Decentralization, Tax Evasion, and the Underground Economy

Economic models of decentralization generally emphasize beneficial consequences− efficient provision of local public goods, hard budget constraints, and sorting of residents according to taste. This paper notes two less benign effects. First, political decentralization makes it easier for subnational governments to collude with enterprises at the center’s expense, offering firms political protection against central tax collectors and bankruptcy agents (“regional fiscal protection”). Second, because multiregional enterprises have a larger set of potential regional protectors, political decentralization advantages them over smaller, single-region firms (the “multiregional advantage”). Fiscal decentralization alleviates some problems, but exacerbates others such as the shift of output underground.

A simple model shows how these and other phenomena follow from the assumption of revenue-maximizing governments in a state with inter-level revenue-sharing and imperfect law enforcement. Various predictions of the model are compared to recent economic experience in Russia and are found to fit remarkably well. Many problems− including official stagnation, booming underground economy, growing interregional fiscal inequality, economic dominance of the “oligarchs”, falling federal tax revenues, and frequent economic conflict between central and regional governments− that are often explained by ad hoc and personal factors (Yeltsin’s health, high-level corruption, misguided economic reform strategies) can all be traced at least in part to the logic of competition in a decentralizing, revenue-sharing state.