Sovereign Debt Crisis and Fiscal Devolution

How does fiscal devolution affect the probability of a sovereign debt crisis? Using annual cross-country panel data from 82 advanced and developing countries, the association between the sovereign debt crisis and fiscal decentralization is investigated. We employ an instrumental variable panel probit model to address potential endogeneity. The results reveal that local tax autonomy reduces the probability of a sovereign debt crisis. In contrast, expenditure devolution is found to increase the probability of a sovereign debt crisis. These favorable and unfavorable effects of fiscal devolution are found to be more evident in the case of decentralization to local governments than in the case of decentralization to subnational governments. In terms of relative magnitudes, our discrete choice analysis demonstrates that the undesirable effects of expenditure decentralization are greater than the favorable effects of tax revenue decentralization. Therefore, countries should be cautious about risks associated with fiscal devolution, particularly the contrasting impact of tax revenue and spending decentralization on the likelihood that sovereign debt crises occur.