External Impact of Local Decisions
When substandard local provision of services has an adverse impact on the
growth prospects and economic productivity of the nation as a whole, local
decisions have national importance. Many services that may be provided by
local governments—education, environmental protection, public health, and
the like—have impacts outside the political and geographic jurisdictions of
localities. Local fiscal decision makers have every incentive to pay less attention
to external beneficiaries than to the local citizenry, who have a direct impact on
the fate of local politicians. In that democratic environment, it is natural that
external effects will have limited impact in the fiscal decision-making process
and on policy outcomes. At a minimum, such external effects create a strong
reason for having special features in the intergovernmental fiscal system to
induce localities to take account of these effects in their decisions—whether the
features are mandates, controls, or transfer programs.
Another type of external impact from decentralized finances is the
macroeconomic impact. When local governments have fiscal autonomy, it
is possible that their actions may make national economic stabilization
more difficult.4 There is concern that uncoordinated decentralization creates
a bias toward deficits, particularly in developing countries. The problem is
particularly acute when the governments with new responsibilities lack the
capacity and resources to deal with them. The ultimate danger is that local
governments will be unable to practice fiscal discipline and will run
uncontrolled deficits, and so may ultimately need to be bailed out by the
central government. Unless there is a perceived hard budget constraint on
local governments, the sustainability of the national system of government
finance is then in jeopardy.