Ann Reg Sci 40:661676 (2006)

DOI 10.1007/s00168-006-0060-z

ORIGIN AL PAPER

Jaime Bonet

Fiscal decentralization and regional

income disparities: evidence
from the Colombian experience

Received: 9 July 2005 / Accepted: 4 August 2005 / Published online: 12 April 2006
Springer-Verlag 2006

Abstract Using the Colombian experience, this paper introduces new empirical
evidence about the relationship between fiscal decentralization and regional
income disparities. The study has made some advances in the empirical analysis of
this relationship. First, a panel data approach is introduced to catch the dynamics of
adjustment involved in a fiscal decentralization policy. Secondly, the analysis is
based on a country experience rather than a cross-country analysis, so the effects of
fiscal decentralization are estimated more objectively than previous research that
exhibits cultural, historical, and institutional variation. Finally, other limitations
observed in previous work, such as the absence of spatial dependence and
sensitivity of the conclusions to the measures of fiscal decentralization used, are
addressed in this paper.
JEL Classification H77 . O18 . R11 . R58
1 Introduction
Although there were some previous fiscal decentralization attempts in Colombia,
the breakpoint was the Political Constitution of 1991. This legislation strengthened
the fiscal decentralization process introducing important changes in the distribution
of resources and responsibilities among the different levels of government. At the
end of the 1990s, this scheme of transfers was caught in the middle of a deep fiscal
crisis and associated slowdown in the growth of the Colombian economy.
J. Bonet (*)
Banco de la Repblica de Colombia (Colombian Central Bank), Regional Economics Application
Laboratory (REAL), University of Illinois at Urbana-Champagne, Urbana, IL, USA
E-mail: jbonetmo@banrep.gov.co
Present Address:
Edificio Banco de la Repblica, El Centro Plaza de Bolivar, Calle 33 # 3-123,
Cartagena, Colombia, South America

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J. Bonet

Notwithstanding the fiscal decentralization process, Colombian regional

income disparities increased during the same period. The departmental sigma
convergence in the real per capita gross domestic product (GDP) increased from
0.34 in 1980 to 0.48 in 2000. This increase was especially significant during the
1990s. At the beginning of this decade, the deviation of the logarithm of the real per
capita GDP was 0.37, reaching 0.5 in 1997.1
The latest studies about fiscal decentralization in Colombia focused on its
macroeconomic implications, especially on its impact on the increasing public
deficit.2 There is little analysis about the influence of fiscal decentralization on
regional income inequalities, one exception being the work of Baron and Meisel
(2003). Although these authors argue that the decentralization process increased
regional income disparities in Colombia during the 1990s, they do not formally test
the relationship between these two variables. Since Colombia experienced
profound structural reforms during the last decade, it is difficult to determine to
what extent the fiscal decentralization process is responsible for the increase in
regional income disparities.3 Hence, the purpose of this paper is to clarify the link
between fiscal decentralization and regional income imbalances in Colombia.
Using panel data estimation, we test the relationship between these two variables
controlling for the effect of other possible explanatory variables such as trade
liberalization and production agglomeration.
This study contributes some new advances in the empirical analysis of fiscal
decentralization. First, we introduce a panel data approach that offers greater
flexibility in accommodating the dynamics of adjustment involved in this policy.
Secondly, we explore the spatial pattern in our panel data set using two spatial tests
that have not been used in previous work. Thirdly, the fact that we use a single
country experience rather than a cross-country analysis allows us to estimate the
effects of fiscal decentralization more objectively than in the previous research,
which ignored cultural, historical, and institutional variation. Finally, the linkage
established in this paper is robust to the variables used to measure decentralization.
We show that the Colombian fiscal decentralization process increased regional
income disparities during the last decade. The allocation of a major portion of the
new local resources to current spending (e.g., wages and salaries), instead of capital
or infrastructure investments, seems to explain this result. In addition, we identify
that the redistributive component in the national transfers was seriously limited
during this period. Finally, the decentralization policy has been implemented
without adequate incentives from the national to the subnational levels to promote
efficient use.
The paper is organized as follows. Section 2 presents a literature review about
the theoretical link between fiscal decentralization and regional income disparities,
as well as the empirical research in this area. Section 3 includes an overview of the
1 During

the 1990s, several papers (Meisel 1993, Mora and Salazar 1994, Birchenall and Murcia
1996, Rocha and Vivas 1998, and Bonet and Meisel 1999, among others) found a polarization
process in regional incomes in the post-war period.
2 Some of these papers are Junguito et al. (1995), Alesina et al. (2000), Correa and Steiner (1999),
Echavarria et al. (2002), Iregui et al. (2001), and Sanchez et al. (2002).
3 During the 1990s, Colombia was immersed in an intense process of structural reforms. An
economic liberalization process introduced trade reforms and opening to direct foreign
investment. There were also labor and social security system reforms, monetary and financial
reforms giving autonomy to the Central Bank, and deregulation and privatization of the economy.

Fiscal decentralization and regional income disparities

663

1990s Colombian fiscal decentralization policy. Section 4 presents the econometric

model and Section 5 contains the analysis of the estimations results. Finally,
Section 6 offers some concluding remarks.
2 Literature review
The theoretical link between decentralization and regional income inequalities can
be established in two different frameworks: pure and non-pure fiscal decentralization. In the pure system, local governments raise pure local taxes and undertake
pure local expenditures, without the benefit of central government transfers. On the
other hand, a non-pure system is composed of local governments having just
the responsibility of allocating resources, without any additional responsibility.
The revenue collection is done by the national government, and, then, these
resources are transferred to subnational governments, according to some
criteria.
In the economic case of pure fiscal decentralization, Armstrong and Taylor
(2000) point out that a key argument in support of decentralization could be the
boost to supply-side policies and long-term growth. A modern growth theory
places much greater emphasis on supply-side policies than a traditional Keynesian
theory, with its emphasis on taxation, spending, and demand. Thus, fiscal
decentralization offers the opportunity for a much more effective regional policy
than one run by the central government, because subnational authorities can control
the key functions that can be used to drive supply-side policies.
Nonetheless, arguments against fiscal decentralizations role in enhancing the
reduction of regional imbalances can also be found in the pure framework. In a
decentralized system, local governments would collect all taxes from and
undertake all expenditures on behalf of its residents, devoid of any consideration
of the other jurisdiction. In contrast, a centralized system would redistribute income
from richer regions to poorer ones, even under regressive tax and expenditure
system in which per capita expenditures or benefits increase as per capita income
increases.
In contrast, a non-pure decentralization scheme offers a different perspective.
Here, a large share of taxes is collected by the national government and then
transferred to regions that have the allocation responsibility. In practice, some
decentralized countries transfer resources from national to local levels, according to
some redistribution criteria, to introduce a horizontal equity among the subnational
entities. By incorporating an adequate transfer system, fiscal decentralization will
encourage development in lagged areas and, consequently, will improve equity
among regions.
Shah (1997) states that industrial countries experiences show that successful
fiscal decentralization cannot be achieved in the absence of a well-designed fiscal
transfer program. Such a program can enhance competition for supply of public
goods, accountability of the fiscal system, and fiscal coordination. Shah points out
that in developing countries, with a few exceptions, transfers with an explicit
standard of equalization are not practiced; instead, they build transfer dependency
and discourage development of responsive and accountable governance. The final
result in developing countries may be fiscal chaos and slow economic growth, and
strangulation of fiscally underprivileged regions.

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J. Bonet

The conclusions in the empirical work developed in this area are also
contradictory. Kim et al. (2003) for Korea and Gil et al. (2002), in a sample of 15
OECD countries, find a positive association between decentralization and regional
income disparity in Korea. Taking a sample of 24 developed and underdeveloped
countries, Shankar and Shah (2001) show that regional development policies have
failed in almost all countries: federal and unitary alike. Finally, other papers
identify a negative relationship between fiscal decentralization and regional
income disparity. These are the works of Tsui (1996) and Qiao et al. (2002) for
China and Rodriguez-Pose and Gill (2003) with a sample of 12 countries.
3 The Colombian fiscal decentralization process
In Colombia, fiscal decentralization can be characterized as a process of gradual
increase in transfers and responsibilities from the national to subnational
governments with limited local autonomy over their spending decisions. The
Political Constitution of 1991 states that about 46.5% of the national revenues
should be transferred to the subnational governments. The resources must be
allocated primarily into the education and health care sectors according to some
rules established in the decrees and laws issued to develop the constitutional spirit.4
To typify this fiscal decentralization process, we have built some indicators to
show the behavior of the expenditures and revenues for national and subnational
governments.5 The indicators express both expenditure and revenue in per capita
terms, as a proportion of the total aggregate revenue and expenditure, and as a
percent of GDP. In addition, we have developed an indicator of the subnational
governments autonomy as the ratio between locally collected revenues to total
local expenditures; the larger this indicator, the greater the local autonomy.6
As Fig. 1 shows, the distribution of revenue among the different levels of
government did not exhibit significant changes during the period analyzed. In
1984, the aggregate subnational revenues corresponded to 27% of total revenues,
whereas, the remaining 73% was collected by the national government. A similar
pattern is observed during the whole period. In 2000, the subnational governments
revenues accounted for 26% and the national for 76%. There is just a change in the
composition of the subnational share because departments lost participation and
municipalities won. While departments accounted for 17% and municipalities for
10% of total revenue in 1984, those shares were 10 and 15% respectively, in 2000.
4 For a thorough historical review of the Colombian decentralization process, see Correa and
Steiner (1999), Iregui et al. (2001) and Sanchez et al. (2002).
5 The source of the fiscal data is the Ministry of Finance. The subnational fiscal database was
produced by the Direccion de Apoyo Fiscal, based on the fiscal information of the Contraloria
General de la Repblica and Banco de la Repblica. For the municipal level, the database
contains information for 804 municipalities that represent 89% of the national population of
2000. For subnational revenues, we take the current incomes, which include tax and non-tax
incomes and capital income. That is, we just exclude the value of transfers from another level of
government. We do not limit the subnational revenues to local taxes income because these
governments have autonomy over two other sources: non-tax and capital income.
6 These indicators have been built by extracting the national transfers from the national
governments expenditures, and from the subnational governments revenues. In this way, both
the national governments expenditures and subnational governments revenues are net of
transfers.

Fiscal decentralization and regional income disparities

665

Colombian Revenue by Level

of Goverment, 1984 - 2000

Percentage

100
80
Municipal

60

Departmental

40

National

20

00

98

20

96

19

94

19

92

19

90

19

88

19

86

19

19

19

84

Year

Fig. 1 Colombian revenue by level of government, 19842000

This behavior reflects the fact that fiscal decentralization has been focused on
the expenditure side. There were no significant changes in the subnational tax
system during this period. The new Constitution maintains the restrictions to create
or modify taxes by departments or municipalities. According to this legislation,
taxes can only be created by the National Congress. Therefore, departments and
municipalities are constitutionally prevented from creating new taxes. Additionally, some local taxes present a specific allocation with rates that are unchanged
(Iregui et al. 2001).
As is observed in Figs. 2 and 3, both revenues as a percentage of GDP and
revenues in per capita terms exhibit a similar pattern: growth at the national and
municipal levels and decrease at the department level. The fact that decentralization
granted more importance to municipalities, rather than departments, seems to
explain the decrease in the departmental revenues share in favor of municipal
revenue. In addition, subnational taxes are more dynamic at the municipal level
than at the departmental one. While the municipal revenues grew at 12% per year in
real terms, the departmental revenues grew at only 3%.

Percentage

Revenue as a Percentage
of GDP, 1984 - 2000
20
18
16
14
12
10
8
6
4
2
0
1984

1986

1988

1990

1992

1994

1996

1998

Year
National

Departmental

Municipal

Fig. 2 Evolution of the revenue as a percentage of GDP, 19842000

2000

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J. Bonet
Ratio between the per capita revenue by
level of government and the aggregate per capita
revenue
100.0

Percentage

80.0
60.0

1984
2000

40.0
20.0
0.0

National

Departmental

Municipal

Level of Government

Fig. 3 Ratio between the per capita revenue by level of government and the aggregate per capita
revenue

At the subnational level, a spatial concentration of revenue is identified.

Approximately 70% of revenue is collected by five departmentsAntioquia,
Atlntico, Cundinamarca, Santander, and Valleand the district of Bogot.7 In
addition, there was a significant increase in the share of Bogots revenue in the
aggregate national revenue: from 12.4% in 1984 to 24.1% in 2000. As Bogots tax
revenue collection represented around 40% of the total municipal revenue in 2000,
the dynamism observed at the municipal level is mainly explained by the growth in
the capital city. This behavior seems to be the result of several institutional reforms
introduced during the 1990s.8
Looking at the expenditure side in Fig. 4, an important change in the
allocation of resources can be noted. In 1984, the national government controlled
77% of the aggregate expenditure, while the subnational ones managed 23%. In

Municipal
Departmental

20
0

19
9

19
9

19
9

19
9

19
9

19
8

19
8

19
8

National

Percentage

Expenditures by Level of Government, 1984 - 2000

100
90
80
70
60
50
40
30
20
10
0

Year

Fig. 4 Expenditures by level of government, 19842000

7 These six territorial entities accounted for approximately 64% of the national GDP, and 53% of
the national population.
8 For a detailed presentation of the Bogots experience, see Gutirrez and Guzmn (2000).

Fiscal decentralization and regional income disparities

667

Expenditures as a Percentage
of GDP, 1984 - 2000
16
14
Percentage

12
10
8
6
4
2
0
1984

1986

1988

1990

1992

1994

1996

1998

2000

Year
National

Departmental

Municipal

Fig. 5 Expenditures as a percentage of GDP, 19842000

2000, the national governments share was 58% and that of the subnational 42%.
After the fiscal decentralization process was strengthened by the Political
Constitution of 1991, the allocation of public spending experienced a significant
change in its distribution. As was observed in the revenue data, the change was
substantially larger at the municipal expenditure level than at the departmental
expenditure level. Municipal expenditures represented 10% of aggregate
expenditures in 1984 and 25% in 2000. On the other hand, departmental
expenditures increased their share from 13 to 17%. This reflects the municipal
bias in the decentralization process.
Measuring expenditure as a percentage of the national GDP, included in Fig. 5,
an increase in this share can be observed at the different levels of government. The
increases were especially significant during the 1990s. The subnational level
increases were the result of the changes introduced by the Political Constitution of
1991. Additionally, Fig. 6 shows changes in the per-capita expenditure as a

Percentage

Ratio between the per capita

expenditure by level of government and the
aggregate per capita expenditure
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0

1984
2000

National

Departmental

Municipal

Level of Government

Fig. 6 Ratio between the per-capita expenditure by level of government and the aggregate per
capita expenditure

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J. Bonet
Ratio between local revenue to expenditure
by level of government, 1984 - 2002
120

Percentage

100
80
60
40
20

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

Year

Departmental

Municipal

Fig. 7 Ratio between local revenue to expenditure by level of government, 19842002

percentage of the national average, with a decrease at the national level and
increases in municipalities and departments.
Similar to the pattern observed in the revenue data, there is spatial concentration
in the subnational total expenditures. Antioquia, Atlntico, Bogot, Cundinamarca,
Santander, and Valle allocated 61% of the total subnational expenditures in 2000.
The concentration is larger in municipalities than in departments. About 71% of
municipal expenditures was allocated by the municipalities of these territorial
entities, and Bogot alone represented 35% of this total.
Another important characteristic of the Colombian decentralization process is
the increasing dependence of subnational governments on the transfers from the
central government. As can be gauged in Fig. 7, whereas the departments own
revenues represented 97% of its expenditures in 1984, this ratio was 45% in 2000.
Something similar happened to the municipalities where their own tax collections
were 76% of their expenditures in 1984 and 44% in 2000.
4 The econometric model
Having described the major changes in revenues and expenditures, attention will
now be focused on estimating the effects of the Colombian fiscal decentralization
process on regional income disparities. The following model is used:
Ii;t 1 2 FDi;t 3 CV i;t i;t
where Ii,t is regional income inequality measured as follows:





PCGDPi;t


Ii;t



1


PCGDPNAL;t

(1)

(2)

and PCGDPi,t is the departmental per capita GDP, and PCGDPNAL,t is the national
per capita GDP. This measure allows us to use a panel data approach in the

Fiscal decentralization and regional income disparities

669

estimation in which i corresponds to departments (i=1, 2,..., 33) and t corresponds

to years of analysis (t=1990, 1991,...., 2000).
Following Qiao et al. (2002), this measure of inequality is based on the concept
of the relative per capita GDP. With perfect equality or an ideal equity condition,
the departmental per capita GDP should be equal to the national average for all
regions in a given year. Then, the inequality measure is the distance from the
relative share to the perfect equal share. For departments with an initial relative per
capita GDP higher than one, an increase in their share indicates that fiscal
decentralization leads to a greater inequality, while a decrease means a more
equitable outcome. Similarly, inequality increases if departments with an initial
relative share of less than one see their shares decrease further, moving away from
one due to fiscal decentralization. The larger the distance in absolute terms, the
higher the inequality in the regional income.9
FDi,t is a measure of fiscal decentralization. Since the 1990s policy in Colombia
introduced significant change in the allocation of resource, but not in their
collection, we consider that the expenditures indicators of decentralization really
reflect that policy. The emphasis of the fiscal policy was on the expenditure side,
not in the revenue collection. Therefore, these indicators are considered as the
measure of fiscal decentralization to determine its impacts on regional income
imbalance. Three different indicators are used: expenditure in per capita terms,
expenditure as a percent of GDP, and share of the departmental expenditure in the
total.
Based on our theoretical framework, we can expect either positive or negative
relationship between decentralization and regional disparities. Taking into account
the non-pure fiscal decentralization framework, the main argument in favor of a
positive linkage between decentralization and reduction of regional imbalances is
the existence of an equitable transfer system. In a pure decentralized schema, a
positive linkage between fiscal decentralization and regional income disparities can
be expected because local authorities have more autonomy to perform the policy
intervention needed to correct regional imbalances.
The analysis of the impact of the decentralization policy on the regional income
disparities in Colombia must take into account the fact that this policy is focused on
two sectors: education and health. By having a direct impact on those sectors, the
policy would influence on the local human resources endowment. Therefore, a
linkage between the enlarged expenditures and the wealth creation at the local level
can be expected through the impact on the human capital included in the regional
production function. The understanding of this relationship will contribute to the
design of adequate regional policies.
CVi,t includes other potential explanatory variables of regional income
inequality in Colombia. We include two variables that might be the main forces
affecting regional income disparity in Colombia during the 1990s. The first one is

9 This measure of income inequality was introduced to run our panel data model at the province
level. Aggregating the measure for each department by year, we obtain an estimate of the national
income inequality. This aggregated measure follows a trend similar to the traditional measures of
inequalities such as Theil index, Gini coefficient, or Sigma convergence. For instance, the
correlation coefficient between our measure and those measures are 0.8, 0.97 and 0.95,
respectively.

670

J. Bonet

the production agglomeration that has taken place in Colombia in the last decades,
with Bogot assuming an increasing importance in the countrys urban network.10
The agglomeration of production can directly cause income disparities when there
are barriers to the inter-regional labor migration or when, as is observed in
developing countries, there exists a labor surplus in the economy. In this study, the
agglomeration production is taken into account through the share of each territory
in the total GDP.
The second factor affecting regional income disparity is the trade liberalization
process carried out in Colombia at the end of the 1980s and the beginning of the
1990s. Colombian industry tariffs were lowered from 43% in 1988 to 11.9% in
1992, and quantitative restrictions were also fully dismantled. To explore to what
extent the trade liberalization policy affected regional income disparities, the share
of total volume of foreign trade in the GDP is included as a measure of the degree
of openness in each territory.11
5 Analysis of the empirical results
The first step in the estimation was to test for potential spatial dependence or
heterogeneity in our observations. According to Anselin (1987), the presence of
spatial problems can cause bias and inconsistency in the OLS estimators.
Intuitively, we can expect a degree of spatial dependence among the expenditure
decisions adopted by each region. For instance, the allocation of resources to
education or health care sector in one department could depend on how much its
neighbors spend.
To test spatial autocorrelation in the error terms, we applied two tests. First, we
ran the model year by year estimating Morans I in the error terms of the crosssection data.12 Secondly, we use a Lagrange multiplier test to discriminate between
spatial error and spatial lag models considering a simple cross-section time series

10 What had been singular in Colombia until the 1960s was that urban growth was quite uniform
among the four main cities. However, beginning in the 1960s, urban growth paralleled the
experience of other Latin American countries with a pattern of one dominant city. At the end of
the period 19602000, Bogot had the major participation in the national GDP; in 1960, this
region contributed 15% of the national GDP, whereas, by 2000, this share increased to 22%.
11 Data have been taken from different sources. The GDP and population information are
provided by the Colombian Statistical Agency (DANE), the fiscal information were taken from
the two sources mentioned in Section 3, and the export and import data were provided by the
Banco de la Repblica. For the purpose of this estimation, the subnational level is composed of
municipalities, districts, and departments.
12 Morans index is the most used measure of spatial dependence. When the weight matrix is
normalized such that the row elements sum up to 1, the I statistic is I e0 We=e0 e, where e is a
vector of OLS residuals and W is the standardized weight matrix. The null hypothesis is the
absence of spatial dependence (Anselin 1987).

Fiscal decentralization and regional income disparities

671

Table 1 Spatial dependence analysis

Year

Morans I in the error terma

Model 1
Value

1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000

0.317
0.407
0.598
0.685
0.314
0.742
0.268
0.270
0.093
0.492
1.218

Model 2
Probability
0.751
0.684
0.550
0.493
0.754
0.458
0.789
0.787
0.926
0.623
0.223

Value
0.018
0.454
1.003
0.784
1.074
1.606
1.080
0.920
0.342
0.026
0.487

Model 3
Probability
0.985
0.650
0.316
0.433
0.283
0.108
0.280
0.358
0.732
0.980
0.626

Value
0.252
0.406
0.384
0.468
0.615
1.083
1.522
0.940
0.013
0.479
0.896

Probability
0.801
0.684
0.701
0.640
0.588
0.279
0.128
0.347
0.989
0.632
0.370

The difference between the models is the measure of fiscal decentralization. Model 1 uses per
capita aggregate expenditures, model 2 uses the share of aggregate expenditures in the total, and
model 3 uses the aggregate expenditure as a percentage of GDP
a
A first-order contiguity matrix-type queen was used

pooled model.13 Both tests were estimated using a first-order weight matrix,14 and
three different models which correspond to the diverse measures of fiscal
decentralization from the expenditure side: expenditure in per-capita terms (Model
1), share of the departmental expenditure in the total (Model 2), and expenditure as a
percent of GDP (Model 3).
As can be observed in Table 1, Morans I is not significant during the years of
analysis for any of the three models estimated. It indicates that the errors are
randomly distributed in the space and, consequently, there is no evidence of spatial
dependence in our data. Additionally, Table 2 includes the results for the LM tests.
These results indicate that the null hypothesis of non-spatial lag and non-spatial
error cannot be rejected. Hence, both Morans I and LM tests support the idea of no
spatial dependence in our panel data.
Based on the result of Morans I and LM tests, we estimate the model using the
traditional panel data estimation procedures. To take into account the possible
existence of unobservable differences that are systematically related across the

e0 W  e=e0 e=N
formula of the LM test for spatial error is LMERR tr W  2 W  0 W  and for spatial lag is

2
e0 W  y=e0 e=N i
LMLAG h
, where e is the estimated error,
b and
0


0

1
b
W X b

IN
X X 0 X
W X b


 2 trW  2 W  W 
2

13 The

b2 are the OLS estimations of the estimators and variance, and W  IT  W . These statistics have
an asymptotic 2(1) (Anselin et al. 2004).
14 A weight matrix is a measure for spatial dependence based on the notion of binary contiguity
between spatial units. This notion implies that the underlying structure of neighbors is expressed
by 01 values. They are considered to be contiguous, and a value of 1 is assigned, when two
spatial units have a common border of non-zero length (Anselin 1987).

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J. Bonet

Table 2 Lagrange multiplier testsa

Model

Model 1
Model 2
Model 3

LM error test

LM lag test

Value

Probability

Value

Probability

0.12063
0.18206
0.00525

0.728
0.670
0.942

2.07E-03
0.48596
0.39488

0.964
0.486
0.530

The different models reflect the different measures on fiscal decentralization. Model 1 uses percapita aggregate expenditures, model 2 uses the share of aggregate expenditures in the total, and
model 3 uses the aggregate expenditure as a percentage of GDP
a
A first-order contiguity matrix-type queen was used

departments, we estimate fixed and random models using our three models. To
determine which model (fixed or random) is appropriate for our data, we apply the
Hausman specification test. As can be observed in Table 3, the Hausman
specification tests rejected the assumption of independence in the three models.
Consequently, the fixed model is the best specification of our model.15
The results of the different estimations are included in Table 3. Following
Bhargava et al. (1982), we use the DurbinWatson statistic to test the OLS
residuals of the fixed-effect models for serial correlation. Given evidence of
autocorrelation in the error terms, we ran a White heteroskedasticity-consistent
covariance estimates. According to Wooldridge (2002), the robust variance matrix
estimator is valid in the presence of any heteroskedasticity or serial correlation
when T is small relative to N, which is our case. Hence, the reported fixed models
results are robust in the presence of any heteroskedasticity or serial correlation.
The results show a positive relationship between the different measures of fiscal
decentralization and regional income disparities, which means that a higher decree
of decentralization is associated with an increase in regional income disparities.
The estimators of the fixed models are statistically significant at the 1% level of
confidence in the case of the subnational per capita expenditure and the subnational
expenditure as a percent of GDP variables, and statistically significant at the 10%
level of confidence in the case of the subnational expenditure as percent of GDP
variable. That indicates that the results are consistent no matter what measure of
fiscal decentralization is taken. In addition, the two additional control variables
trade openness and production agglomerationturned out to be positive and
statistically significant at the 1% level of confidence. Hence, we can conclude that
the Colombian fiscal decentralization process has contributed to the increase of
regional income inequalities during the 1990s.
Why did fiscal decentralization fail to reduce regional income disparities in
Colombia? One of the main arguments is the lack of an equitable transfer system.
Although the Colombian transfer rules include some redistributive issues, the
resources transferred under these criteria have been seriously limited. As the 1991
Political Constitution states that no new responsibilities can be delegated without
assigning the necessary resources to finance them, the formula to transfer the
situado fiscal established that, initially, the amount distributed should guarantee

15 For more information about panel data estimation procedures and Hausmans specification test,
see Baltagi (2001) and Wooldridge (2002).

Fiscal decentralization and regional income disparities

673

Table 3 Results of fixed-effect models

Variable

Model 1

Aggregate per capita expenditure

4.13E-07
(6.13)a

Aggregate expenditure share

Model 2

5.23
(1.86)b

Aggregate expenditure as percent of GDP

Openness indicator
Agglomeration index
Adjusted R-squared
Number of observations
Hausmans specification test
DurbinWatson test

Model 3

0.6291
(3.72)a
31.49
(3.92)a
0.81
363
64.49a
0.78

0.6857
(3.77)a
33.75
(3.90)a
0.78
363
77.46a
0.64

0.3087
(2.94)a
0.6673
(3.69)a
34.5
(3.86)a
0.78
363
73.32a
0.63

Significant at 1%: White heteroskedasticity-consistent covariance estimate

Significant at 10%: White heteroskedasticity-consistent covariance estimate

enough resources to cover the same level of public goods produced during the
previous year. Given the scarce resources, this condition implies that the remaining
resources, which are those to be distributed according to some redistributive
criteria, are seriously limited. For instance, according to the distribution of the 2001
situado fiscal (CONPES, 2001), the first criteria took approximately 85% of the
transferred resources, whereas, the remaining 15% was available to be allocated
based on the redistributive criteria. Hence, the available resources to increase
coverage were not enough to overcome the observed disparities.
Another argument to explain the negative association between fiscal
decentralization and regional income disparities in Colombia is the type of
expenditure allocated by the subnational governments. To reach higher economic
growth, an increase in local government spending can be a necessary, but not
sufficient, condition. According to Davoodi and Zou (1998), fiscal decentralization
measures do not distinguish between current spending (e.g., wages and salaries)
and capita spending; nor do they distinguish spending on welfare and social
security from infrastructure spending. As the conventional wisdom points towards
positive growth effects of capital and infrastructure spending and negative growth
effects of welfare and current spending, excessive spending by subnational
governments on the wrong expenditure items can lead to lower growth, even if
the expenditure assignment is optimal.
In Colombia, while capital and infrastructure spending are still allocated by the
national government, there was a significant increase in current spending in the two
sectors affected by decentralization: health and education. In the health care
system, Karl (2000) mentions that the 1997 average salary was 1.5 times higher
than the average salary mandated by the government. In the education sector, a
bargaining process between the national government and the powerful Teacher
Union determines the increase in wages. Cerquera et al. (2000) show that the

674

J. Bonet

education costs were higher than the resources allocated to this sector during the
period 19962000.
It should also be mentioned that many departments and municipalities lack the
institutional capacity to perform effectively the assigned functions (Ahmad and
Baer, 1997). The Social Policy National Council (CONPES, 2002) states that
decentralization has resulted in a dissipated expansion process with considerable
cost overruns as a consequence of an inadequate management in the territorial
entities. These problems are associated with an increase in the administrative staff
and low productivity. In some cases, the augmented inflow through the local levels
has been used to increase bureaucracy and corruption rather than an effective
provision of public goods.
From a pure fiscal decentralization scheme, we argue that the Colombian
experience failed because the efficiency gains have not materialized as revenue
collection and expenditure decisions by local governments were still constrained
by the central government. Wiesner (2003) points out that education and health, the
key sectors in the Colombian decentralization process, continue to be highly
centralized either because national funds are the main source of financing or
because national labor unions actually determine resource uses and policy priority.
Although there have been some improvements in the municipalities tax collection,
transfers are the main source of revenue.
Instead of arguing that subnational revenue dependence was a major constraint
to the success of the decentralization process, we consider that a major failure was
the incentives established by the legislation adopted. According to the policys
regulation, subnational governments receive resources no matter if they operate
efficiently or not. Hence, there is a perverse incentive to promote inefficiency. As
the transfer system does not take into account the local tax capacity, local
governments do not have any incentive to collect taxes. Moreover, the larger the
local expenditures, the larger the resources transferred. As a matter of fact,
subnational governments running large fiscal deficits were bailed out by the
national government during the 1990s.16
6 Conclusions
In this paper, we have provided a model to test the impact of the fiscal decentralization
process implemented in Colombia during the 1990s on the regional income
disparities. Using an inter-departmental panel data set, we find strong evidence
supporting the thesis that the fiscal decentralization process increased regional income
disparities during the period analyzed. This behavior seems to be explained by a set of
factors: the allocation of a major portion of the new local resources to current spending
(e.g., wages and salaries), instead of capital or infrastructure investments, the lack of a
redistributive component in the national transfers, the absence of adequate incentives
from the national to the subnational levels to promote an efficient use of them, and the
lack of institutional capacity at the subnational governments.

16 Detailed

information about this process can be found in Echavarria et al. (2002).

Fiscal decentralization and regional income disparities

675

The analysis of the empirical results provides important elements to discuss the
way in which fiscal decentralization policy affects regional income inequalities. An
equitable transfer system, an adequate selection of sectors in which resources are
allocated, and an adoption of the correct incentives seem to play an important role
in the success of decentralization reducing regional income disparities. Policy
makers must take into account these arguments to implement a better
decentralization policy.
Finally, we want to stress that our two controlling variables, the level of
openness of the economy and the economic agglomeration trend, also had a
negative impact on regional income imbalances. This result indicates that the
analysis of the 1990s structural reforms on the regional income disparities should
be the focus of further research. From the regional policy-maker point of view, it is
important to understand the regional structural changes that resulted from the
reforms.
Acknowledgements The author wants to thank Geoffrey Hewings, Werner Baer, Stephen
Parente, Maria Teresa Ramirez, Ana Maria Iregui, Armando Galvis, Javier Perez, and Adolfo
Meisel for their comments. He also thanks the Banco de la Republica de Colombia for its
financial assistance. The author takes responsibility for any errors.

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