Revisiting the Fiscal Decentralization-Income Inequality Nexus: Fourier Cointegration and Causality Evidence from High- and Low-Decentralized OECD Countries

Abstract

Income inequality remains a major policy challenge across OECD countries despite relatively advanced welfare systems and redistributive institutions. In this context, fiscal decentralization (FD) has frequently been proposed as a mechanism for improving the responsiveness and effectiveness of public policies. However, the empirical literature provides conflicting evidence regarding whether FD reduces or increases income inequality. This study re-examines the relationship between FD and income inequality in 29 OECD countries over the period 1996-2022. FD is measured using a composite index constructed through principal component analysis that jointly captures revenue and expenditure decentralization. The empirical analysis employs Fourier-augmented panel cointegration, augmented mean group (AMG) estimation, and Fourier Toda-Yamamoto causality techniques, allowing for cross-sectional dependence and smooth structural changes. The results confirm the existence of a long-run relationship between FD and income inequality. However, AMG estimates reveal substantial cross-country heterogeneity, with FD reducing inequality in some countries while increasing it in others. Furthermore, the causality results indicate that the direction of influence varies with countries' degree of FD. In highly decentralized OECD countries, income inequality causes FD, whereas in less decentralized countries, FD causes income inequality. Robustness analyses using expenditure and revenue decentralization measures further reveal inequality-reducing effects in less-decentralized countries. These findings suggest that the distributive consequences of FD are conditional, multidimensional, and stage-dependent rather than uniform across countries. The study contributes to the literature by demonstrating that the FD-income inequality nexus varies with decentralization levels and may evolve from a policy instrument to an institutional response mechanism. From a policy perspective, the results imply that decentralization reforms should be designed in accordance with countries' existing fiscal structures and supported by appropriate revenue authority and fiscal equalization arrangements.