It seems that federal competition has worked for the US. From a new published paper by Hatfield and Kosec:
This paper exploits exogenous variation in the natural topography of the United States to estimate the causal impact of inter-jurisdictional competition on income growth. We find that doubling the number of county governments in a metropolitan area leads to a 17% increase in the average annual growth rate of earnings per employee over 1969–2006, and a 10% increase in 2006 income per employee. Decomposing income effects using 2000 Census worker-level data, we find that approximately half of the effect stems from making workers more productive, while the other half comes from changing the composition of the workforce and inducing workers to work more hours. We also present evidence that inter-jurisdictional competition leads local governments to raise more in taxes, spend more, and issue more debt (per capita), but does not help them obtain more inter-governmental transfers. However, the additional cost from this increase in expenditures to a median-wage employee is much smaller than the increase in that employee's wages due to greater inter-jurisdictional competition.
The key to their method
. . . we focus on one nation—the United States— and consider how variation in the number of competing jurisdictions across metropolitan statistical areas (MSAs) affects growth. To address threats to identification, we implement an instrumental variables strategy inspired by Hoxby (2000): we use the total miles of small streams in an MSA to instrument for its number of county governments. We argue that, while small streams are unlikely to directly affect growth in the modern era, more streams increased the number of natural “break-points” between counties at the time of an MSA’s founding, leading to more counties and thus more inter-jurisdictional competition.
We investigate the effect of inter-jurisdictional competition on economic growth using data from Metropolitan Statistical Areas (MSAs) and Consolidated Metropolitan Statistical Areas (CMSAs) in the United States. We refer to the collection of MSAs and CMSAs as MSAs. MSAs are comprised of an urbanized nucleus with a population of at least 50,000 and the collection of adjacent communities that have a high degree of integration with that nucleus (as evidenced by commuter patterns).
The draft is here.
Federal competition has worked for the US, and I wish it would also work in developing countries. Federal competition is not equivalent of "decentralization," although decentralization is a requirement for it. The main purpose of decentralization is to empower local governments that know best the needs and constraints of their localities to facilitate bottom-up solutions to local problems. Federal competition means something else, it means that local governments compete for people and businesses to move to their territories, and they compete by providing better public service than their competitors. This is happening, but very rarely, in some developing countries (although it might be happening more often than we think). In Guatemala, for example, there are some municipalities that are doing quite well in terms of the provision of public services, and more people are moving there (one example is the municipality of Santa Catarina Pinula). Good management of the public finances is key, and they have done it. Leadership is key as well.
A friend of mine (Juan Roberto Brenes) wanted to create new municipalities in Guatemala, using public land. This is similar to the idea of charter cities.