The essential logic is that devolution of political and administrative power as well as fiscal resources to lower levels of governments (state or provincial governments, municipalities and village administrations) would lead to improved economic efficiency in provision of public services to local residents and this in turn contributes positively to economic growth at the local and national levels (so-called Oates’ Decentralization Theory). For example, if a certain city does not provide essential services then residents are likely to move to other cities (i.e. vote with their feet).
In reality, the evidence between decentralization and economic growth is unclear and mixed. For example, Davoodi and Zou (1998) using cross-country data for the period 1970-89 found a negative correlation between fiscal decentralization (measured as a share of local government expenditure in total government expenditure) and growth leading them to interpret the results as:
(i) recurrent expenditures at local government levels do not necessarily contribute to growth;
(ii) capacity of local governments’ is usually inadequate to provide services needed for growth; and
(iii) the complementarity between political, administrative and fiscal decentralization is complex and therefore the relationship between decentralization and growth is complicated.
While other studies, such as the one on China’s twenty-one provinces during 1986-92 found a negative relationship and an insignificant contribution in the states of USA during 1948-94, Akai and Sakata (2002) and Huther and Shah (1998) found a positive correlation between fiscal decentralization and growth. Ihmi (2005) found that the benefits of fiscal decentralization depends on how much political freedom the residents enjoy and therefore, together contribute to growth.