In this paper, I test the effect of fiscal decentralisation on ethnic conflict while emphasising state capacities as a crucial mediating variable. I assume that fiscal decentralisation is unlikely to produce any effect in countries characterised by low state capacities and weak institutions.
The rationale is threefold. (i) State capacities are usually lower at the local level than at the central level; yet implementing fiscal decentralisation requires that subunits are endowed with sufficient bureaucratic and technical competences. (ii) Devolution of policy-making authority to lower tiers of governments is usually assumed more genuine in countries characterised by good governance. (iii) When state capacities are weak, ethnic groups may be tempted to claim more than fiscal decentralisation and seek independence.
I assume also that minorities that are the most ethnically distant from the rest of the population are those that should benefit most from fiscal decentralisation. The system GMM estimations confirm that ethnically distinctive minorities benefit more from fiscal decentralisation. Regarding state capacities, findings are radically different with respect to the indicators that are used. Fiscal decentralisation is found to reduce the likelihood of conflict if GDP per capita is considered as a proxy for state capacity, while opposite results emerge when governance indices are used.