Fiscal Decentralization, Macroeconomic Stability and Economic Growth
Author: Nasir Iqbal

Over the last three decades, there has been a growing tendency towards fiscal decentralization especially in emerging and developing economies. Recently, the government of Pakistan has taken two major steps towards strengthening the process of fiscal decentralization by signing the 7th National Finance Commission (NFC) award – through which a bulk of resources has been transferred to the provinces – and by passing the 18th Constitutional Amendment – through which a wide range of fiscal responsibilities have been shifted from the center to the provinces. These developments would cause a fundamental shift in the division of powers between the center and the provinces, with the latter would have more autonomy in performing various functions like the provision of public goods and services and macroeconomic management. The proponents of fiscal decentralization suggest that fiscal decentralization can contribute to economic growth directly and indirectly by means of macroeconomic stability. However, the empirical literature on the growth and stability effects of fiscal decentralization remains inconclusive. Given the increasing trend and the inconclusive outcomes of the existing studies, it is important to examine the potential effects of fiscal decentralization in Pakistan within a rigorous macroeconomic framework. In this context, the main objective of this dissertation is to analyze, both theoretically and empirically, the impact of fiscal decentralization on macroeconomic stability and economic growth by looking at the various dimensions of fiscal decentralization and macroeconomic stability. The dissertation develops a theoretical framework based on the endogenous growth model. This model captures the direct as well as indirect impact of fiscal decentralization on economic growth within a unified framework. The model is then empirically tested using three different measures of fiscal decentralization i.e. revenue decentralization, expenditure decentralization and composite decentralization. The macroeconomic stability index is based on inflation, fiscal discipline and exchange rate management. The Generalized Method of Moment (GMM) is used to empirically estimate the impact of fiscal decentralization on macroeconomic stability and economic growth. The time series data over the period 1972-2010 is used. ix The findings show that revenue decentralization has a positive association while expenditure decentralization has a negative relationship with economic growth and macroeconomic stability in Pakistan. The weak institutional and administrative framework at the provincial level is the main reason behind the ineffectiveness of expenditure decentralization. The role of democratic institutions in explaining the effectiveness of expenditure decentralization was examined. The findings show that, when it is complemented with good institutions, expenditure decentralization becomes effective in promoting economic growth and macro-stability. It is also seen that composite decentralization has a positive impact on economic growth and macroeconomic stability. This implies that simultaneous decentralization processes reinforce each other in achieving the growth and macro-stability. Moreover, the results reveal that fiscal decentralization, especially revenue decentralization, is beneficial for the economy of Pakistan. To achieve long run economic growth and macro-stability, revenue decentralization should be better streamlined by making the provinces rely on their own resources. Expenditure decentralization can be effective if the provinces are made accountable through good institutions. Summing up, if it is implemented with the provision of real fiscal autonomy, adequate accountability and sufficient administrative capacity, fiscal decentralization can play an important role in the development supervisors Dr. Musleh ud Din

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Keywords : Economic Growth, Fiscal Decentralization, Macroeconomic Stability
Supervisor: Musleh ud Din
Cosupervisor: Ejaz Ghani

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