Heterogeneity, Fiscal Federalism, and the Size of Government

Abstract

What explains cross-national differences in the fiscal impact of government, including the size of the welfare state? Standard explanations center on citizen and government ideology and ethnic heterogeneity, with a smaller role for institutions such as majoritarianism, presidentialism, and federalism. Recent research has discovered that fiscal federalism has previously been mismeasured in such a way as to obscure its impact on policy. This paper argues that, in high-income countries, ethnic and religious heterogeneity was historically associated with the retention of federal institutions. Cross-national statistical results show that fiscal federalism suppresses government consumption, particularly on goods and services, while religious heterogeneity has an independent effect on government consumption, employment, and social spending. By contrast, jurisdictional competition under fiscal federalism does not provide incentives to cut government investment or transfers. Fiscal federalism appears to constrain government by keeping administrative costs low, while religious heterogeneity reduces the generosity of the welfare state. Together, fiscal federalism with a large number of jurisdictions and religious heterogeneity explain essentially all differences in size of government between the United States and more comprehensive welfare states such as Denmark, Canada, and the Netherlands.

Keywords: fiscal federalism, decentralization, welfare, government, fractionalization

JEL Classification: P16, P51, H50, H70, H11, H5