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The literature on fiscal decentralization (fd) has been thriving, while its welfare implications under political diversity has not yet been explored formally in a satisfactory way. This paper attempts to fill this gap by presenting a formal model where, given a degree of fd, the central government chooses the general tax rate to maximize a weighted sum of local utilities and local governments choose their tax collection effort. The non-cooperative solution of the model reveals that while the tax rate increases with the extent of fd and political unison, local tax collection effort decreases in both. Regional spillovers have a negative effect on local tax collection efficiency and a positive effect on the optimal tax rate. We find that the central government utility peaks at a lower level of fd than the case with no spillovers, which lends support for the Decentralization Theorem. The model also indicates that polarization and income inequality have clear negative effects on welfare in case of spillovers.
