FISCAL FEDERALISM AND MACROECONOMIC PERFORMANCE IN NIGERIA
ABSTRACT
Fiscal decentralization, which mirrors the amount of fiscal autonomy and responsibility accorded to subnational government, has been an important subject in the policy equation of many developing, transition, and developed countries. This thesis investigates the impact of fiscal decentralization on macroeconomic performance in Nigeria. Specifically, it seeks to analyze the effects of fiscal decentralization on economic growth, inflation rate, exchange rate, and interest rate in Nigeria, examine the evolution, structure, and practices of fiscal federalism in Nigeria, investigate the underlying factors promoting or inhibiting the true practice of fiscal federalism in Nigeria, and determine the extent of fiscal decentralization in Nigeria. Within the framework of a simple endogenous growth model, the Vector Autoregressive (VAR) estimation technique was employed in this thesis on a set of four dynamic time series data models with latent variables. Three indicators of fiscal decentralization, subnational fiscal autonomy, subnational spending share, and subnational dependency were used to measure the degree of fiscal decentralization in Nigeria. Data for the study were sourced from secondary sources. The findings are many and offer strong evidence that there is a connection between fiscal decentralization and macroeconomic performance in Nigeria. Fiscal decentralization has a significant positive impact on growth suggesting that fiscal decentralization promotes economic growth in Nigeria. However on the contrary fiscal decentralization has an insignificant negative impact on the other three indicators of macroeconomic performance in Nigeria: inflation rate, exchange rate, and interest rate. Nigeria has not operated as a true federation since it adopted a federal constitution in 1946 till date. Fiscal responsibility and taxing powers still remain considerably centralized, while subnational levels experience fiscal mismatch between spending and taxing powers. The true practice of fiscal federalism in Nigeria has been inhibited by several factors which include, the dominance of the federal government in the sharing of national financial resources from the Federation Account, the imposition of the command structure of the military on fiscal federalism, the pattern of assignment of responsibilities by the constitution among federating units, and over-reliance on the revenue from the Federation Account. No doubts, fiscal federalism is unarguably a potent economic strategy that can be used to maximize provision of public services as well promote macroeconomic stability. Central to the success of fiscal decentralization, is clarity in revenue and expenditure authority and responsibilities. The urgent reform that is required is the need for government to redress the prevailing fiscal mismatch at subnational government levels through appropriate policies to increase tax revenues to subnational governments as well as reforms of expenditure responsibilities to enhance their efficiency in the provision of public services.
TABLE OF CONTENTS
Title page…………………………………………………………………………………….ii
Declaration…………………………………………………………………………………..iii Certification…………………………………………………………………………………iv
Dedication…………………………………………………………………………………...v
Acknowledgements…………………………………………………………………………vi
Table of Contents…………………………………………………………………………..viii
List of Tables………………………………………………………………………………...xii
List of Figures………………………………………………………………………………xiv
List of Abbreviations………………………………………………………………………..xv
List of Appendices………………………………………………………………………….xvi
Abstract…………………………………………………………………………………….xvii
CHAPTER ONE: INTRODUCTION
1.1 Background to the Study……………………………………………………………...1
1.2 Statement of the Problem……………………………………………………………...3
1.3 Research Questions……………………………………………………………………7
1.4 Objectives of the Study………………………………………………………………..7
1.5 Statement of Research Hypotheses……………………………………………………7
1.6 Scope of the Study…………………………………………………………………….8
1.7 Justification of the Study……………………………………………………………...8
1.8 Structure of the Study………………………………………………………………...10
CHAPTER TWO: REVIEW OF THE LITERATURE
2.0 Introduction…………………………………………………………………………..11
2.1 The Concept of Federalism…………………………………………………………...11
2.2 The Concept of Fiscal Federalism………………………………………………….....12
2.3 The Rationale for Multilevel Government and Division of Responsibilities…………13
2.4 Conceptual Basis for Tax and Revenue Sharing Arrangement…………………….....18
2.5 Intergovernmental Transfers……………………………………………………….....23
2.6 Review of Theoretical Issues………………………………………………………..25
2.7 Review of Methodological and Empirical Issues…………………………………...29
2.8 Fiscal Federalism in Developed Countries………………………………………….38
2.8.1 Australia…………………………………………………………………….38
2.8.2 Germany…………………………………………………………………….39
2.8.3 The United States of America……………………………………………....40
2.8.4 Canada………………………………………………………………………43
2.9 Fiscal Federalism in LDCs and Transition Economies……………………………...44
2.9.1 India………………………………………………………………………...45
2.9.2 Argentina……………………………………………………………………46
2.9.3 Brazil………………………………………………………………………..47
2.9.4 China………………………………………………………………………..48
2.10 Relevant Issues and Challenges……………………………………………………49
2.10.1 Decentralization and the assignment of Revenue from Natural
Resources………………………………………………………………...49
2.10.2 Decentralization and Corruption………………………………………...55
2.10.3 Decentralization Regional Disparities and National Unity……………...58
CHAPTER THREE: EVOLUTION PRACTICES AND PROFILE OF FISCAL
FEDERALISM IN NIGERIA
3.0 Introduction………………………………………………………………………...63
3.1 Evolution of the Federal Structure and Fiscal Federalism in Nigeria……………...63
3.2 Profile and Challenges of Fiscal Federalism in Nigeria……………………………68
3.3 Assignment of Revenue (Taxing) Powers in Nigeria………………………………73
3.4 Assignment of Expenditure Powers and Responsibilities in Nigeria………………80
3.5 Revenue Structure and Fiscal Dependence………………………………………...84
3.5.1 Revenue Source Dependence……………………………………………...85
3.5.2 Intergovernmental Fiscal Relations Dependence.........................................90
3.6 Implication of Current Fiscal Arrangement………………………………………...93
3.7 Review of Revenue Allocation Experience in Nigeria……………………………..97
3.7.1 The First Phase of Revenue Allocation (1946-1967)……………………...98
3.7.2 The Second Phase of Revenue Allocation (1967-1979)…………………...99
3.7.3 The Third Phase of Revenue Allocation (1979-1999)……………………100
3.8 Patterns and Trends of Government Revenue…………………………………….106
3.9 Patterns and Trends of Government Expenditure………………………………...110
3.10 Result of Government Fiscal Operations and Macroeconomic Implications……..112
3.11 Patterns and Trends of Macroeconomic Variables………………………………..119
CHAPTER FOUR: THEORETICAL FRAMEWORK AND METHODOLOGY
4.0 Introduction……………………………………………………………………….124
4.1 Theoretical Framework……………………………………………………………124
4.2 Model Specification……………………………………………………………….131
4.2.1 The Growth-Decentralization Model (Model 1)…………………………...131
4.2.2 The Inflation-Decentralization Model (Model 2)………………………….132
4.2.3 The Exchange-Decentralization Model (Model 3)………………………...132
4.2.4 The Interest-Decentralization Model (Model 4)…………………………...133
4.3 Model Estimation Technique……………………………………………………...133
4.3.1 Test for Stationarity………………………………………………………..134
4.4 Definition of Variables and Data Sources………………………………………...135
CHAPTER FIVE: DISCUSSION OF EMPIRICAL RESULTS
5.0 Introduction……………………………………………………………………….138
5.1 Unit Root Test Results……………………………………………………………139
5.2 Presentation of Estimated Empirical Results……………………………………..140
5.2.1 Presentation of Estimated Empirical Results in Growth-Decentralization
Model……………………………………………………………………...140
5.2.2 Presentation of Estimated Empirical Results in Inflation-Decentralization
Model……………………………………………………………………...143
5.2.3 Presentation of Estimated Empirical Results in Exchange rate-
Decentralization Model……………………………………………………146
5.2.4 Presentation of Estimated Empirical Results in Interest rate-
Decentralization Model……………………………………………………149
5.3 Response of Macroeconomic Variables to Fiscal Decentralization Shocks……...151
5.3.1 Growth Responses to Fiscal Decentralization Shocks…………………….152
5.3.2 Inflation rate Responses to Fiscal Decentralization Shocks………………154
5.3.3 Exchange rate Responses to Fiscal Decentralization Shocks……………..156
5.3.4 Interest rate Responses to Fiscal Decentralization Shocks………………..158
5.4 Variance Decomposition of Macroeconomic Variables………………………….160
5.4.1 Variance Decomposition of Growth……………………………………...160
5.4.2 Variance Decomposition of Inflation rate………………………………..163
5.4.3 Variance Decomposition of Exchange rate………………………………165
5.4.4 Variance Decomposition of Interest rate………………………………....167
5.5 Summary of the Results of Econometric Investigation………………………….169
5.6 Policy Implications of Findings………………………………………………….171
CHAPTER SIX: SUMMARY, CONCLUSION AND RECOMMENDATIONS
6.1 Summary…………………………………………………………………………174
6.2 Conclusions………………………………………………………………………177
6.3 Recommendations………………………………………………………………..178
6.4 Contribution to Knowledge……………………………………………………...179
6.5 Limitations of the Study…………………………………………………………180
6.6 Suggestions for Future Researches………………………………………………181
References………………………………………………………………………………182
Appendices……………………………………………………………………………...203
CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Fiscal decentralization, which mirrors the amount of fiscal autonomy and responsibility accorded to subnational governments has been an important subject in the policy equation of many developing and developed countries. Fiscal federalism is essentially about the allocation of government resources and spending to the various tiers of government (Oates, 1972; Tanzi 1995). In general the intensification of clamour for greater decentralization is informed by a combination of people desiring to get more involved in government, and the inability of the central government to deliver quality services (Chete, 1998). Fiscal decentralization serves as a constraint on the behavior of revenue-maximizung central government, while it serves as a booster on behalf of underdeveloped subnational governments. Since 1990s there has been a resurgence of interest in the macroeconomic performance of developing countries. A prominent element in the policy advice given to developing countries to enhance growth and development potentials is the fundamental need to restructure the public sector to make it more responsive to efficient and equitable provision of public services for the public sector’s contribution to a stable macroeconomic performance (Aigbokhan, 1999). A trend that has emerged from this public sector restructuring is the devolution of spending and revenue-raising responsibilities to lower levels of government not only in federal systems, but also in many unitary countries. This trend is a reflection of the movement towards participatory democracy and the need to provide public goods and services that meet the preferences of people in each locality.
Federalism is essentially about multilevel government structure, rather than within a level structure of government, for the performance of government functions and service delivery to the people. Each level of government can be viewed as an institution with definite functions to perform (Rivlin, 1991). The conventional wisdom in economics is that all functions allocated to government should be those that the market is not able to perform in the efficient allocation of resources, equitable distribution of income, and economic stability and growth (Varian, 1990; Layard and Walters, 1978).
There are different forms of federalism. The prominent ones are fiscal, political and administrative. Decentralized systems of government give rise to a set of fiscal exigencies referred to as fiscal federalism also known as fiscal decentralization. It refers to the scope and structure of the tiers of governmental responsibilities and functions, and the allocation of resources among the tiers of government to cope with respective functions. Decentralization encompasses a wide range of distinct processes. The main ones are administrative deconcentration, or the transfer of state functions from higher to lower levels of government while retaining central control over budgets and policy making; fiscal deconcentration, or the ceding of influence over budgets and financial decisions from higher to lower levels; and development or transfer of resources and political authority to lower-level authorities that are independent of higher levels of government.
The concepts of concentration and deconcentration are issues relating to decentralization. Deconcentration is often considered to be the weakest form of decentralization and is used most frequently in unitary states that redistribute decision making authority and financial management responsibilities among different levels of the central government. It merely shifts responsibilities from central government officials in the capital city to those working in states, regions, provinces or districts, creates strong field administration or local administrative capacity under the supervision of central government ministries.
Political federalism deals with the devolution of powers between tiers of government, where the tiers each, within a sphere, coordinate its partially independent tasks (Oates, 1972; Asobie, 1998; Taiwo 1999). It follows, therefore, that there would be constitutional or some legal provisions to protect the autonomy of the different tiers of government.
Administrative federalism, on the other hand, involves delegation of functions to lower-level governments, usually according to the guidelines or controls imposed by the higher level government and, therefore, without the autonomy which is characteristic of decentralization. Of the different forms of federalism the one of relevance in this study is fiscal federalism.
Recent interest in fiscal decentralization fueled the debate about public sector reforms in general, and the role of sub-national governments in macroeconomic policy-making process. In all countries, power is necessarily divided to some extent between the central and other levels of government. The extent of division of power has important implications for the functioning of the public sector and efficient provision of services. Division of policy-making powers influences not only delivery of services but also their financing that in turn determines macroeconomic performance of countries. Fiscal decentralization requires that sub-central units of the government must make decisions about provision of public services at the lower level (Yilmaz, 1999). The important question that remains to be answered is whether lower-level governments’ spending increases, for example, fiscal deficits at the central level and put macroeconomic stability into jeopardy. In general, macroeconomic variables such as prices, money supply, interest rate, unemployment, foreign exchange rate may be subjected to violent fluctuations which may compromise the growth of the national economy and promote an unstable macroeconomic environment. This is of particular importance in the performance of the stabilization function, usually assigned to the central government, especially with respect to the issue and management of the national currency, on the basis of its spatial incidence which covers the entire country. Thus, it can be seen that issues of fiscal federalism affect national development and macroeconomic stability.
1.2 Statement of Research Problem.
The overall objective of this study is to examine the issue of fiscal federalism and effects on macroeconomic performance in Nigeria. Fiscal federalism is the product of the reciprocal and dynamic interaction between different tiers of government, and therefore poses questions as to how the nature and conditions of the financial relations in any federal system affect the production and distribution of the wealth of a nation. In particular it influences how political decisions and interests influence the location of economic activities and the distribution of the costs and benefits of these activities.
There has been a resurgence of interest, in many parts of the world, in problems of multi-level government finance. Recent and ongoing political and economic developments raise questions about the role of nation, subnational governments and supranational public authorities in the provision and financing of public sector programmes.
Problems of fiscal decentralization and intergovernmental fiscal relations are of wide-spread concern in developing countries. Much of the established literature of fiscal federalism has been explicitly or implicitly oriented toward the institutions and policy issues that arise within developed countries, particularly Canada and the United States (Wildasin, 1997; Artis, 2006; Austin 2006). There is hitherto no consensus in the literature on the effects of fiscal federalism on macroeconomic performance in developed and developing countries. The literature on the potential macroeconomic effects of fiscal federalism is quite vast but mixed. Decentralization may improve allocative efficiency, but it may also make stabilization policies more difficult to carry out (Prud’homme, 1994; Tanzi, 1995). While there are several reasons that fiscal decentralization has been adopted around the world the common motive of many is that fiscal decentralization is considered to have the potential to improve the performance of the public sector. The theory of fiscal federalism holds that for certain public goods, the decision to provide these goods in a decentralized fashion can increase efficiency and accountability in resource allocation (Bird and Vaillancourt, 1998 as cited in Kwom, 2003; Oates, 1999).
However recent studies have held that the conventional argument that decentralized provision of public goods will increase efficiency in resource allocation may not be applicable in developing countries (Bahi and Linn, 1994; Prud’homme, 1995). Recent experience with fiscal decentralization in numerous developing and transition economies has led many observers to question whether fiscal decentralization undermines macroeconomic stability. In several countries, central government transfers to lower-level governments have increased fiscal deficits at the central level, creating pressures on central banks to monetize additional debt and thus jeopardizing stability. In other countries, central governments attempting to control their deficits have reduced transfers to lower-level governments, creating fiscal distress at lower levels (Wellisch and Wildasin, 1996).
Most developing countries do not meet implicit or explicit assumptions posed by the fiscal federalism theory. In developing countries, for example, local voter preferences may not be as readily reflected in local budget outcomes as in developed countries. Local governments have weak administrative capacities to carry out their own fiscal decisions. Without an independent decision-making capacity to determine the quantity and quality of public goods provided and sources of finance that internalize the costs, decentralized provision of local public goods may not increase efficiency (Kwon, 2008).
Several studies in developed countries regarding decentralization have found that the stage of economic development in a country measured by income, urbanization and the Gross Domestic Product (GDP) is associated with a significantly greater subnational share of expenditures (Kee, 1977; Bahi and Nath, 1986; Waisylenko, 1987; Panizza, 1999).
Despite the controversy concerning the effects of fiscal decentralization in developing countries, fiscal decentralization continues to take place in developing countries as well as in developed ones. There has been a growing body of literature that deals with fiscal decentralization in developing and transition economies. The emerging literature clearly departs from the broad principles and practices of fiscal federalism to the quality of macroeconomic governance because it perceives the federal system as possessing high potentials for macroeconomic mismanagement and instability (Prud’homme, 1994). As Oates (1994) puts it, “fiscal federalism has much to offer, but it is a complicated enterprise”. The common conclusion which seems to arise from such views is that a decentralized governance structure is incompatible with prudent fiscal management (Tanzi, 1996).
Many of the empirical literature on Nigeria have been concerned with explaining the pattern of intergovernmental relations (Mbanefor, 1993; Sarah et al, 2003) or providing an impressionistic view within the context of political economy of possible consequences of such relationships (Ekpo, 1994). A notable exception is the work of Aigbokhan (1999) and Chete (1998) which investigate the relationship between fiscal federalism and economic growth. Missing from the empirical literature on Nigeria is an empirical analysis of the impact of fiscal decentralization on macroeconomic performance. In an attempt to fill this void, this study is therefore an extension of previous studies that are based on one macroeconomic variable, as the thesis is more comprehensive in its scope.
Fiscal federalism in Nigeria dates back to 1954 when the country, which had until then been governed as a unitary state by the British, adopted a federal constitution. However, despite over fifty years of experience with fiscal federalism, the country is still beset with the challenges of macroeconomic management, poor output growth rate, high inflation rate, and weak balance of payment position. The absence of good macroeconomic governance has also raised the problematic issue of credibility in public policy. Relevant question central to this thesis is could fiscal federalism challenges be responsible for poor macroeconomic performance in Nigeria? Another question is: What are the current issues promoting or inhibiting the principles and practice of fiscal federalism in Nigeria? In Nigeria, fiscal federalism has generated intense debate and controversy in recent years. Debates about fiscal management within federal system are not peculiar to Nigeria. From independence in 1960 till date (2011) Nigeria’s fiscal management system has neither been efficient nor equitable (Ike, 1981). Indeed it manifested a wide spectrum of vulnerability, ethnicity, language, region and religion interactively forming Nigeria’s matrix of cultural pluralism (Ike, 1981). The Federal Government has, for more than four decades assumed certain responsibilities which rightly belonged to the lower tiers of government and, in the process, had compromised efficiency in public expenditure management, resulting in high levels of unsustainable overall deficits, high inflation, slow economic growth and poor external sector balance (Ike, 1981; Anyanwu, 1995; Aigbokhan 1999; Chete, 1998).
There is the problem of how to allocate revenue vertically to the different tiers of government in relation to the constitutionally assigned functions. The discordance between fiscal capacity of the various levels of government and their expenditure responsibilities, and the non-correspondence problem, is a striking feature of the Nigeria federal finance. There is also the problem of how revenue should be shared horizontally among the states and among the local councils. All these put together have far-reaching implications for the harmonious co-existence of the component units and hence of the system as a geo-political entity (Elaigwu, 1994). The success of a federal system depends on an acceptable distribution of resources and functions among the different tiers of government so that efficiency in the use of scarce resources is encouraged towards achieving macroeconomic stability. All these are the issues of concern in this study.
1.3 Research Questions
Given the sensitivity and dynamics of the issues involved in this study the study seeks to provide answers to the following research questions;
(i) Could fiscal federalism challenges be responsible for poor macroeconomic performance in
Nigeria?
(ii) What are the factors inhibiting or promoting the principles and practice of fiscal federalism
in Nigeria?
1.4 Objectives of the Study
The overall objective of this study is to investigate the relationship between fiscal decentralization and macroeconomic performance in Nigeria. The specific objectives are to:
(i) Examine the evolution, structure and practices of fiscal federalism in Nigeria;
(ii) Investigate the underlying factors promoting or inhibiting the true practice of fiscal federalism in Nigeria;
(iii) Determine the extent of fiscal decentralization in Nigeria;
(iv) Analyze the empirical effects of fiscal decentralization on some selected indicators of macroeconomic performance: economic growth, inflation rate, interest rate and exchange rate.
1.5 Statement of Research Hypotheses
The following testable hypotheses which are drawn from the research questions are considered appropriate for this study and are therefore subjected to empirical investigation. These hypotheses are stated in their null context as follows:
H0: There is no significant decentralization in Nigeria
H0: Fiscal decentralization does not significantly influence economic growth in Nigeria
H0: Fiscal decentralization does not significantly influence inflation rate in Nigeria
H0: Fiscal decentralization does not significantly influence exchange rate in Nigeria
H0: Fiscal decentralization does not significantly influence interest rate in Nigeria
H0: The true practice of fiscal federalism has not been inhibited by any factors in Nigeria.
1.6 Scope of the Study
The study examines the relationship between fiscal federalism and macroeconomic performance in Nigeria and employs data covering a period of thirty eight year (1970-2007). The choice of this period is explained by the availability of data. Also 2007 is taken as the cut off year as it marked the end of the first eight year dispensation in the third republic. This period is also crucial given the years of military rule and the relative centralization within a federal framework, leading to a greater homogenization or uniformity than it is federally desirable. From three regions in 1960, the country grew to four regions in 1963. During the Civil War of 1967 to 1970, the country was carved into twelve states. By 1976, the states had increased to nineteen and it remained that way until 1987 when it was increased to 21. In August, 1991, the number of states increased to 30 and a separate Federal Capital Territory was carved out in place of the old capital in Lagos. By October 1996, six additional states were created, thus bringing the total number to 36, excluding the Federal Capital Territory and 774 local governments. These changes have very serious implications on revenue transfers to states and local governments. This increasing number of units at the lower tiers has raised the issue of the viability of these components units of government with far reaching implications for a stable fiscal federalism and political economy. Also the dominance of oil as major source of government revenue during this period posed serious challenge to fiscal federalism
Focusing on Nigeria, provides an in-depth analysis of the determinants of a stable fiscal federalism in a plural society and how fiscal federalism can transform an organic union into a flourishing, strong and virile economy, and becoming one of the top twenty economies in the world. The study also reviewed fiscal federalism in developed countries, LDCs and transition economies.
1.7 Justification for the Study
There has been a resurgence of interest in many parts of the world in problems of multi-level government finance. While there are several reasons that fiscal decentralization has been adopted around the world, the common reason motivating much of the research on fiscal decentralization is its potential to improve the performance of the public sector and thereby enhance prospects for higher growth. Established federations in developed countries have been the traditional focus of economic research on fiscal federalism. Theoretically, fiscal decentralization is expected to foster growth by transferring spending power to the levels of government that are best equipped to meet local demand adequately. However the role of decentralization as a means to foster growth and development has been questioned in recent literature. Much of the new literature points out that decentralization can be dangerous, especially in developing countries. Above all, skeptics point out the challenges of macroeconomic management, adjustment, and reform in decentralized system especially when they feature formally federal constitutions that empower states with veto authority over central government decisions (Treisman, 1999; Wibbels, 2006; Davoodi and Zou, 1998; Tanzi, 1995; Prud’homme, 1995).
There are several ways that fiscal decentralization may affect macroeconomic performance in theory. On the one hand, decentralization may provide a useful restraint on central profligacy. On the other hand, it may create dangerous incentives for local fiscal free-riding. Or it may lock in current patterns of fiscal and monetary policy, whether profligate or conservative, by increasing the number of actors with a veto over changing the system of macroeconomic governance. Both the theoretical and empirical literature reveals that the relationship between fiscal decentralization and macroeconomic stability is somewhat complex. Also the impact of fiscal decentralization on growth and development is an empirical issue that needs to be resolved.
This study is therefore, important for a number of reasons. First, though the literature on fiscal federalism has blossomed over the years, yet these studies have focused more on developed countries (Agiobenebo, 1999; Olowonini, 1999; Anyanwu, 1999). Secondly, the study establishes a foundation for policy-makers for sequencing reforms of government in developing countries. Finally the formalized theory (i.e. theoretical model) provides applied economists with a meaningful specification for estimating the impact of fiscal federalism on macroeconomic performance.
1.8 Structure of the Study
The study is divided into six chapters. The first chapter deals with the introduction, and the second chapter reviews the theoretical literature, the empirical literature, and methodological issues in the literature. The third chapter focuses on the evolution, practices, and profile of fiscal federalism in Nigeria. The fourth chapter comprises of the theoretical framework and methodology. The fifth chapter is model estimation and analysis of results. Chapter six comprises of the summary of findings, recommendations, conclusions, as well as limitations of the study and suggestions for further research.
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