Acta Universitatis Danubius. Œconomica, Vol 10, No 3 (2014)

Local Decentralisation and Economic Growth in Nigeria

Hammed Adetola Adefeso¹

Abstract: The current global drive towards devolution of financial resources and responsibilities has been increasingly justified on the basis that greater transfers of these financial resources and responsibilities to sub-central governments are theoretically expected to deliver greater economic efficiency in the provision of public goods and services and hence greater economic growth. There is a mixed result on these theoretical expectations across earlier empirical literatures. Using the instrumental variables (IV) technique of analysis with the recent data from Nigeria for the period 1970-2013, this study found no robust significant effect of the decentralisation of spending or revenue on growth of real GDP per capital in Nigeria. The implication of this to the policy makers is that when it comes to the determinants of improved economic activities, decentralisation either fiscal expenditure or revenue side would not be instrumental to economic growth possibly because of existence of endemic corruption among politicians in Nigeria.

Keywords: Local Decentralisation, sub-central government, economic growth, Nigeria

JEL Classification: C3; H77

1. Introduction

Nigerian and other African governments have undergone repeated decentralisation reforms as many developing countries have a mandate to decentralize aspects of their public finance and concurrently, there has been a considerable debate in the developed countries such as the United State and OECD countries in the recent years on the merits of such fiscal decentralization. Much of these recent movements devolving of revenue collection and expenditure to local authorities have been driven by belief that fiscal decentralization enhances government efficiency in the public sector, cut the budget deficit, enhance service delivery and economic growth as first expressed by Tiebout (1956) and others studies like Oates (1972; 1999), Xie et al (1999). Generally, such transfer of fiscal power, responsibility and resources to lower tiers of government allows for even regional development in terms of provision of public goods and services to meet local needs and this will in turn reduce poverty level and promote overall economic performance. This is because government at lower levels have informational advantages over the central government concerning the improved and efficient resource allocation (Oates, 1972) and therefore they are in a better position to identify and deliver the kind of public goods and services that match local preferences and needs and over time efficiency gains will lead to the development of local as well as national economy at large.

Other scholars however, have challenged the significance of the economic efficiency of fiscal decentralization on service delivery of local government, reduction of poverty level and economic growth and development. They are of opinion that the informational advantage claimed by local government may not be significant because the central government may appoint its representatives to local offices where they purposely to gain the knowledge about local preferences under fiscal centralized system, so the government at the centre delegates and not devolves of fiscal responsibilities as in the case of fiscal decentralization. Even the central government can also involve worker at sub-central governmental level during the decision making process, this will influence resource allocative efficiency. The local government officials are not adequately trained most especially in the developing countries, this is because they are not elected into office through a democratic election and if they are, there is still the problem of availability of greater incentive to process information (World bank, 1995). It has also been argued that the control of macroeconomic and in particularly corruption at lower levels of government would be more difficult as it gives room for politicians to embezzle public funds (Suleiman, 2009).

Following this theoretical disagreement is the empirical estimation which tends to be ambiguous and inconclusive as a result of differing results. For example, while a strand of argument asserts confidently for single-country studies there exist positive and significant relationship between fiscal decentralisation and economic growth(Nguygen and Anwar, 2011) that fiscal decentralisation does not have economic impact because of the benefits derived from economies of scale in the provision and delivery of public goods (Thieben 2000), the study of Davoodi and Zou (1998) concluded that fiscal decentralisation is negatively correlated to economic activity in developing countries but has no significance in developed countries compared with findings of Prud’homme (1995) who argued that fiscal decentralisation is fundamentally suitable for developed countries and also compared with the conclusion of Enikolopov and Zhuravskaya (2003) which revealed significantly positive effect of fiscal decentralisation for developing countries alone. The evidence is that the link between decentralization and growth is not straightforward and is largely influenced by country specificities, as well as process design. Despite this, 63 of 75 transition and developing economies with populations of 5m people are either have granted or in the process of granting fiscal decentralization policy by transferring financial resourses and responsibilities to local government. (Woller and Philips, 1998; Rodriguez-Pose and Kroijer, 2009)

Obviously, whether or not there is any significant growth and efficiency gained associated with fiscal decentralization can never be settled merely on theoretical grounds alone. It must be subjected to rigorous empirical analysis (World bank, 1995) which is the thrust of this study. Most of the existing studies on the subject matter have been narrowly concerned with analysing the trend of intergovernmental relations within the limited context of political economy or using merely narrative and descriptive analysis to establish differential or unequal allocation of revenue and functions among tiers of government (see for example Suberu 1991, Akindele and Olaopa 2002) and impact of such on the Nigerian economy. And this has equally led to the review with a view of finding appropriate revenue formula in Nigeria which is one of the most decentralized countries in the continent. This methodology is grossly inadequate in analyzing Fiscal Decentralization-Economic Growth nexus (World Bank, 1995) which is scarcely explored (Breuss and Eller, 2004) most especially in developing country and hence this study.

Moreover, several studies have employed Ordinary Least Squares (OLS) estimation technique to empirically examine the impact of fiscal decentralisation on economic growth despite the fact that a number of studies have identified the possibility of reverse causality and endogeneity among fiscal decentralisation and economic growth (see for example, Adefeso and Saibu 2014, Jin, et al. 2005, Thiessen (2003), Martinez-Vazquez and McNab 2003, Xie et al. 1999, Zhang and Zuo 1998). Specifically, Adefeso and Saibu (2014) and Martinez-Vazquez and McNab (2003) argue and concluded that reversal causality exists because efficiency and other benefits derives from fiscal decentralisation emerge as countries grow and develop. However, existing literature does not control for this endogeneity and this has made the OLS estimates to be biased and not consistent. This study departs from other studies by catering for the problem of endogeneity through the application of Two-Stage Least Square (TSLS) on the over-identified equations. The remainder of the paper is structured as follows: Section 2 focuses on Empirical Literature Review surrounding the fiscal decentralisation and economic growth nexus. Theoretical Framework and Methodology are discussed in section 3 and the study is wrapped up by section 4 which focuses on empirical results and concluding remark.

2. Empirical Literature Review

The following table provides the summary of conflicting results of the main studies on fiscal decentralisation and economic growth nexus on time series analyses up till date.

Table 2.1. Summary of Single Country Empirical studies on the Fiscal Decentralisation Policy and Economic Growth nexus

Source: Author collection (2014)

2. Theoretical Framework and Methodology

The theoretical model of fiscal decentralisation and economic growth assumes without loss of generality, three levels of government namely federal, state and local. Fiscal decentralisation level is the spending by sub-national governments as a fraction of the total government spending. For instance, fiscal decentralisation increases if spending by state and local governments rises relative to spending by the federal government. Barro (1990) presents the production function where the interaction between private capital and public services are elegantly captured. This simple model explores a link between public services and economic growth. In this model, the government uses income tax revenues to finance public services which are considered to be inputs to private production. It is this complementarity between public services and private capital that creates a potentially positive linkage between public services and economic growth in the model. The models specifically shows that spending on public services which enhance the productivity of the private capital or firms that creates a potentially positive linkage between public services and economic growth in the model as shown below:

y = A_{ }.......................................................................................1

where y stands for economic growth, k is the private capita and g is the publicly provided services. a, b, c and d measure parameter efficiency.

This study however departs from Barro model and follows Davoodi and Zou (1998) by assuming that public spending is carried out by three levels of government namely: federal, state and local. Assume that k represents private capital, g is the total public spending on the provision of public services and it is the composition of f, federal government spending, s, state government spending and l, local government spending. i.e.

g = f + s + l.........................................................................................2

The resulted production function is Cobb-Douglas production function exhibits constant return to scale as specified below:

y = _{       }...................................................................................3

where a + b + c + d = 1 and 0< a, b, c, d <1, 0< b <1, 0< c <1, 0< d <1. The total government spending, g, among different levels of government takes the following form:

f = _{ } g, s = _{ } g, l = _{ } g...............................................4

where _{ } + _{ } + _{ } = 1 and 0< _{ } < 1 for i = f, s, and l. _{ } is the share of federal government in total spending, _{ } and _{ } are the share of state and local government in total spending respectively. The consolidated government spending g is financed by a flat output tax at rate τ:

g = τy, τ = g/y ........................................................................5

in order to derive the long-run growth rate of the economy, the analysis of the decision made by the private sector is crucial. Taken the government’s decisions on τ as given, a long-lived representative individual who maximizes his discounted utility,

Max U = _{ }.........................................................................6

where c is the consumption of the public goods and services produced in this economy; 𝜎 is the inverse of the intertemporal elasticity of substitution and p is the rate of time preference. The dynamic budget constraint the consumer faces is: _{ } = (1 - τ)y – c (1 - τ)_{       } – c .............................7

given the total government spending g, a constant tax rate τ, and the shares of spending by different levels of governments m_i’s, where i = f, s, l. The representative agent’s choice of consumption is determined by equation 6 subject to equation 7 and the government’s budget allocation. The consumer then chooses optimally the consumption path {c(t): t _{ }} and path of the capital stock {k(t) : t _{ }} which characterised balanced growth path. The consumer’s optimal allocation of resources is derived through Hamiltonian:

L= _{ } +_{ }..................................................8

_{ } = 0 _{     } = _{ } …….…………………………………. 9

_{ }= -_{ } ⇒ _{ }………………………10

_{ } =_{ } ⇒ _{ } ………………………………………………..11

The solution for per capital growth rate of the economy along balanced growth path is given by

_{ }= _{   }..............................................12

The equation above shows that long run growth rate per capital output of the economy which is the measure of economic growth is a function of the tax rate and the shares of spending by different levels of government and exogenous factor. This forms the basis for the empirical examination of the relationship between fiscal decentralisation and economic growth and a country is more fiscally centralized if _{ } has higher value as noted in the literature.

Given a share of total government spending in GDP and if the actual allocation diverges from the growth-maximizing expenditure share, some reallocation of public spending among three levels of governments will be growth-enhancing. This can be shown by maximising equation (9) while choosing _{ }and _{ } subject to the _{ } + _{ } + _{ } = 1. The growth-maximising government budget shares are simply the following:

_{ }= _{ } ..................................................................13

_{ }= _{ } ....................................................................14

_{ }= _{ }......................................................................15

It is therefore, clear that the growth-maximising spending shares are equal to the ratios of individual productivity over the aggregate productivity and as long as the existing government budget shares do not correspond to growth-maximizing shares, the growth rate and hence economic growth can always be increased without altering the total budget’s share in GDP.

3.1. Model Specification

The simultaneous regression equation that will be estimated on Nigerian economy using annual data from 1970 to 2013 are pooled from statistical bulletin published by Central Bank of Nigeria and African Development Indicator is specified below:

_{ } = _{ } + _{ } + _{ } + _{ } + _{ }..................................................16

_{ } = _{ } + _{ } + _{ } + _{ }..............................................................17

where t is the number of time periods,_{ }, _{ }, _{ } are scalar parameters while _{ } is a vector. _{ }is the average growth rate, _{ } is the measure of fiscal decentralisation and _{ } is the tax rate. _{ } is a vector of control variables which are health expenditure, human capita and openess, _{ } is the public burrowing theoretically, that there is positive relationship between degree of decentralisation and public borrowing rate of sub-nationals (Treisman, 2000) and _{ } and _{ } is the disturbance term that is assumed to be serially uncorrelated and orthogonal to the explanatory variables. The focus of this research are the coefficients _{ } and _{ } which may be positive or negative and statistically significant given the conventional arguments in favour or against of average growth rate and fiscal decentralization policy respectively.

The consequences of ignoring the endogeneity problem discussed briefly in section 1 as this study has noticed in numerous studies is that the estimated result will be baised and inconsistent because error term of such equation is correlated with the explanatory variable of the equation. In other to overcome the econometric problems of endogeneity from equation 13 and 14 which are structural equation of the simultaneous equations model where _{ } and _{ } are the endogenous variables and _{ } vector and _{ } are strictly exogenous variables, the study estimate an over identified equation using the method of Two-Stage Least Square (TSLS).

3.2 . Multivariate Cointegration Analysis and Error Correction Modeling

The cointegration analysis is fairly common and is well documented in the studies like Banerjee, et. al 1993; Hylleberg and Mizon 1989; Engle and Granger 1987; Johansen 1988; Johansen and Juselius 1990. Only summary is provided for here. According to Johansen (1988), multivariate cointegration model is based on the error correction representation given by:

Y_t =_{ } +_{ } Y_t-i + Y_t–1+ ε_t ..............................................(18)

Where Y_t is an (nx1) column vector of ρ variables, μ is an (nx1) vector of constant terms, α and β captured coefficient matrices, Δ is a difference operator, and ε_t ~ IID(0, _{ }). The coefficient matrix β is known as the impact matrix, and it contains information about the long-run relationships. Johansen’s methodology requires the estimation of the VAR equation (3) and the residuals are then used to compute two likelihood ratio (LR) test statistics that can be used in the determination of the unique cointegrating vectors of Y_t. The cointegrating rank can be tested with two statistics: the trace test and the maximal eigenvalue test.

2. Empirical Results and Concluding Remark

Analysis of the time series data employed in this study tend to exhibit either a determistic and/or stochastic time trend and are therefore non stationary at level; i.e., the variables in question have, means, variances and covariances that are not time invariant except expenditure on health and public burrowing. Direct application of OLS or GLS to non-stationary data produces regressions that are misspecified or spurious in nature (Engle and Granger, 1987). We therefore, subjected the variables for a unit root test using an Augmented Dickey-Fuller test (ADF) (Dickey-Fuller,1981) and Philip-Perron test (Philip-Perron, 1988). The results of this stationarity tests at level show that most of the variables are non stationary at level. We then difference the variables once in order to carry out stationarity tests on the differenced variables, the results of this confirmed stationarity as shown in the table 2 below:

Table 2. Result of the Unit Root Tests based on Augmented Dickey-Fuller Test

Note: All variables and symbols are defined earlier.

Source: Author computation (2014)

This shows that most of the variables involved are integration of order 1. The next step is to test for the existence of a cointegration relationship among the variables using the Johansen Cointegration approach described above. The Johansen Cointegration test result indicates the existence of cointegration between variables employed. The maximum trace statistics reject the null hypothesis of no cointegration at 5 per cent level.

Table 3. Two Stage Least Square Estimation

Dependent Variable: Growth Rate of Per Capital GDP

Note: *, ** represent 5%, 10% level of significance, *** represents both 5%, 10% level of significance

Source: Author Computation (2014)

In term of statistical significance, fiscal decentralisation measure either at expenditure side or revenue side is statistically insignificant in all the regressions while other explanatory variables like for example tax rate and health which are statistically significant and positively correlated with economic growth. This empirical result is supported by the study of Woller and Philips (1998) which failed to find any strong and systematic relationship between fiscal decentralisation and economic growth in the developing countries. Other literatures that arrived at this conclusion include Xie, Zou and Davoodi (1999), Nauumets (2003), Bodman and Ford (2006). This study therefore concludes that fiscal decentralisation is not instrumental to economic growth in Nigeria.

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