Emerging Issues in Fiscal Federalism - Home - Forum of … · 2016-03-08 · 4 Emerging Issues in Fiscal Federalism The rest of the paper is organized as follows. Section 2 is con-cerned

Theme Paper

Emerging Issues in FiscalFederalism

Anwar ShahIndira RajaramanFernando Rezende

Abstract

This paper is intended to serve as a primer for the theme of fiscalfederalism—design of fiscal constitutions for countries wheregovernment functions are shared among multiple orders ofgovernment. Principles and practices in allocation of spending,taxing and regulatory responsibilities are presented followed bya discussion of current issues in practice. An overview of theprinciples and practices of intergovernmental transfers is pre-sented. A synthesis of tools and mechanisms for dealing with fiscalconflicts and overcoming regional fiscal disparity is elaborated.Finally, underlying reasons for the growing popularity of federalmodel of governance are explored.

1. Introduction

Fiscal federalism is concerned with the design of fiscal constitutionswhen decision-making is among various orders of governments. Thedesign of fiscal constitutions entails the division of powers for taxing,spending and regulatory functions as well as fiscal arrangementsthat accompany such arrangements. This paper presents an overviewof principles and practices in fiscal federalism and highlights emerg-ing challenges and responses to these challenges by federal countries.

4 Emerging Issues in Fiscal Federalism

The rest of the paper is organized as follows. Section 2 is con-cerned with the allocation of responsibilities. It provides an over-view of expenditure assignment principles and practices followedby tax assignment principles and practices. Section 3 provides anintroductory overview of intergovernmental finance and distilslessons from practice of intergovernmental transfers and institu-tional arrangements for fiscal relations. Section 4 deals with resolv-ing fiscal conflicts. Section 5 highlights mechanisms for achievingregional equity in federal countries. A final section reflects on thereasons behind the growing popularity of the federal model ofgovernance.

2. Allocation of Responsibilities

The “assignment problem”, or the allocation of expenditure andtax functions to various levels of governments, is the most funda-mental issue in a federation. It is therefore the first fiscal sub-theme we have identified for consideration. The literature on fiscalfederalism argues that finance should follow function. Assigningresponsibility for spending must, therefore, precede assigningresponsibility for taxation, because tax assignment is generallyguided by spending requirements at different levels and cannotbe determined in advance. It may be desirable to decentralizetaxation at the same time as decentralizing spending, so that sub-national governments will not have to rely exclusively on grantsfrom higher levels of government. If subnational governments arenot responsible for raising at least some level of their revenues, theymay have too little incentive to provide local public services in acost-effective way. If subnational governments are assigned morerevenues than their spending requires, they may have an incentiveto reduce taxes or increase public sector wages.

2.1 Expenditure Assignments Principles

The fiscal federalism literature provides broad guidance in delinea-ting expenditure responsibilities among member units in afederation. The basic principles enunciated by this literature are

Emerging Issues in Fiscal Federalism 5

relevant even for unitary states where subnational governments aresimply extensions of higher level governments. In such cases, byfollowing these principles, the central government’s agents face justthe right incentives for efficient and equitable delivery of publicservices. These principles are discussed below and qualificationswhere appropriate for unitary governments are stated.

2.1.1 Efficient Provision of Public Services

Public services are provided most efficiently “by the jurisdictionhaving control over the minimum geographic area that wouldinternalize benefits and costs of such provision” (Oates, 1972,p. 55). Nevertheless, some degree of central control or compen-satory grants may be warranted in the provision of services whenthere are spatial externalities or economies of scale.

2.1.2 Fiscal Efficiency

Decentralized decision-making in a federation results in differentialnet fiscal benefits (imputed benefits from public services minustax burden) being realized by citizens depending on the fiscal capa-cities of their place of residence. It is argued that such differentialnet benefits (NFBs) would encourage people to move to a resourcerich area, although appropriate economic opportunities may notexist. It is argued that the national government should have a rolein correcting such a “fiscal inefficiency” (Boadway and Shah, 1993;Boadway, Roberts, Shah, 1994).

2.1.3 Regional (Horizontal) Equity

Differential net fiscal benefits across various jurisdictions also leadto unequal treatment of citizens with identical private incomesdepending on their place of residence. This is because their after-tax income inclusive of NFB would be different depending on theirresidence. This calls for a role by the national government in dealingwith these fiscal inequities.

2.1.4 Redistributive Role of the Public Sector

While the central government may assume a dominant role inpursuit of vertical equity, involvement of subnational governments


in implementing specific programs can be tailored to meet indivi-dual jurisdictions’ circumstances (Boadway, 1992).

2.1.5 Provision of Quasi-Private Goods

Modern governments provide many services that by virtue of theirtechnologies are essentially private goods, for example, health,education, and social insurance. Public provision of these privateservices is justified on grounds of equity. Since benefits accruemainly to residents of separate jurisdictions, such services wouldbe better provided by subnational governments. A central govern-ment’s involvement is nevertheless justified to ensure horizontaland minimum standards of service in all jurisdictions—suchstandards for most services encourage the free flow of goods andservices in the nation as a whole.

2.1.6 Preservation of Internal Common Market

As suggested by Boadway (1992), constitutional guarantees for freedomestic flow of goods and services may be the best alternative toassigning regulatory responsibilities solely to the central govern-ment.

2.1.7 Economic Stabilization

It is customary to argue that the federal government should beresponsible for stabilization policies because such policies cannotbe carried out effectively by a local jurisdiction. Local pursuit ofsuch fiscal policies leads to much of the gains being lost to outsidejurisdictions. A monetary policy has little scope for being carriedout at a local level. These guidelines for a centralized fiscal policyhave, however, only limited relevance for a country with a decentra-lized constitution. Decentralized countries overcome these limita-tions by having an independent central bank with a mandate forprice stability and through institutional arrangements for fiscalpolicy consultation and coordination.

2.1.8 Spending Power

In a federation, there is always some degree of conflict among prio-rities established by various orders of government. One way to


induce lower order governments to follow priorities established bythe higher order government is for the higher order governmentto use its powers of the purse, the so-called spending power. Boththe national and state governments could legitimately pursue suchpolicies.

Besides having exclusive authority to carry out monetary policyand provide public services that are national in scope, the centralgovernment has a role in correcting fiscal inefficiencies and regionalinequities arising from differential fiscal capacities of various jurisdic-tions. It has also a redistributive role, exercised through a tax andtransfer system or through the joint provision of such public servicesas education and health, which are “transfers in kind” (Boadway,1992). The central government may also provide compensatorygrants to cover the spillovers from provincial-level services.

Both the central and provincial governments could providematching transfers to influence lower level priorities to further theirown objectives. All other services are best provided by local govern-ments, with central and provincial governments defining minimumstandards. Table 1 presents a representative assignment of majorpublic services based on theoretical considerations discussed earlier.The table shows that a significant number of major services wouldbe suitable for concurrent assignment to two or more orders ofgovernment. For such services, it is important to specify clearly andprecisely the roles of various levels of government to avoid duplica-tion and confusion and to ensure accountability to electorate. Suchprecise specification is critical for infrastructure and social servicesin most developing countries.

2.2 Roles and Responsibilities of

Local Governments

The fiscal federalism approach treats local government as asubordinate tier in a multi-tiered system and outlines principlesfor defining the roles and responsibilities of orders of government.Hence, one sees that in most federations, as in Canada and theUnited States (dual federalism), local governments are extensionsof the state governments. In a few isolated instances, as in Brazil

Tab

le 1

. R

epre

sent

ativ

e A

ssig

nmen

t of

Exp

endi

ture

Res

pons

ibili

ties

Func

tion

Polic

y, sta

ndar

ds,

Prov

ision

and

Prod

uctio

n an

dC

omm

ents

and

over

sight

adm

inist

rati

ondi

strib

utio

n

Inte

rreg

iona

l and

inte

rnat

iona

lU

UN

, PB

enef

its a

nd c

osts

inte

rnat

iona

lco

nflic

ts re

solu

tion

in sc

ope

Ext

erna

l Tra

deU

U, N

, SP

Ben

efits

and

cos

ts in

tern

atio

nal

in sc

ope

Tele

com

mun

icat

ions

U, N

PP

Has

nat

iona

l an

d gl

obal

dim

en-

sions

Fina

ncia

l tra

nsac

tions

U, N

PP

Has

nat

iona

l an

d gl

obal

dim

en-

sions

Env

iron

men

tU

, N, S

, LU

, N, S

, LN

, S, L

, PE

xter

nalit

ies

of g

loba

l, na

tion

al,

stat

e, a

nd lo

cal s

cope

Fore

ign

dire

ct in

vest

men

tN

, LL

PLo

cal i

nfra

stru

ctur

e cr

itica

l

Def

ence

NN

N, P

Ben

efits

and

cost

s nat

iona

l in

scop

e

Fore

ign

Affa

irs

NN

NB

enef

its an

d co

sts n

atio

nal i

n sc

ope

Mon

etar

y po

licy,

cur

renc

y,U

, IC

BIC

BIC

B, P

Inde

pen

den

ce f

rom

all

lev

els

and

bank

ing

esse

ntia

l; so

me

inte

rnat

iona

l rol

efo

r com

mon

disc

iplin

e

Inte

rsta

te co

mm

erce

Con

stitu

tion,

NN

PC

onst

itut

iona

l saf

egua

rds i

mpo

r-ta

nt fo

r fac

tors

and

goo

ds m

obili

ty

Tabl

e 1—

cont

inue

d

Func

tion

Polic

y, sta

ndar

ds,

Prov

ision

and

Prod

uctio

n an

dC

omm

ents

and

over

sight

adm

inist

rati

ondi

strib

utio

n

Imm

igra

tion

U, N

NN

U b

ecau

se o

f for

ced

exit

Tran

sfer

pay

men

tsN

NN

Red

istr

ibut

ion

Cri

min

al a

nd c

ivil

law

NN

NR

ule

of la

w, a

nat

iona

l con

cern

Indu

stri

al p

olic

yN

NP

Inte

nded

to

prev

ent

“beg

gar

thy

neig

hbou

r” p

olic

ies

Reg

ulat

ion

NN

, S, L

N, S

, L, P

Inte

rnal

com

mon

mar

ket

Fisc

al P

olic

yN

N, S

, LN

, S, L

, PC

oord

inat

ion

poss

ible

Nat

ural

Res

ourc

esN

N, S

, LN

, S, L

, PP

rom

otes

reg

iona

l eq

uity

and

inte

rnal

com

mon

mar

ket

Edu

catio

n, h

ealth

, and

soci

al w

elfa

reN

, S, L

S, L

S, L

, PTr

ansf

ers i

n ki

nd

Hig

hway

sN

, S, L

……

S, L

, PB

enef

its a

nd c

osts

var

y in

scop

e

Park

s and

recr

eatio

nN

, S, L

N, S

, LN

, S, L

. PB

enef

its a

nd c

osts

var

y in

scop

e

Polic

eS,

LS,

LS,

LPr

imar

ily lo

cal b

enef

its

Wat

er, s

ewer

, ref

use

and

fire

prot

ectio

nL

LL,

PPr

imar

ily lo

cal b

enef

its

Not

e: U

= su

pran

atio

nal r

espo

nsib

ility

, IC

B =

inde

pend

ent c

entr

al b

ank,

N =

nat

iona

l gov

ernm

ent,

S =

stat

e or

pro

vinc

ial g

over

nmen

t,L

= lo

cal g

over

nmen

t, P

= n

ongo

vern

men

tal s

ecto

rs o

r civ

il so

ciet

y.So

urce

: Sha

h (1

994,

200

4, 2

007)

and

Boa

dway

and

Sha

h (f

orth

com

ing)

.


(cooperative federalism), they are equal partners with higher-levelgovernments, and in an exceptional case, Switzerland, they are themain source of sovereignty and have greater constitutional signifi-cance than the federal government. Thus, depending on the consti-tutional and legal status of local governments, state governmentsin federal countries assume varying degrees of oversight of theprovision of local public services. That is why one sees an insig-nificant role for local governments in Australia but an expansive rolein Brazil and Switzerland.

The fiscal federalism literature, however, does provide a norma-tive framework for assignment of responsibilities to local govern-ments. The assignment of public services to local governments orto metropolitan or regional governments can be based on considera-tions such as economies of scale, economies of scope (appropriatebundling of local public services to improve efficiency throughinformation and coordination economies and enhanced account-ability through voter participation and cost recovery) and cost-benefit spillovers, proximity to beneficiaries, consumer preferences,and budgetary choices about the composition of spending (Table 2). Theparticular level of government to which a service is assigned deter-mines the public or private production of the service in accordance withconsi-derations of efficiency and equity. Large metropolitan areaswith populations in excess of one million could be considered forsubdivision into a first tier of municipal governments of smallersize responsible for neighbourhood-type services and a second tierof metropolitan-wide government providing area-wide services. Thefirst-tier governments could be directly elected, and elected mayorsof these governments could form the metropolitan council at thesecond tier. Two-tier structures for metropolitan governance havebeen practiced in Melbourne, Australia; Vancouver, Canada; Alleghenycounty, Pennsylvania, United States; and Stockholm, Sweden.

In mature federations, special-purpose agencies or bodiesdeliver a wide range of metropolitan and regional public services,including education, health, planning, recreation, and environ-mental protection. Such bodies can include education and libraryboards; transit and police commissions; and utilities providingwater, gas, and electricity. These agencies deal with public services


whose delivery areas transcend political jurisdictions and are betterfinanced by loans, user charges, and earmarked benefit taxes, suchas a supplementary mill rate on a property tax base to finance alocal school board. If kept to a minimum, such agencies help fullyexploit economies of scale in the delivery of services where politicalboundaries are not consistent with service areas. A proliferation ofthese agencies can undermine accountability and budgetary flexibi-lity at local levels. Accountability and responsiveness to voters areweakened if members of special-purpose bodies are appointed ratherthan elected. Budgetary flexibility is diminished if a majority oflocal expenditures fall outside the control of local councils.

2.3 Current Issues in Expenditure Assignment

The information revolution and globalization are posing specialchallenges to constitutional assignment within countries. The infor-mation revolution, by letting the sun shine on government opera-tions, empowers citizens to demand greater accountability fromtheir governments. Globalization and the information revolutionrepresent a gradual shift to supranational regimes and local gover-nance. In adapting to this world, there is a growing tension amongvarious orders of governments in federal systems to reposition theirroles in order to retain relevance. The federal and provincial govern-ments in mature federations are continuously redefining their roleswith the federal government attempting to take over some provin-cial functions while it looses its control in its traditional areas ofresponsibility to supranational regimes. Similarly, provincialgovernments seek greater involvement in local functions. In newfederations, decentralization of expenditure responsibilities is beingfollowed by regulatory oversight and controls by higher levelgovernments. Further, unfunded mandates to local governmentsrepresent a major source of tension. While the globalization andinformation revolution calls for local governments to perform awider role in local governance, assumption of such role is hamperedby constitutional and legal provisions in most federal countries andis further constrained by strategic behaviours of federal andprovincial governments.


Tabl

e 2.

Ass

ignm

ent

of l

ocal

pub

lic s

ervi

ces

to m

unic

ipal

and

reg

iona

l/m

etro

polit

an g

over

nmen

ts

Allo

catio

n cr

iteri

a fo

r pr

ovisi

onA

lloca

tion

crite

ria

for

publ

icvs

. pr

ivat

e pr

oduc

tion

Publ

ic se

rvic

eE

cono

mie

sE

cono

mie

sB

enef

itPo

litic

alC

onsu

mer

Eco

nom

icC

ompo

-Ef

fici-

Equ

ity

Com

posit

eof

scal

eof

scop

eco

stpr

oxi-

sove

r-ev

alua

-sit

een

cysp

illou

tm

ity

eign

tytio

n of

sect

oral

choi

ces

Fire

fig

htin

gL

LL

LL

ML

PG

P

Polic

e pr

otec

tion

LL

LL

LM

LP

GG

Ref

use

colle

ctio

nL

LL

LL

ML

PP

P

Nei

ghbo

urho

od p

arks

LL

LL

LM

LP

GG

Stre

et m

aint

enan

ceL

LL

LL

ML

PP

P

Traf

fic m

anag

emen

tL

ML

LL

ML

PP

P

Loca

l tra

nsit

ser

vice

LM

LL

LM

LP

PP

Loca

l lib

rari

esL

LL

LL

ML

GG

G

Prim

ary

educ

atio

nL

LM

ML

MM

PG

P, G

Seco

ndar

y ed

ucat

ion

LL

MM

LM

MP

GP,

G

Publ

ic t

rans

port

MM

ML,

MM

MM

P, G

GP,

G

Wat

er s

uppl

yM

MM

L, M

MM

MP

GP,

G


Tab

le 2

—co

ntin

ued

Allo

catio

n cr

iteri

a fo

r pr

ovisi

onA

lloca

tion

crite

ria

for

publ

icvs

. pr

ivat

e pr

oduc

tion

Publ

ic se

rvic

eE

cono

mie

sE

cono

mie

sB

enef

itPo

litic

alC

onsu

mer

Eco

nom

icC

ompo

-Ef

fici-

Equ

ity

Com

posit

eof

scal

eof

scop

eco

stpr

oxi-

sove

r-ev

alua

-sit

een

cysp

illou

tm

ity

eign

tytio

n of

sect

oral

choi

ces

Sew

age

disp

osal

MM

MM

MM

MP,

GP,

GP,

G

Ref

use

disp

osal

MM

MM

MM

MP

PP

Publ

ic h

ealt

hM

MM

MM

MM

GG

G

Hos

pita

lsM

MM

MM

MM

P, G

GP,

G

Ele

ctri

c po

wer

MM

MM

MM

MP

PP

Air

and

wat

er p

ollu

tion

MM

MM

MM

MG

GG

Spec

ial p

olic

eM

MM

MM

MM

GG

G

Reg

iona

l par

ksM

MM

L, M

MM

MG

GG

Reg

iona

l pl

anni

ngM

MM

L, M

MM

MG

GG

Not

e: L

is lo

cal g

over

nmen

t, M

is re

gion

al/m

etro

polit

an g

over

nmen

t; G

is p

ublic

sect

or, P

is n

ongo

vern

men

tal s

ecto

r.So

urce

: Sha

h (2

007)

.


2.4 Tax Assignment Principles

The division of revenue sources among federal and subnationalgovernments constitutes the tax assignment problem. Once expen-diture assignment has been agreed on, tax assignment and designof transfers become critical elements in matching expenditure needswith revenue means at various levels of government. Tax assignmentcan be undertaken independently of expenditure assignment—a common practice in developing countries. The advantages ofcentralized tax administration and decentralized provision of publicservices become apparent, however, when tax assignment reflectsanticipated spending. Such arrangements prevent overdependenceof lower levels of government on intergovernmental transfers, whichcan otherwise distort local spending priorities. Where theoreticalguidance on tax assignment is unclear, expenditure assignment canprovide a powerful argument for assigning tax responsibility to thegovernment with the greatest need for more money. Efficiency andequity arguments have to be tempered by administrative considera-tions, and the exact assignment depends upon informed judgement.We can, however, outline the economic principles that come intoplay in deciding which taxes to assign to what order of government.

Four general principles require consideration in assigning taxingpowers to various governments. First, the economic efficiency crite-rion dictates that taxes on mobile factors and tradable goods thathave a bearing on the efficiency of the internal common marketshould be assigned to the central government. Subnational assign-ment of taxes on mobile factors may facilitate the use of sociallywasteful “beggar thy neighbour” policies to attract resources to theirown areas by regional and local governments. In a globalized world,even the central assignment of taxes on mobile capital may not bevery effective in the presence of tax havens and the difficulty oftracing and attributing incomes from virtual transactions to variousphysical spaces. Second, national equity considerations warrant thatprogressive redistributive taxes should be assigned to the centralgovernment, which limits the possibility of regional and localgovernments following perverse redistribution policies using bothtaxes and transfers to attract high-income people and repel low-



income ones. Central assignment of progressive redistributive taxes,however, leaves open the possibility of supplementary, flat-rate, localcharges on residence-based national income taxes. Third, theadministrative feasibility criterion (lowering compliance and admi-nistration costs) suggests that taxes should be assigned to the juris-diction with the best ability to monitor relevant assessments. Thiscriterion minimizes administrative costs as well as the potentialfor tax evasion. For example, property, land and betterment taxesare good candidates for local assignment because local governmentsare in a better position to assess the market values of such assets.Fourth, the fiscal need or revenue adequacy criterion suggests thatto ensure accountability, revenue means (the ability to raiserevenues from own sources) should be matched as closely as possiblewith expenditure needs. The literature also argues that long-livedassets should primarily be financed by raising debt, so as to ensureequitable burden sharing across generations (Inman, 2005). Further-more, such large and lumpy investments typically cannot be financedby current revenues and reserves alone.

These four principles suggest that user charges are suitable foruse by all orders of government, but the case for decentralizingtaxing powers is not as compelling as that for decentralizing publicservice delivery. This is because lower-level taxes can introduceinefficiencies in the allocation of resources across the federationand cause inequities among people in different jurisdictions. Inaddition, collection and compliance costs can increase significantly.These problems are more severe for some taxes than others, so theselection of which taxes to decentralize must be made with care,balancing the need to achieve fiscal and political accountability atthe lower levels of government against the disadvantages of havinga fragmented tax system. Table 3 illustrates a representativeassignment of taxing powers. The trade-off between increasedaccount-ability and increased economic costs from decentralizingtaxing responsibilities can be mitigated by fiscal arrangements thatpermit joint occupation and harmonization of taxes to overcomefragmentation and by fiscal equalization transfers that will reducethe fiscal inefficiencies and inequities that arise from different fiscalcapacities across regional and local governments.

Tabl

e 3.

A R

epre

sent

ativ

e A

ssig

nmen

t of

Tax

ing

Pow

ers

Type

of t

axD

eter

min

atio

n of

Col

lect

ion

Com

men

tsan

dBa

seRa

tead

min

istra

tion

Cus

tom

sN

NN

, PIn

tern

atio

nal t

rade

taxe

sC

orpo

rate

inco

me

N, U

N, U

N, U

Mob

ile fa

ctor

, sta

biliz

atio

n to

olR

esou

rce

taxe

s Res

ourc

e re

ntN

NN

Hig

hly

un

equ

ally

dis

trib

ute

d t

ax(p

rofit

s, in

com

e) ta

xba

ses

Roy

altie

s, fe

es, c

harg

es, s

ever

ance

taxe

s,S,

LS,

LS,

L, P

Ben

efit

tax

es/c

harg

es f

or s

tate

-loc

alpr

oduc

tion

, out

put,

and

prop

erty

taxe

sse

rvic

esC

onse

rvat

ion

char

ges

S, L

S, L

S, L

, PTo

pre

serv

e lo

cal e

nvir

onm

ent

Pers

onal

inco

me

NN

, S, L

NR

edis

trib

utiv

e, m

obile

fac

tor;

sta

biliz

a-tio

n to

olW

ealth

taxe

s (ta

xes o

n ca

pita

l, w

ealth

),N

,N

, SN

Red

istr

ibut

ive

Wea

lth tr

ansf

ers,

inhe

rita

nces

, and

beq

uest

sPa

yrol

lN

, SN

, SN

, SB

enef

it c

har

ge,

e.g.

soc

ial

secu

rity

cove

rage

Mul

tista

ge sa

les t

axes

(val

ue-a

ided

tax)

NN

NB

orde

r ta

x ad

just

men

ts p

ossi

ble

unde

r[V

AT])

fede

ral

assi

gnm

ent;

pot

enti

al s

tabi

li-za

tion

tool

Sing

le-s

tate

sale

s tax

es (m

anuf

actu

rer,

who

lesa

le, r

etai

l)O

ptio

n A

SS,

LS,

LH

ighe

r com

plia

nce c

ost

Opt

ion

BN

SN

Har

mon

ized

, low

er c

ompl

ianc

e co

st“S

in ta

xes”

Exci

ses o

n al

coho

l and

toba

cco

N, S

N, S

N, S

, PH

ealth

car

e a

shar

ed re

spon

sibi

lity

Tab

le 3

—co

ntin

ued

Type

of t

axD

eter

min

atio

n of

Col

lect

ion

Com

men

tsan

dBa

seRa

tead

min

istra

tion

Bet

ting,

gam

blin

gS,

LS,

LS,

L, P

Stat

e an

d lo

cal r

espo

nsib

ility

Lott

erie

sS,

LS,

LS,

L, P

Stat

e an

d lo

cal r

espo

nsib

ility

Rac

e tra

cks

S, L

S, L

S, L

, PSt

ate

and

loca

l res

pons

ibili

tyTa

xatio

n of

“ba

d” C

arbo

nN

, UN

, UN

, UTo

com

bat g

loba

l/nat

iona

l po

llutio

nB

TU

Tax

esN

, S, L

N, S

, LN

, S, L

, PPo

llut

ion

im

pact

may

be

nat

ion

al,

regi

onal

or l

ocal

Mot

or fu

els

N, S

, LN

, S, L

N, S

, L, P

Tolls

on

fede

ral/p

rovi

ncia

l/loc

al ro

ads

Eff

luen

t cha

rges

N, S

, LN

, S, L

N, S

, L, P

To d

eal w

ith in

ters

tate

inte

rmun

icip

al o

rlo

cal t

axes

Con

gest

ion

tolls

N, S

, LN

, S, L

N, S

, L, P

Tolls

on

fede

ral/p

rovi

ncia

l/loc

al ro

ads

Park

ing

fees

LL

L, P

To c

ontr

ol lo

cal c

onge

stio

nM

otor

veh

icle

s: R

egist

ratio

n, tr

ansf

erS

SS

Stat

e re

spon

sibili

tyta

xes a

nd a

nnua

l fee

sD

rive

r’s k

itche

n fe

esS

SS

Stat

e re

spon

sibili

tyB

usin

ess t

axes

SS

SPr

imar

ily lo

cal b

enef

itsE

xcise

sS,

LS,

LS,

LR

esid

ence

-bas

ed ta

xes

Prop

erty

SL

LC

ompl

etel

y im

mob

ile fa

ctor

, ben

efit

tax

Land

SL

LC

ompl

etel

y im

mob

ile fa

ctor

, ben

efit

tax

Fron

tage

, bet

term

ent

S, L

LL

Cos

t rec

over

yPo

llN

, S, L

N, S

, LN

, S, L

Paym

ent f

or se

rvic

esU

ser c

harg

esN

, S, L

N, S

, LN

, S, L

, PPa

ymen

t for

serv

ices

rece

ived

Not

e: U

is su

pran

atio

nal a

genc

y, N

is n

atio

nal/

fede

ral,

S is

stat

e or

pro

vinc

e, L

is m

unic

ipal

or l

ocal

and

P is

pri

vate

.So

urce

: Sha

h (2

007)

and

Boa

dway

and

Sha

h (f

orth

com

ing)

.


2.5 Current Issues in Tax Assignment Practice

The coordination of sales taxes, the assignment of resources taxationand local revenue autonomy remain sources of major conflict infederal countries. The coordination of sales taxes where all ordersof government are involved in some form of sales taxation remainsan area of major conflict with no easy compromises. While concep-tually such issues can be resolved amicably, in practice, these haveproven intractable politically. Resource taxation is another area ofconflict in federal countries due to uneven geographical concentra-tion of resources. For local taxes, revenue autonomy in setting taxbases remains an elusive issue in many federal countries.

3. Instruments of IntergovernmentalFinance

Instruments of intergovernmental finance have an importantbearing on efficiency, equity and accountability in federal systems.These are discussed below.

3.1 Tax Base and Revenue Sharing

Mechanisms

Tax base and revenue sharing mechanisms are customarily usedto address fiscal imbalances or mismatched revenue means andexpenditure needs arising from the constitutional assignment oftaxes and expenditures to different levels of governments. Tax basesharing means that two or more levels of government levy rates ona common base. Tax base determination usually rests with thehigher-level government with lower orders of government levyingsupplementary rates on the same base. Tax collection is by one levelof government, generally the central government in market econo-mies and the local government in centrally planned economies,with proceeds shared downward or upward depending on revenueyields. Tax base sharing is quite common in mature federations andalmost nonexistent in newer federations in developing countries.

A second method of addressing vertical fiscal imbalances isrevenue sharing, whereby one level of government has uncondi-


tional access to a specified share of revenues collected by anotherlevel. Revenue sharing agreements typically specify how revenuesare to be shared among federal and lower level governments, withcomplex criteria for allocation and for the eligibility and use offunds. Such limitations run counter to the underlying rationale ofunconditionality. Revenue sharing mechanisms are quite commonin developing countries. They often address multiple objectives,such as bridging fiscal gaps, promoting fiscal equalization andregional development, and stimulating tax effort at lower levels.

3.2 Intergovernmental Transfers

Intergovernmental transfers or grants can be broadly classified intotwo categories: general-purpose (unconditional) and specific-purpose (conditional or earmarked) transfers.

3.2.1 General-Purpose Transfers

General-purpose transfers are provided as general budget support,with no strings attached. These transfers are typically mandatedby law, but occasionally they may be of an ad hoc or discretionarynature. Such transfers are intended to preserve local autonomy andenhance interjurisdictional equity. General-purpose transfers aretermed bloc transfers when they are used to provide broad supportin a general area of subnational expenditures (such as education)while allowing recipients discretion in allocating the funds amongspecific uses. General-purpose transfers simply augment the reci-pient’s resources. Since the grant can be spent on any combinationof public goods or services or used to provide tax relief to residents,general non-matching assistance does not affect relative prices.Formula-based general-purpose transfers are very common.

3.2.2 Specific-Purpose Transfers

Specific-purpose, or conditional, transfers are intended to provideincentives for governments to undertake specific programs oractivities. These grants may be regular or mandatory in nature ordiscretionary or ad hoc. Conditional transfers typically specify thetype of expenditures that can be financed (input-based conditiona-lity). These may be capital expenditures, operating expenditures,


or both. Conditional transfers may also require attainment of certainresults in service delivery (output-based conditionality). Input-based conditionality is often intrusive and unproductive, whereasoutput-based conditionality can advance grantors’ objectives whilepreserving local autonomy.

Conditional non-matching transfers provide a given level offunds without local matching, as long the funds are spent for aparticular purpose. Conditional non-matching grants are bestsuited for subsidizing activities considered high priority by a higher-level government but low priority by local governments.

Conditional transfers may incorporate matching, provisions—requiring grant recipients to finance a specified percentage of expen-ditures using their own resources. Matching requirements can beeither open-ended, meaning that the grantor matches whateverlevels of resources the recipient provides, or closed-ended, meaningthat the grantor matches recipient funds only up to a pre-specifiedlimit.

Matching requirements encourage greater scrutiny and localownership of grant-financed expenditures; closed-ended matchingis helpful in ensuring that the grantor has some control over thecosts of the transfer program. Matching requirements, however,represent a greater burden for a recipient jurisdiction with limitedfiscal capacity. In view of this, it may be desirable to set matchingrates in inverse proportion to the per capita fiscal capacity of thejurisdiction in order to allow poorer jurisdictions to participate ingrant-financed programs.

Conditional open-ended matching grants are the most suitablevehicles to induce lower-level governments to increase spendingon the assisted function. If the objective is simply to enhance thewelfare of local residents, general-purpose non-matching transfersare preferable, as they preserve local autonomy. To ensure account-ability for results, conditional non-matching output-based transfersare preferable to other types of transfers. Output-based transfersrespect local autonomy and budgetary flexibility while providingincentives and accountability mechanisms to improve servicedelivery performance.


3.2.3 Designing Fiscal Transfers

The design of fiscal transfers is critical to ensuring the efficiencyand equity of local service provision and the fiscal health of sub-national governments (for a comprehensive treatment of the econo-mic rationale of intergovernmental fiscal transfers, see variouschapters in Boadway and Shah, 2007). A few simple considerationscan be helpful in designing these transfers.

3.2.4 Guidelines for Grant Design

1. Clarity in grant objectives. Grant objectives should be clearlyand precisely specified in order to guide grant design.

2. Autonomy. Subnational governments should have completeindependence and flexibility in setting priorities. They shouldnot be constrained by the categorical structure of programmesand uncertainty associated with decision-making at the centre.Tax-base sharing—allowing subnational governments to intro-duce their own tax rates on central bases, formula-based reve-nue sharing, or bloc grants—is consistent with this objective.

3. Revenue adequacy. Subnational governments should have ade-quate revenues to discharge designated responsibilities.

4. Responsiveness. The grant programme should be flexible enoughto accommodate unforeseen changes in the fiscal situation ofthe recipients.

5. Equity (fairness). Allocated funds should vary directly with fiscal needfactors and inversely with the tax capacity of each jurisdiction.

6. Predictability. The grant mechanism should ensure predict-ability of subnational governments’ shares by publishing five-year projections of funding availability. The grant formulashould specify ceilings and floors for yearly fluctuations. Anymajor change in the formula should be accompanied by hold-harmless or grandfathering provisions.

7. Transparency. Both the formula and the allocations should bedisseminated widely, in order to achieve as broad a consensusas possible on the objectives and operation of the programme.

8. Efficiency. The grant design should be neutral with respect tosubnational governments’ choices of resource allocation todifferent sectors or types of activity.


9. Simplicity. Grant allocation should be based on objective factorsover which individual units have little control. The formulashould be easy to understand, in order not to reward grants-manship.

10. Incentive. The design should provide incentives for sound fiscalmanagement and discourage inefficient practices. Specifictransfers to finance subnational government deficits should notbe made.

11. Reach. All grant-financed programmes create winners andlosers. Consideration must be given to identifying beneficiariesand those who will be adversely affected to determine the overallusefulness and sustainability of the programme.

12. Safeguarding of grantor’s objectives. Grantor’s objectives are bestsafeguarded by having grant conditions specify the results tobe achieved (output-based grants) and by giving the reci-pient flexibility in the use of funds.

13. Affordability. The grant programme must recognize donors’budget constraints. This suggests that matching programmesshould be closed ended.

14. Singular focus. Each grant programme should focus on a singleobjective.

15. Accountability for results. The grantor must be accountable forthe design and operation of the programme. The recipientmust be accountable to the grantor and its citizens for financialintegrity and results—that is, improvements in service deliveryperformance. Citizens’ voice and exit options in grant designcan help advance bottom-up accountability objectives.

Some of these criteria may be in conflict with others. Grantorsmay therefore have to assign priorities to various factors in comparingdesign alternatives (Boadway et al., 1994b; Canada 2006; Shah,2007, Boadway and Shah, forthcoming).

As noted earlier, for enhancing government accountability tovoters, it is desirable to match revenue means (the ability to raiserevenues from own sources) as closely as possible with expenditureneeds at all levels of government. However, higher-level govern-ments must be allowed greater access to revenues than needed tofulfil their own direct service responsibilities, so that they are able


to use their spending power through fiscal transfers to fulfilnational and regional efficiency and equity objectives.

Broad objectives for national fiscal transfers can be identified.Each of these objectives may apply to varying degrees in differentcountries; each calls for a specific design of fiscal transfers. Lack ofattention in design to specific objectives leads to negative percep-tions of these grants. The six broad objectives are:

1. Bridging Vertical Fiscal Gaps2. Bridging the Fiscal Disparities through Fiscal Equalization

Transfers3. Setting National Minimum Standards4. Compensating for Benefit Spillovers5. Influencing Local Priorities6. Dealing with Infrastructure Deficiencies and Creating Macro-

economic Stability in Depressed Regions

3.3 Lessons from International Practices in

Intergovernmental Fiscal Transfers

Review of international practices yields a set of practices to avoidand a set of practices to emulate. A number of important lessonsalso emerge (Table 4).

3.4 Current Issues in Intergovernmental Finance

Vertical fiscal gaps, i.e. mismatch in revenue means and expenditureneeds and revenue autonomy at subnational orders remains an areaof concern. This is particularly so in those federal countries wherethe centralization of taxing powers is greater than necessary to meetfederal expenditures inclusive of its spending power. This resultsin undue influence on subnational policies to meet nationalobjectives through the use of fiscal transfers. This is a concern atthe state-local levels in Australia, Germany, India, Malaysia, Nigeria,Russia, Spain, and South Africa among others. In Germany, theseconcerns are prompting a wider review of the assignment problemand a rethinking of the division of powers among federal, Länder,and local governments. A consensus is yet to be formed on a newvision of fiscal federalism in Germany.

The reform of conditional transfers is of concern to subnationalgovernments in most federal countries due to their ad hoc natureand in view of their distortionary impacts on subnational prioritiesand policies. Equalization transfers also invite controversy due eitherto the complexity of the formulae or the lack of consensus on thestandard of equalization.

3.4.1 Institutional Arrangements for

Fiscal Relations

Who should be responsible for designing the system of federal-state-local fiscal relations? There are various alternatives (see Shah,2006 for an evaluation framework and comparative reflections onalternate institutional arrangements). The first and most commonlyused practice is for the federal government to decide on it alone.The most obvious one is to make the federal government solelyresponsible, on the grounds that it is responsible for the nationalobjectives that are to be delivered through the fiscal arrangements.In many countries, this is the norm and one or more central govern-ment agencies assume exclusive responsibility for the design andallocation of fiscal transfers. A potential problem with this approachis the natural tendency of the federal government to be overly invol-ved with state decision-making and not to allow the full benefitsof decentralization to occur. This biases the system toward a centra-lized outcome, despite the fact that the grants are intended to facili-tate decentralized decision-making. To some extent, this problemcan be overcome by imposing constitutional restrictions on theability of the federal government to override state and local deci-sions. In India the federal government is solely responsible for Plan-ning Commission transfers and centrally sponsored schemes. Thesetransfers have strong input conditionality with the potential toundermine state and local autonomy. The 1988 Brazilian consti-tution provides strong safeguards against federal intrusion by enshrin-ing the transfers’ formula factors in the constitution. These safeguardsrepresent an extreme step, as they undermine the flexibility of fiscalarrangements to respond to changing economic circumstances.

Alternatively, a separate body could be involved in the designand ongoing reform and enforcement of fiscal arrangements. Thiscould be an impartial body or a body made up of both federal and


Gra

nt o

bjec

tive

Bri

dge

fisca

l gap

Red

uce

regi

onal

fisc

aldi

spar

ities

Com

pens

ate

for b

enef

itsp

illov

ers

Set n

atio

nal m

inim

umst

anda

rds

Gra

nt d

esig

n

Rea

ssig

nmen

t of r

espo

nsib

i-lit

ies,

tax

abat

emen

t, ta

x-ba

sesh

arin

g

Gen

eral

non

mat

chin

g fis

cal

capa

city

equ

aliz

atio

n tr

ansf

ers

Ope

n-en

ded

mat

chin

gtr

ansf

ers w

ith m

atch

ing

rate

cons

iste

nt w

ith sp

ill-o

ut o

fbe

nefit

s

Con

ditio

nal n

on-m

atch

ing

outp

ut-b

ased

blo

c tr

ansf

ers

with

con

ditio

ns o

n st

anda

rds

of se

rvic

e an

d ac

cess

Con

ditio

nal c

apita

l gra

nts w

ithm

atch

ing

rate

that

var

ies

inve

rsel

y w

ith lo

cal f

isca

lca

paci

ty

Exam

ples

of b

ette

r pra

ctic

es

Tax

abat

emen

t and

tax-

base

shar

ing

(Can

ada)

Fisc

al e

qual

izat

ion

with

exp

licit

stan

dard

that

det

erm

ines

tota

lpo

ol a

s wel

l as a

lloca

tion

(Can

ada,

Den

mar

k, a

ndG

erm

any)

Gra

nt fo

r tea

chin

g ho

spita

ls(S

outh

Afr

ica)

Roa

d m

aint

enan

ce a

ndpr

imar

y ed

ucat

ion

gran

ts(I

ndon

esia

bef

ore

2000

)

Edu

catio

n tr

ansf

ers (

Bra

zil,

Chi

le, C

olom

bia)

Hea

lthtr

ansf

ers (

Bra

zil,

Can

ada)

Exam

ples

of p

ract

ices

to a

void

Def

icit

gran

ts, w

age

gran

ts(C

hina

), ta

x by

tax

shar

ing

(Chi

na, I

ndia

)

Gen

eral

reve

nue

shar

ing

wit

hm

ultip

le fa

ctor

s (B

razi

l and

Indi

a); f

isca

l equ

aliz

atio

n w

itha

fixed

poo

l (A

ustr

alia

, Chi

na)

Clo

sed-

ende

d m

atch

ing

gran

ts

Con

ditio

nal t

rans

fers

with

cond

ition

s on

spen

ding

alo

ne(m

ost c

ount

ries

), po

rk b

arre

ltr

ansf

ers (

USA

, e.g

. $20

0m

illio

n ea

rmar

k in

200

6 fo

r a“b

ridg

e to

now

here

” in

Ala

ska)

, ad

hoc

gran

ts

Tabl

e 4.

Pri

ncip

les

and

Bet

ter

Prac

tice

s in

Gra

nt D

esig

n

Gra

nt o

bjec

tive

Influ

ence

loca

l pri

oriti

es in

area

s of h

igh

nati

onal

but

low

loca

l pri

ority

Prov

ide

stab

iliza

tion

and

over

com

e inf

rast

ruct

ure

defic

ienc

ies

Sour

ce: S

hah

(200

7).

Gra

nt d

esig

n

Ope

n-en

ded

mat

chin

gtr

ansf

ers (

pref

erab

ly w

ithm

atch

ing

rate

var

ying

inve

rsel

yw

ith fi

scal

cap

acity

)

Cap

ital g

rant

s, p

rovi

ded

mai

nten

ance

pos

sible

Exam

ples

of b

ette

r pra

ctic

es

Cap

ital g

rant

for s

choo

lco

nstr

uctio

n (I

ndon

esia

bef

ore

2000

), h

ighw

ay c

onst

ruct

ion

mat

chin

g gr

ants

to st

ates

(Uni

ted

Stat

es)

Mat

chin

g tr

ansf

ers f

or so

cial

assi

stan

ce (C

anad

a be

fore

2004

)

Cap

ital g

rant

s with

mat

chin

gra

tes t

hat v

ary

inve

rsel

y w

ith

loca

l fisc

al c

apac

ity

Exam

ples

of p

ract

ices

to a

void

Cap

ital g

rant

s with

no

mat

chin

g an

d no

futu

reup

keep

requ

irem

ents

Ad

hoc

gran

ts

Stab

iliza

tion

gran

ts w

ith n

ofu

ture

upk

eep

requ

irem

ents

Tab

le 4

—co

ntin

ued

state representatives. It could have true decision-making authorityor be purely advisory. Whatever body is responsible, to be effective,it needs to be able to coordinate decision-making by the two levelsof government. Three commonly practiced options are: (1) an inde-pendent grants commission; (2) an intergovernmental forum; and(3) an intergovernmental-cum-civil-society forum.

Some countries set up a quasi-independent body, such as agrants commission, to design and reform the fiscal system. Suchcommissions can have a permanent presence, as in Australia orSouth Africa, or they can be brought into existence periodically tomake recommendations for the next five years, as in India. Indiahas also instituted independent grants commissions at the statelevel as advisory bodies for state-local fiscal transfers. These commis-sions have proven ineffective in some countries, largely becausemany of their recommendations have been ignored by the govern-ment and not implemented, as in South Africa. In other cases thefederal government may have accepted and implemented the com-mission’s recommendations but have been ineffective in reformingthe system due to self-imposed constraints, as in India. In somecases these commissions become too rigorous and academic in theirapproaches, contributing to the creation of an overly complex sys-tem of intergovernmental transfers. This has been the case withthe Commonwealth Grants Commission in Australia.

A few countries use intergovernmental forums, executive federa-lism or federal-provincial committees to negotiate the terms ofthe system, as Canada and Germany do. In Germany this systemis enhanced by having state governments represented in theBundesrat, the upper house of the parliament. This system allowsfor explicit political input from the jurisdictions involved andattempts to develop a common consensus. Typically such forumsopt for simplicity in design to make the system transparent andpolitically acceptable.

Finally, a variant of the above is to use an intergovernmentalcum legislative cum civil society committee with equal repre-sentation from all constituent units, chaired by the federal govern-ment to negotiate changes in existing federal-provincial fiscalarrangements. The Finance Commission in Pakistan is an example



of this model, which is constituted periodically to determine alloca-tions for the next five years. Pakistan also follows the same approachby having province level finance commissions for designing andallocating provincial-local fiscal transfers. This approach has theadvantage that all stakeholders—donors, recipients, civil society,and experts-are represented on the commission. Such an approachkeeps the system simple and transparent. An important disadvan-tage of this approach, however, is that due to the unanimity rule,such bodies may be permanently deadlocked, as has recently beenwitnessed at the federal level in Pakistan.

4. Resolving Fiscal Conflicts

A second subtheme of the conference relating to issues in fiscalfederalism was that of resolving fiscal conflicts. Fiscal conflicts infederal countries usually arise from (a) conflicting interests in thedivision of fiscal resources especially in countries with a concentra-tion of natural resources in a few regions; (b) lack of clarity andcoordination of roles in fields of shared rule; (c) fiscal transfers thatappear to pass the buck and buttress citizens’ negative percep-tions that they simply represent the “magical art of passing moneyfrom one government to another and seeing it vanish in thin air”;(d) “beggar thy neighbour policies” under decentralized decision-making; and (e) economic divisions within the nation that foster asense of alienation in lagging regions.

One continuing source of tension is vertical fiscal gaps, or themismatch between revenue means and expenditure needs at lowerorders of government. Vertical fiscal gaps and revenue autonomyof subnational orders of government remain areas of concern infederal countries where the centralization of taxation powers isgreater than necessary to meet federal objectives. This leads toundue central control over subnational policies and can even under-mine bottom-up accountability.

Various options have been tried by federal countries to resolvefiscal conflicts. One is having clarity in roles and responsibilitiesand institutional mechanisms for coordination, especially in theexercise of shared rule. Another is asymmetric federalism arising


from uniform principles to achieve amicable and sustainable fiscalcompacts and outcomes. Yet another is ensuring that financefollows functions and that the division of the fiscal pie is fair andtransparent, especially in the sharing of fiscal dividends from naturalresources through transparent compacts that compensate resourcerich regions for costs of infrastructure services and environmentaldegradation associated with natural resources exploitation. Inter-regional conflicts associated with attempts to shift the burden oflocal taxes on non-residents and a race towards bottom can belimited by having proper assignment of taxes and harmonizationof taxes on inter-state trade. Macro fiscal conflicts resulting in fiscalindiscipline can be avoided through legislated fiscal rules. Outputor performance based grants with conditions on standards andaccess to public services but having flexible choices in designingprogrammes and in spending allocations can also help foster resultsbased accountability and help restore the trust of the people ingovernment.

5. Federalism and Regional Equity

Ensuring regional equity within federal nations was the thirdsubtheme of fiscal federalism for this conference.

Large regional disparities represent serious threats in federalstates as the inability of the federation to deal with such inequitiescreates potential for disunity and, in extreme cases, for disinte-gration. It is heartening, however, to note that federal countriesgenerally do better in restraining regional inequalities in order toavoid the greater political risk caused by widening regionaldisparities. Regional fiscal equity is often addressed in federalnations (a) by overcoming the fragmentation of an internal commonmarket through removal of barriers to trade and factor mobility;and (b) by creating a level playing field for poorer jurisdictionswith fiscal equalization and national minimum standards grantsin order to afford them opportunities for integrating their economieswith the rest of the country. Such grants work as the glue that holdsthe federation together by enabling poorer jurisdictions to providereasonably comparable levels of public services at reasonably


comparable levels of taxation, and foster mobility of factors ofproduction (land, labour and capital) and mobility of goods, aswell as help enhance a common economic union.

6. Why Fiscal Federalism?Some Conclusions

Federal fiscal constitutions have been recommended for large anddiverse countries as they create incentives for multiple orders ofgovernment to provide services competitively, efficiently, equitably,and responsibly to their own residents. This is accomplished whilerespecting diversity in local identities and preferences. Federal fiscalarrangements pay special attention to regional economic divisionsin order to ensure level playing field to strengthen the economicunion. This explains why federal countries generally do betterthan unitary countries on all aspects of public governance—citizenparticipation, political freedom, political stability, rule of law,efficient and equitable service delivery, human development, fiscaland economic management, curtailing corruption and equitableand inclusive governance.

In conclusion, federal countries have shown a remarkableability to adapt to meet emerging challenges in fiscal federalism.While challenges they face may be very similar, the solutions theydiscover and adopt are often unique and local. This represents aremarkable attestation to the triumph of the spirit of federalismin a never ending quest for the right balance and of excellence inresponsive, responsible, equitable and accountable governance.

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Emerging Issues in Fiscal Federalism - Home - Forum of … · 2016-03-08 · 4 Emerging Issues in Fiscal Federalism The rest of the paper is organized as follows. Section 2 is con-cerned