"Decentralization, Tax Evasion, and the Underground Economy: A Model 
with Evidence from Russia"

TREISMAN, Daniel
treisman@polisci.ucla.edu

Abstract:

      Economic models of decentralization generally emphasize 
beneficial consequences--efficient provision of local public goods, 
hard budget constraints, and sorting of residents according to 
taste.  This paper notes two less benign effects. First, political 
decentralization makes it easier for subnational governments to       
collude with enterprises at the center¹s expense, offering firms 
political protection against central tax collectors and bankruptcy
agents (Œregional fiscal protection¹). Second, because
multiregional enterprises have a larger set of potential regional
protectors, political decentralization advantages them over
smaller, single-region firms (the Œmultiregional advantage¹).
      Fiscal decentralization alleviates some problems, but 
exacerbates others such as the shift of output underground. A simple 
model shows how these and other phenomena follow from the assumption 
of revenue-maximizing governments in a state with inter-level
revenue-sharing and imperfect law enforcement. Various predictions
of the model are compared to recent economic experience in Russia
and are found to fit remarkably well. Many problems--including
official stagnation, booming underground economy, growing
interregional fiscal inequality, economic dominance of the
Œoligarchs¹, falling federal tax revenues, and frequent economic
conflict between central and regional governments--that are often
explained by ad hoc and personal factors (Yeltsin¹s health,
high-level corruption, misguided economic reform strategies) can
all be traced at least in part to the logic of competition in a
decentralizing, revenue-sharing state.