Fiscal decentralization as a strategic risk-management tool: Institutional threshold effects on EU output volatility

Abstract

This study examines whether fiscal decentralization operates as a strategic macroeconomic risk-management instrument and whether its effectiveness depends on institutional quality. Using a balanced panel of 27 European Union member states over 2008–2023, a composite fiscal decentralization index combining expenditure and revenue autonomy is constructed, and a dynamic specification is estimated using a two-step System-GMM estimator. Output volatility is measured as a five-year rolling standard deviation of real GDP growth. The results indicate that fiscal decentralization exhibits a statistically significant effect on volatility whose direction depends on governance quality. Institutional quality directly reduces volatility, and the interaction between decentralization and institutional quality is negative and highly significant. A critical institutional threshold of 1.865 (WGI estimate scale), above which decentralization reduces output volatility, is identified. These findings indicate that decentralization functions as a conditional risk-management mechanism embedded within institutional capacity. The results provide policy-relevant insights into EU fiscal architecture design in an era of recurrent macroeconomic shocks.