This dissertation explores the effects of inter-governmental transfers on macroeconomic stability, evaluating the case of Peru, which experienced a large increase in transfers to local governments from 2001 to 2010, linked to the fiscal revenue from the development of natural resources.

The findings indicate that, although the surge in transfers in Peru is not an imminent threat on macroeconomic stability, it created a fiscal risk through two main channels. First, the reduction in the fiscal space of the central government to conduct counter-cyclical fiscal policy, since it shares with sub-national governments an increased proportion of its revenue from corporate income tax on extractive industries, which is the tax that grew most in Peru over the last decade and is also the most volatile. And second, the high increase of local expenditures due to increased transfers from the central government, which is a manifestation of the flypaper effect. This increased local expenditure contributed to a larger share of local government participation in the general government. In turn, this increased participation contributed to put pressure on the central government to allocate more funds to local governments when transfers fell. Contrary to conventional wisdom, the results also show that local governments in Peru do not reduce their fiscal effort in terms of own taxation in response to the high increase in transfers.

This dissertation builds on the literature on the link between decentralization and macroeconomic stability, with particular reference to the allocation of the fiscal revenue from the development of natural resources among levels of government, which is an important issue in many countries around the world, in the context of the high rise in commodity prices of the last decade. It provides lessons related to the consequences of sharing a large proportion of the fiscal revenue from the development of natural resources with sub-national governments, as well as policy options for Peru to improve its decentralization process.