Unobserved Heterogeneity and Bias in Tests of the Leviathan Hypothesis

Abstract

This paper highlights a potential source of bias in empirical tests that attemptto link the level of fiscal centralization to the total amount of public spending in a givenjurisdiction. This paper is the first to propose biased estimation as a possible explanationfor the mixed results in this line of literature and is also the first to test for this bias bycontrolling for both time-variant and time-invariant population heterogeneity. We beginby establishing a link between government centralization and the level of heterogeneityof preferences among constituents. We then combine this link with results from recentstudies that link heterogeneity to lower levels of public provision, which highlights thesource of our proposed bias. Our model uses ethnic fractionalization as well as incomeinequality as measures of time-variant heterogeneity of preferences. We find that theomission of time-invariant heterogeneity has an impact on the estimated relationshipbetween centralization and public spending. Depending on the specification, the resultingbias can be severe enough to change the estimated direction of the relationship betweencentralization and spending. (H77, H73)