A Leves o Government Gross Domestic Product (GDP), Exenditure-based Consoidated Federa, Provincia, Territoria and Loca Government Revenue and Exenditure, or Fisca Year Ending March 3 Source: author A ew imortant remarks need to be made on the data invoved in this research aer. First o a, due to their historica nature, it was necessary to comute observations or most rovincia series rom two dierent tabes. Provincia GDP series were ound or the eriod in tabe Provincia Gross Domestic Product (GDP), Exenditure-based and or the eriod in the tabe Gross domestic roduct (GDP), exenditure-based, rovincia economic accounts. When divergences occurred between the two data sets, which we ound was usuay between and 5%, we used the observations comied in the atest o the two tabes. Consoidated rovincia budgetary series were aso comied rom two dierent tabes. Tota government revenue 3

32 series, used to cacuate the TXRT variabe, a goba measure o the tax burden o a rovincia economy, were taken rom tabes Federa Government and Government Sector Revenue and Exenditure and Government sector revenue and exenditure, rovincia economic accounts. Since a amounts were in nomina terms, we used rovincia GDP in current doars to cacuate most ratios. Provincia nomina GDP series were ound in tabe or and tabe Gross domestic roduct (GDP), Income-based, Provincia Accounts or The variabe EXPEND, the sending equivaent o TXRT used in regressions with exenditure-tye decentraization indicators, was comied with nationa account series taken rom tabes and Simiary, the variabe INV, the ratio o rivate investment in ixed caita and machines to GDP used data rom the same nationa account series or both sub eriods. To comute POP, the annua growth rate o tota ouation, we used singe series since the data was accessibe or 954 to Finay or series on sending in ost-secondary education by a eves o government used to comute EDUC, a roxy or human caita in each rovince, data was taken rom tabe Tota Exenditure on Education, by Direct Source o Funds and Tye o Education u to 999, the ast year data was comied by Statistics Canada or this exenditure category. This constraint was one o the reason we used 4 ags on indeendent variabes or our rovincia regressions. Data used or the decentraization indicators (RI, PI, MUNI, SCHOOL, PRI and AI) or oca and rovincia government exenditure had to be disaggregated between the two eves and were ony accessibe on CANSIM II u to Data on oca government revenue and exenditure or were taken rom tabe Loca Government Revenue and Exenditure and tabe or Loca government exenditure was divided between genera sending and schoo board exenditure. This was done in order to cature the otentiay dierent eects o these two categories. Whie we coud susect genera oca government sending to be ositivey correated with growth, due to greater roximity to oca needs and greater sensitivity to government cometition, schoo board exenditure shoud be negativey correated with growth due to the beneits o greater coordination and economies o scae. 32