Social capital, institutions and tax decentralization

The quality of the institutional environment is a crucial issue in understanding the effective outcome of fiscal decentralization initiatives. However, there has been so far very little work on the subject. In this paper we contribute to fill this gap by considering the municipalities belonging to three provinces in Southern Italy and proxying the presence of a weak institutional environment with the capture of the local government by Mafia-type organizations. The analysis exploits an unforeseen change in fiscal policy by central government increasing Vertical Fiscal Imbalances and tests whether the effects of the lower tax decentralization on municipal spending are conditioned by the quality of the institutional environment. We find no sensible effects when the institutional environment is weak; on the contrary, a 4-6% increase in average spending per capita is estimated as a consequence of the lower tax autonomy in municipalities not captured by Mafia clans. The evidence is robust both to controls for potential confounding factors and sensitivity analyses. Overall, our findings suggest that some caution is needed before deciding to devolve more fiscal power to lower tiers of government.