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KYUSHU UNIVERSITY DOCTORAL THESIS 07/ 2022 Empirical studies on Strategic Interactions among Neighboring Municipalities in Japan NGUYEN TUAN DUNG KYUSHU UNIVERSITY Graduate School of Economics Department of Economic Engineering The dissertation was accepted for the defence of the degree of Doctor of Philosophy in Economics on June 2022. Takeshi Miyazaki, Department of Economic Engineering, Graduate School of Economics, Kyushu University, Fukuoka, Japan. Co-supervisor 1: Prof. Taro Takimoto, Department of Economic Engineering, Graduate School of Economics, Kyushu University, Fukuoka, Japan.

Co-supervisor 2: Prof. Kunio Urakawa Department of Economic Engineering, Graduate School of Economics, Kyushu University, Fukuoka, Japan. Defence of the thesis: June 24, 2022, Fukuoka, Japan. Declaration: Hereby I declare that this doctoral thesis, my original investigation and achievement, submitted for the doctoral degree at Kyushu University, has not been submitted for any academic degree elsewhere.

Nguyen Tuan Dung _____________________________________ Signature 2 Table of Contents Abstract. 6 List of Figures. 7 List of Tables. Non-cooperative regime.

Previous empirical studies on strategic interaction in public expenditure 16 2. Spending interaction in developing countries. Intervention practices from central governments.3 Previous empirical studies on strategic interaction in public salaries. Strategic interaction in municipal spending.

Strategic interaction in public salary levels. Post-Great East Japan Earthquake policies regarding public sector salaries. Local public servant salaries. Possible sources of strategic interaction.

82 4 Abstract The thesis aims to systematically synthesize the theoretical background and recent empirical evidence on strategic interaction among jurisdictions regarding public spending and to uncover empirical shreds of evidence on the presence of strategic interaction among neighboring Japanese municipalities regarding changes in municipal spending and public salary levels. Variables on the attributes of 1704 Japanese municipalities from 2010 to 2016 will be used, to empirically examine whether municipalities change their public expenditure/public salary levels in response to corresponding changes in neighboring municipalities. I will build spatial models that took into account both correlations in spatial lag and spatial error. The models will be estimated by the Generalized Spatial Two-Stage Least Squares estimators for the main analysis and the Maximum Likelihood estimators for robustness checks.

It is suggested from the results that the Japanese municipalities may consider their neighbors’ choices in making local expenditure/public salary decisions. The spatial strategic interactions on local public expenditures among Japanese municipalities exist, as revealed by the positive and statistically significant spatial lag coefficients at conventional levels. Exceptionally, in the periods following intervention by the central government, there were significant positive impacts of changes in neighboring municipalities’ public sector salary levels on changes in a given municipality. The results are consistent across various specifications used as robustness checks, including the use of different spatial weighting matrices, additional control variables, and spatial panel models.

The findings and suggestions drawn from this thesis might provide useful insights for central governments in formulating effective regional planning and fiscal policies to make expenditure flow at sub-national levels more equal and efficient. 5 Abbreviations EDI Economic Development Incentives FITS-M Fiscal Index Tables for Similar Municipalities FY Fiscal year GEJE Great East Japan Earthquake GS2SLS Generalized Spatial Two-Stage Least Squares estimator IV-GMM Instrument variable- Generalized Method of Moment LAT Local allocation tax LM Lagrange Multiplier LSS Service for impaired people ML Maximum likelihood NRW North Rhine-Westphalia OLS Ordinary Least Squares QML Quasi-maximum likelihood S2SLS Spatial Two Stage Least Squares SAR Spatial Autoregressive model SARMA Spatial Autoregressive Moving Average model SDM Spatial Durbin Model SEM Spatial Error model SLX Spatial Lag of X model SUR-GNS General Nesting Spatial Seemingly Unrelated Regressions SYS-GMM System generalized method of moments US United States 6 List of Figures Figure 4-A. Average Laspeyres Index Values, 2010–2016. Kernel Distribution of Laspeyres Index Values for 2010, 2012, 2014, and 2016.

Kernel Distributions of Change Rates in Laspeyres Index Values between 2010 and 2011, 2011 and 2012, 2012 and 2014, and 2014 and 2016. Differences between a Municipality’s Own Laspeyres Index Values and those of Neighboring Municipalities’ within 60 km between 2014 and 2010. 56 7 List of Tables Table 2-A. Evidences of expenditure spillovers stimulating spending interactions.

Evidences of yardstick competition stimulating spending interactions. Evidences of fiscal competition stimulating spending interactions. Evidences of inter-government cooperation. Evidences of political ideology stimulating spending interactions.

Evidence of social learning stimulating spending interactions. Summary statistics of variables in 2010 and 2016. Diagnostics tests for spatial dependence. Spatial interactions in the change of municipal expenditure among the Japanese neighboring municipalities (GS2SLS).

Spatial interactions in the change of municipal expenditure among the Japanese municipalities (ML). Summary statistics of variables in 2010 and 2014. Spatial model estimates from year-by-year cross-sectional regressions. Spatial interactions among municipalities regarding public sector salary levels.

Spatial interactions among municipalities regarding salary changes under other differenced specifications. Spatial interactions among municipalities regarding salary levels under spatial panel models. Variable units, definitions, and sources. 82 8 Acknowledgements First and foremost, I would like to express my deepest appreciation to my advisor, Professor Takeshi Miyazaki, for the dedicated support and guidance throughout my Ph.

His patience, inspiration, and willingness helped me go through difficulties that I myself may struggle with and cannot get through. I am deeply indebted to my sub-supervisors, Professor Taro Takimoto and Professor Kunio Urakawa, for their insightful comments and suggestions, which significantly enhance my thesis and widen my horizon of knowledge. Moreover, I would like to thank all my professors at Kyushu University for their knowledge shared with me during class hours, seminars, and presentations. I would like to extend my special thanks to Professor Ohga Chiharu and professors at the International Student Center for teaching us initial survival Japanese, which is essentially beneficial to our healthier, happier, and more colorful life in Japan.

Special thanks should also go to my fellow friends, especially Yu Younan, Tapan Mahmud, Wang Li and Yasunori Ito for their support and their sincere friendship that allow me to continue working hard. I also would like to express my warm gratitude to the Japanese government, which through the Monbukagakusho Scholarship, enables me to pursue my academic goals and cherish our family moments without much worry. Last but not least, I would like to thank my family: my wife, two lovely daughters, parents, and sisters for their continuous support and understanding. They provide me with physical and spiritual strength to make my Ph.

study more enjoyable and meaningful. 9 Chapter 1 Introduction In the past three decades, decentralization has been a focal point of policy reform in most parts of the world. The delegation of extended fiscal autonomy to assign more public expenditures and revenues from the central government to local governments have been widely recommended by the policy advisors. The key driver for the growing interest in fiscal decentralization is "to increase efficiency, transparency, and accountability in the public sector" (Ebel & Yilmaz, 2002, p.

Greater autonomy of local governments opens up the likelihood of local fiscal interactions. The traditional belief was that a jurisdiction’s spending depends solely on its income, its grants from other levels of government, and its demographic and/or political characteristics. However, sub-national governments do not make their decisions in isolation. There is another important determinant of the state and local government expenditures: the expenditures of neighboring authorities.

Citizens and public servants are likely to be influenced by the actions of nearby jurisdictions. Spatial interactions in the level and structure of expenditures used to receive less attention in the literature than tax interactions. However, in the last two decades, there has been a substantial rise in the empirical works that examine whether sub-national governments make their spending decisions by taking into account the behavior of their neighbors (López et al., 2017; Ferraresi et al. The increasing concern could be because local governments rarely have large tax competencies, for that reason “spending decisions gain much more weight” (Langer, 2019).

Case et al. (1993) are popularly considered the first ones who formalized the notion of expenditures of neighboring jurisdictions as an important determinant of own government expenditures. Although the above-mentioned subject has reached an identifiable state of maturity, there is no extensive review that generalizes and synthesizes the recent empirical studies on the horizontal spending interaction among neighboring 10 governments. The only review paper about strategic interaction among governments was written roughly 20 years ago (Bruecker, 2003).

Therefore, I provide a proper review of theoretical background and empirical evidences found in the recent studies on fiscal spending interdependence among neighboring jurisdictions. The former empirical works have shown shreds of evidence that confirm the hypothesis that local jurisdictions do not make spending decisions in isolation. Those empirical studies on strategic interaction in light of government expenditures are diverse in categories of spending as well as researching countries, including total expenditure in Indonesia (Granado et.al, 2008), current expenditure in Italy (Bartolini & Santolini, 2012) as well as different sub-categories like culture in Sweden (Lunberg, 2006), education in China (Gu, 2012), industry- infrastructure in Czech (Lenka, 2009), and business development in the US (Wang, 2018), to name a few. However, previous evidence drawn from quasi- experimental approach employing exogenous variation is scarce.

Quasi- experimental settings that provide exogenous variation in the variable of interest are required to consistently estimate the spatial interaction parameters in the field of spatial econometrics (Gibbons & Overman, 2010). To fill the research gap, I construct two studies on strategic interaction among Japanese municipalities that employ quasi-experimental approach. While the former study focuses on strategic interaction regarding public expenditures in general; the latter goes further in discovering the counterpart strategic interaction in public salary – one of the core subcategories of government spending. The first study aims to estimate the responses of Japanese municipalities to changes in municipal spending in their neighboring municipalities, using the number of houses destroyed in each municipality by the Great East Japan Earthquake (GEJE) – the most powerful earthquake ever recorded in Japan and one of the costliest earthquakes in human history – as a source of exogenous 11 variation in local spending.

I built a spatial model that examined both interdependences in spatial lag and spatial error. The model is estimated by the Generalized Spatial Two-Stage Least Squares estimator (GS2SLS) and is further checked by maximum likelihood estimation. The results indicate that spatial strategic interactions on local public expenditures among Japanese municipalities exist, revealed by the positive and statistically significant spatial lag coefficients at conventional levels. The robustness check using maximum likelihood estimation also show comparable and consistent results.

It is suggested that the Japanese municipalities in the study sample may consider their neighbors’ choices in making local expenditure decisions. Appropriate salary levels in the public sector are crucial for ensuring the quality and efficiency of public services (Morikawa 2016). However, it remains unclear whether local jurisdictions consider their neighboring jurisdictions’ salary levels while making decisions regarding modifying their public sector salaries. Thus, my second study aims to provide evidence of strategic interaction among Japanese municipalities while determining public sector salaries.

Using a sample of 1704 Japanese municipalities from 2010 to 2016, we empirically examine whether municipalities change their salary levels in response to the changes of other municipalities. Close attention is paid to the influence of central government policies on public sector salaries following the GEJE and its aftermath. I also develop a spatial model incorporating both spatial lag and error dependence and use a generalized spatial two-stage least squares approach to obtain estimates (Kelejian and Prucha 1998, 2010). The results suggest that municipalities do pay attention to other municipalities when making decisions on their public sector salaries.

In the periods following intervention by the central government, there were significant positive impacts of changes in neighboring municipalities’ public sector salary levels on the corresponding changes in a given municipality. The results are consistent across various specifications used as robustness checks, including the use of different spatial weighting matrices, 12 additional control variables, and spatial panel models.