How does fiscal decentralization affect CO2 emissions? The roles of institutions and human capital

Highlights: • The fiscal decentralization-CO₂ nexus for seven OECD countries is examined. • Cross-sectional dependence and slope heterogeneity exist within the data. • Indirect impacts of fiscal decentralization on CO₂ through institutional quality and human capital are found. • One-way causality runs from fiscal decentralization to CO₂ emissions. The debate regarding whether fiscal decentralization can effectively mitigate carbon dioxide (CO₂) emissions has gained increasing attention, although there is little empirical evidence to support this issue. To provide empirical evidence in support of the theoretical argument, this study investigates the impact of fiscal decentralization on CO₂ emissions by using a balanced panel dataset of seven OECD countries between 1990 and 2018. Further, we explore the roles institutions and human capital play in the impact of fiscal decentralization on CO₂ emissions. Hence, in addition to the direct impact, we assume fiscal decentralization could indirectly affect CO₂ emissions through various channels, such as institutions and human capital. The empirical results indicate that fiscal decentralization improves environmental quality. Moreover, the relationship between fiscal decentralization and environmental quality is strengthened by improvements in the quality of institutions and the development of human capital. In addition, there are one-way effects from fiscal decentralization, GDP, human capital, eco-innovation, and institutional quality on CO₂ emissions, but not the other way round. In terms of policy implications, this study suggests that by authorizing a lower unit of the state, countries could successfully implement policies related to improving environmental quality.