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Shared Mandates, Moral Hazard, and Political (Mis)alignment in a Decentralized Economy

Inter-American Development Bank Working Paper, March 2015.

This paper investigates the effects of political (mis)alignment on public service delivery when mandates are shared between state and local governments.  As argued by Oates (1972) long ago, when local administrations are not pressured to internalize externalities, they will be tempted to free ride and under-provide services. For any service that requires shared responsibilities, the same concern should apply. The risk is serious in the context of environmental policies.

The authors analyze sewage treatment policies in the state of São Paulo, Brazil. Relying on difference-in-differences estimations, they establish a causal relationship between political alignment and higher sewage treatment provision. Conceptually, they find that, with uncertain local commitment and weakly enforceable local obligations, shared mandates lead to a moral hazard issue implying service under-provision. Accounting for spillovers is clearly not on the agenda of local politicians, as revealed by the low 19 commitment to sewage treatment in this study. The results show that political alignment attenuates such moral hazard effects.

The policy implications of these results are twofold. The first set of implications is relevant to the assignment of mandates for activities with spillovers in the design of fiscal federalism. Results imply that the higher the risks of free riding in the presence of spillovers, the higher the government level that should be in charge. This is not a new result but this case study adds to the collective evidence on this issue. This paper confirms that the general result also holds for shared mandates, thereby contributing to filling in what Mookherjee (2014) identified as a gap in the literature.

The second set of implications is more pragmatic in that it addresses what to do when mandates are shared and when there is political misalignment across government levels. This paper shows that relying on political alignment can offer a solution to imperfect service delivery resulting from poor coordination across government levels. This solution is, however, quite unstable and is unlikely to be as effective as relying on the design of inter-governmental transfers to minimize political interference with the allocation of resources across government levels.

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Estache, Antonio, Grégoire Garsous and Ronaldo Seroa da Motta (2015). “Shared Mandates, Moral Hazard, and Political (Mis)alignment in a Decentralized Economy”. IDB Working Paper Series 593. Inter-American Development Bank, March 2015.