Innovation: Fiscal Decentralisation and Corruption

In this short post, we are to provide support to the argument that the degree of fiscal decentralisation affects the innovation milieu of a country through influencing the closeness among relevant stakeholders (public, private and third sector).

Closeness, corruption, innovation milieu

To this end, we have two considerations: (i) a more decentralised structure is closer to the society and thus it promises more fiscal prudency, visibility and transparency that in turn reduces the level of corruption; (ii) and at the same time, it offers more sustained collaboration opportunities because of the trust base of stakeholders is underpinned by more moderate corruption. In this course, a more intensive way of learning through failed and succeeded innovations and imitations are on the cards in a highly decentralised structure over the more centralised ones. In short, their innovation ecosystems tend to perform better.
Chart 1 devotes attention to the relationship between fiscal decentralisation and corruption perception in 2012. Again, the ensuing feature of a more centralised institutional architecture appears to be less efficient anti-corruption framework, i.e. more corruption perception. It holds in case of Eastern Partnership Countries (EPCs) like Armenia, Azerbaijan, Belarus, Georgia and Ukraine. It seems that higher level of fiscal decentralisation supported Georgia to have substantially less corruption perception compared to other EPC countries, however.[1]
Chart 1. Fiscal decentralisation and corruption perception in selected countries (2012)
Chart 1. Fiscal decentralisation and corruption perception in selected countries (2012)Note: vertical axis refers to the Corruption Perception index developed by the Transparency International (2012), while horizontal axis represents the fiscal decentralisation index prepared by Ivanyna and Shah (2013). Source: own compilation based on data mentioned.
Additionally, if we consider the correlation between the governance closeness to the society including business sphere (Governance Closeness Index, GCI) and innovation performance, we can claim with due diligence that the link between is medium strong (i.e. correlation is slightly above 0.6) (Chart 2). As a consequence, being closer to the society and business spheres may imply greater chance for meaningful collaborations and a more fertile innovation milieu.[2]
Chart 2. Governance closeness index and innovation performance
chart2 Notes: Governance closeness index is stem from Ivanyna and Shah (2013), while for innovation performance the Innovation subindex of the Global Competitiveness Report 2012 was used. Source: own compilation based on data mentioned.
This more fertile innovation milieu is mainly guaranteed by lower level of corruption and informal economy which safeguards the basic incentives to aspire to efficiency and effectiveness improving techniques and solutions. The positive consequence of decentralisation has been long illustrated even at firm level. Enterprises with decentralised product-oriented feedback mechanisms have proved to be much more flexible and innovative than centralised ones (Kolodny – Dresner, 1981). The opportunity to rely on feedback mechanism also implies that enterprises have the necessary willingness to obtain knowledge from outside the firm’s wall and to be engaged in ‘open innovation’. This is not entirely the case in EPC countries.
As the godfather of public choice theory and a pioneer of the theory of fiscal federalism with competition, James M. Buchanan emphasized: improved allocations and results can only be achievable if improvements happen in the institutions that generate them (Buchanan, 1967). Additionally, as Buchanan and Musgrave (1998) accentuated, an exit option should be given to the citizens to have a chance to leave the service offered them in one place and to claim a better one in another. It would have a disciplinarian effect on those who are to exploit through a political and bureaucratic structure. So that the State Leviathan can be significantly curbed which is in line with the Hayekian view stating that liberal state offers more room for trial and error, thus innovation freedom.

On the degree of closeness (centralisation, decentralisation)

One final point on the degree of decentralisation and centralisation may be in order. After what degree of centralisation (decentralisation) can we attribute negative (positive) effect to the given institutional architecture? Aristotel once said that sometimes quesitioning the question itself is a better way forward. Why should we believe in a certain turning point? We do by no means want to give a misleading feeling of comfort that we can identify a solid turning point, a turning degree of which after the positive and negative features are gaining momentum in an easily identifiable way.
In 1600, William Gilbert discovered that an iron piece is magnetic, however, was not able to explain why it loses its magnetic capability when it is glowing with very high temperature in a furnace. Almost 400 years later, mankind discovered that the order of iron atoms is shifting towards chaos during continuous warming so that magnetic ability is dissolving with the higher and higher temperature. Nevertheless, there must be a critical point when the order of iron atoms and the chaos appearing in their system are more or less equal: there must be a situation when neither the order nor the chaos can rule. By now we know that this critical point is at 770 °C. The long lasting analysis of critical points suggest that there are critical points that can only reached through fining, interventions (warming that iron piece), and there are also critical points that can evolve by itself (e.g. when snowfalls trigger avalanche at a certain point, at a critical point).
In a wider sense, regarding economic-social system, order can be seen as a situation when formal and informal institutions are in harmony by providing fertile ground for development and growth. A crucial uncertainty inducing mechanism (i.e. one that might be able to govern towards critical point) can be given by the development of politics which is, of course, influenced vica-versa by informal institutions. In a more centralised system, where government is far from the average voter representing the society, the country’s political elite is more likely to have weaving relations with elites defined as individuals at the top tenth percentile of the income distribution including influential interest groups.
And “when the elites’ interests differ from those of the rest of society, it is their views that count – almost exclusively” (Rodrik, 2014). In other words, illiberalism can come into force.
Rodrik thinks it over and states that “A politician who represents the interests primarily of economic elites has to find other means of appealing to the masses. Such an alternative is provided by the politics of nationalism, sectarianism, and identity – a politics based on cultural values and symbolism rather than bread-and-butter interests. […] Identity politics is malignant because it tends to draw boundaries around a privileged in-group and requires the exclusion of outsiders – those of other countries, values, religions, or ethnicities. This can be seen most clearly in illiberal democracies such as Russia, Turkey, and Hungary. In order to solidify their electoral base, leaders in these countries appeal heavily to national, cultural, and religious symbols.”
The above mentioned may lend support to the following implication. The intermediate range, neither the high harmony nor the extreme disharmony between formal and informal institutions seems to be a playing field of political system and politics. Further research would be of essence in getting a better understanding why it is worth over long run to make efforts to maintain the socio-economic-political system in such an intermediate phase and what kinds of repercusions are associated with those efforts. For sure, long term commitment to democratic values, sound governance, modern public services to increase well-being of people, and so on cannot be seen as granted. More decentralisation might be seen as an instructive way forward.
Some aspects of this analysis are parts of a comprehensive research project, called INNOVER EAST which addresses the issue of how to increase energy efficiency in EPCs by looking at their innovation ecosystems. See more on INNOVER EAST: http://www.innovereast.eu/

Buchanan, J. M. (1967):Public Finance in Democratic Process. The University of North Carolina Press, Chapel Hill.
Buchanan, J. M. – Musgrave, R. A. (1998): Public Finance and Public Choice: Two Contrasting Visions of the State. MIT Press, Cambridge, London
Kolodny, H. F. – Dresner, B. (1981): Linking Arrangements and New Work Designs: A Study of the Coordination between Self-Maintaining Units and Their Organisational Context. Ontario Quality of Working Life Centre, Toronto.
Ivanyna, M. – Shah, A. (2013): How Close Is Your Government to Its People? Worldwide Indicators on Localization and Decentralization. World Bank, Policy Research Working Paper No. 6138 Available: http://elibrary.worldbank.org/doi/pdf/10.1596/1813-9450-6138 Accessed on: 26.08.2014
Rodrik, D. (2014): How Rich Rule. Project-Syndicate, Available: http://www.project-syndicate.org/commentary/dani-rodrik-says-that-widening-inequality-drives-economic-elites-toward-sectarian-politics Accessed on: 11.09.2014

[1] This intuitively foreseeable insight was recently documented and tested econometrically by Ivanyna and Shah (2013). The authors argue that more decentralised governance as measured by governance closeness index (GCI) is associated with higher human development, lower corruption, and higher growth.

[2] Corruption offers a springboard to the issue of informal economy. Because of the corruption-prone environment, the size of the informal economy is corpulent in EPC countries, especially in Georgia (Schneider et al. 2010; Schneider, 2012). The fact that the share of firms competing against unregistered firms (in % of total firms) is relatively high in Belarus (42.9), Georgia (54.1) and Ukraine (50.2) also indicates to some extent the rather innovation deterring feature of the countries. Data stem from World Bank Development Indicators.