FISCAL DECENTRALISATION AND POLITICAL ECONOMY OF POVERTY REDUCTION: THEORY AND EVIDENCE FROM PAKISTAN

Abstract

This thesis explores the relationship between fiscal decentralisation and poverty. The thesis consists of four parts. First part reviews the related literature addressing different aspects of fiscal decentralisation and poverty and highlighting the research gap that this thesis intends to address. It also explains the possible channels through which fiscal decentralisation potentially affects poverty. Second part describes the political economy, fiscal decentralisation and poverty in Pakistan. It underlines that fiscal policy decisions in Pakistan are made to reflect many vested interest groups and institutions that may be failed to provide basic social services. Additionally, it discusses the development of federalism and fiscal decentralisation in Pakistan and shows that how the vertical and horizontal resource distribution affect the social and economic development of the provinces. This part also discusses various approaches, measurements and trends of poverty in Pakistan. Third part presents a systematic relationship between fiscal decentralisation and poverty both theoretically and empirically. The theoretical framework implies that if the federal transfer rate is larger, then the decentralisation measure will be greater. Since a larger federal transfer rate reduces poverty, poverty and expenditure decentralisation are expected to be negatively related. In addition to the model, there is an extensive empirical study on Pakistan to look at the impact of fiscal decentralisation on poverty besides investigating the potential channels through pro-poor sectoral outcomes. Ordinary Least Squared, Fixed and Radom Effect Models and Generalised Method of Moment Instrumental Variables methodology is used on simple time series as well as panel datasets covering four provinces of Pakistan over the period from 1975 to 2009. The empirical results suggest a strong relationship between expenditure decentralisation and poverty – proxy alternatively by headcount poverty, poverty gap, severity of poverty and the human development index. Both rural and urban poverty reduction have statistically significant relationship with expenditure decentralisation. The results also reveal that decentralisation improves pro-poor sectoral outcomes of education, health and agriculture that consequently affect poverty.
The last part illustrates the effectiveness of the devolution reforms by transferring fiscal, political and administrative authorities to local governments on certain social and economic sectors that are believed to be pro-poor. The evidence shows that the devolution significantly changes the size and magnitude of investment on many social and economic sectors. In all provinces, the investment increases in sectors such as education, healthcare, agriculture, water management, water supply and sanitation, rural development and the civil work. Since these services are strongly associated with local needs, it is reasonable to conclude that the devolution implicitly enhances the living standard of the local communities, especially the poor.