Martin Besfamille | Institute of Economics, Pontifical Catholic University of Chile

We study the optimal degree of fiscal decentralization in a federation under imperfect regional state capacity. Regional governments are characterized by their capital endowment. Two regimes are compared on efficiency grounds: partial and full decentralization. Under partial decentralization, regional governments have no tax powers and rely on central bailouts to refinance incomplete projects. Under full decentralization, regional governments refinance incomplete projects through capital taxes, in a context of tax competition. We show that when the difference in capital endowments is low, the higher the capital in the rich region the more often full decentralization dominates. This result is weakened for higher levels of capital endowment's difference.

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