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2. FISCAL FEDERALISM: THEORY AND PRACTICE
The normative theory of public finance is largely based on Diamond and
Mirrlees (1971) model of optimal taxation and Atkinson and Stern (1974) model
of optimal public expenditures within the context of a centralized State. However,
when it comes to dealing with in a federal setup, a number of additional elements
such as intergovernmental fiscal transfers, externalities (fiscal and spatial), and
strategic interactions among governments etc., get introduced. This thus, requires
a broader framework for addressing fiscal federalism.
Fiscal federalism inter alia, plays an important role in the implementation
of core elements of the state policy. As allocation, distribution and stabilization
functions are major policy objectives of public finance (Musgrave and Musgrave,
1989), the subsequent sections in this Chapter deal with important elements of the
state policy, and the role of fiscal federalism within the overarching theoretical
framework. Assignment of responsibilities (expenditure and tax), concept of
equalization, determinants of fiscal position, strategic interactions among
constituent units, and fiscal externalities are also discussed in this Chapter. In
addition, the core issues involved in designing intergovernmental fiscal transfers
are also part of this Chapter. Some international experiences in select countries of
fiscal federalism are included as illustrations for the purpose of comparing them
with the Indian system at a later stage.
2.1 CORE ELEMENTS OF THE STATE POLICY
Mainstream public finance literature typically identifies three core
elements of the State (Kaul, 2006):
ª First, as the aggregator of national policy preferences and through the
political process implement policy initiatives (Arrow, 1963). For
efficient provision of social goods, a political process of budget
determination is resorted (Musgrave and Musgrave, 1989). As
resources are often limited, the process involves inter se prioritization
of initiatives for dealing with various issues.
ª Second, correction of market failures and promotion of desired levels
of societal or intergenerational distribution as the overall allocation
and distribution authority.
15
ª Third, based on their unique coercive powers, governments at various
levels impose taxes and collect revenue to pay for planned public
expenditures and put in place regulatory and other measures required
for the society to realize cherished policy goals.
2.2 DECENTRALIZATION VERSUS CENTRALIZATION
Determination of optimal size of jurisdiction for the various public
functions is an important concern. It is said that welfare increases through the
differentiation of public services in accordance with costs and preferences at the
appropriate governmental level. As Oates (1999) puts forth it, ‘‘... we need to
understand which functions and instruments are best centralized and which are
best placed in the sphere of decentralized levels of government’’.
Regarding the allocation function of the public sector, the principle of
fiscal decentralization has been advanced (Musgrave, 1959; Oates, 1972). The
principle of fiscal decentralization is applicable as:
1. Local governments prefer to bear the costs of financing expenditures that help
in meeting the local preferences. As preferences across regions differ, local
governments, therefore, are also in a better position to determine the
expenditure priorities of their inhabitants.
2. Local governments try to balance the benefits of public goods with the costs.
If the marginal cost of local public goods is subsidized by national
governments, local governments tend to overspend on such activities. In order
to address the problem of overspending, degree of spillovers across
jurisdictions needs to be considered.
3. On the other hand, if a public good provides benefits not only locally but also
across jurisdictions, a local jurisdiction may discount some of those benefits
and under provide for that public good. In such a case, there are two options.
Either a higher level of government may be in a better position to provide for
that public good or alternatively, it may need to subsidize local governments'
expenditures.
4. When there are economies of scale in the provision of public goods, these
services can be provided more efficiently at larger scales than in a single local
jurisdiction. In such a case, it may be more appropriate for a higher level of
government to provide for the public good.
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5. The other side of the coin is raising of revenue. Conventional wisdom
suggests that revenues ought to be raised by taxing the most “immobile” tax
bases. Taxing a mobile factor, it can easily avoid the tax by moving outside
the relevant jurisdiction, thereby leading to a loss in revenues and causing
distortions in the economy. Generally speaking, it is easier for households,
firms, and economic entities to move within a nation than across nations, as
such these factors are less mobile from the perspective of a central
government than from that of a local government. This may be another reason
for central governments to subsidize/ compensate local governments'
expenditures on certain public goods.
6. Local governments also interact strategically, competing to attract and/or hold
a larger share of mobile tax bases. This phenomenon has been known as a
“race to the bottom”. It often leads to poorer quality of public services as
local governments collectively cut tax rates to an unviable proposition.
2.3 ASSIGNMENT OF RESPONSIBILITIES
With these initial insights now, we discuss in more detail expenditure
responsibilities, followed by tax responsibilities.
2.3.1 The Assignment of Expenditure Responsibilities
Public sector functions can be classified into three categories: the
stabilization, distribution, and allocation functions. The stabilization function
refers to smoothing business cycles, reducing inflation and unemployment,
encouraging economic growth, and obtaining other related macroeconomic
objectives. If the economic criteria for assignment are efficiency and equity, it is
typically concluded that the stabilization function should largely be performed by
the central government because the mobility of resources makes it unlikely to
pursue an effective stabilization policy by a lower level of government (Gramlich,
1987). In any case, local governments have limited powers to borrow or to issue
money curtailing any possible stabilization role by them.
Redistribution also largely, belongs to the realm of central government.
Attempts by regional governments to redistribute income are likely to be
disenchanted by the mobility of high-worth individuals and of capital, and any
such attempt to redistribute income will create distortions and inefficiencies in
geographic location (Oates, 1972). Moreover, the unequal and possibly inadequate
17
fiscal capacities of local governments also make centralization desirable on equity
grounds.
However, the allocation function, or the decision to provide kind of
services, is invariably left to local levels of government. These governments can
adapt service levels more closely to the preferences of their citizens, thereby
making available to individuals a wider range of fiscal choices than perhaps,
provided by a straight jacketed provisioning by the central government. This is the
well-known “Subsidiarity Principle”, also sometimes referred to as the
“Decentralization Theorem” (Oates, 1972, 1993, 1999).
Decentralization principle may also not be applicable where the service
has widespread spillovers. National defense is often cited as a classic example.
Environmental quality as well, falls into this category. A second exception may be
cases where provision of services involves economies of scale. An example may
be municipal solid waste: even large cities benefit from sharing a single landfill
rather than procuring their own individually, and even small towns and villages
may benefit from sharing a single conservancy service. In such cases, if there are
multiple levels of government, a middle tier may be more suitable. Alternatively,
local government may on their own form voluntary compacts. These
considerations suggest a “best practice” of assignment of expenditure
responsibilities across different levels of government. Activities such as national
defense, monetary policy, and income redistribution are appropriately assigned to
the central government; activities like police and fire protection, trash collection,
and local roads are assigned to local governments. Of course, the actual practice
on assignment of expenditure responsibilities differs somewhat from these “best
practices”. Nevertheless, despite substantial variation in expenditure assignments,
the broad principles are generally upheld in most countries.
The argument for decentralization gets further weakened in case of
economies of scale in the provision of environmental public goods and more so, if
the expenditure on these goods involves spillover effects. In this regard, consider
emissions control or pollution cleanup as a government expenditure responsibility.
Which level of government should be assigned this responsibility? Put differently,
which level of government should be assigned the responsibility for environmental
quality? Environmental quality is clearly a good that has externality – and public
good – aspects. However, there are different “types” of environmental services,
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and the answer to the expenditure assignment question depends on the precise
value a society assigns to the environmental quality.
2.3.2 The Assignment of Tax Responsibilities
Assignment of tax responsibilities among the different levels of government is
a must to provide adequate financing for requisite expenses. Although there is
much diversity in the fiscal structures of national and local governments, here
again several general “best practices” have emerged that provide a useful point for
discussion (Musgrave, 1983; McLure, 1994; Bird, 1999):
1. Only the federal government should impose progressive income taxes.
Due to the potential mobility of factors, any attempt by local government
to redistribute income by progressive income taxes is likely to lead to the
out-migration of more mobile, higher income individuals; and thereby
leaving lesser mobile, lower income individuals to bear the burden.
Income taxes are also thought to be effective counter-cyclical instruments,
and macroeconomic goals are at best pursued by national government
policies.
2. The central government is better placed to impose taxes on the bases those
are distributed unequally across jurisdictions, and use the revenues from
such taxes to equalize fiscal capacities across different jurisdictions.
3. Local governments rely predominately, upon user charges and taxes on
immobile tax bases. In particular, user charges are used to finance goods
that provide measurable benefits to identifiable individuals within a single
jurisdiction, and taxes are used where it is difficult to identify and to
measure individual costs and benefits. The assignment of taxes should
also meet the test of administrative feasibility.
4. Local governments generally speaking, try to avoid taxes on mobile tax
bases, especially capital. As with progressive income taxes, the potential
mobility of capital or other mobile factors of production leads to out-
migration if these factors are taxed at higher-than-average tax rates. By
the same token, attempts to induce in-migration of mobile factors can lead
to a so-called “race-to-the-bottom”, as local governments compete with
each other to attract and to hold these factors by extending tax breaks and
other fiscal incentives.
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5. Local governments need to be assigned adequate sources of revenues
consistent with their expenditure responsibilities. Local governments
ought to have some discretion over the rate of taxes to promote
accountability of local officials and to establish a link between services
demanded and the cost of service provision. Locally assigned taxes should
exhibit adequate revenue elasticity so that collections can grow with the
demand of services over time.
6. Intergovernmental transfers should be used to finance services that
generate spillovers to nearby jurisdictions as strictly local finance will
lead to inefficient provision. As a case in point, let us consider two local
jurisdictions each of which provides an impure public good (e.g., pollution
abatement) whose benefits spill over to the other jurisdiction. It could be
empirically established that each locality need to receive a subsidy (e.g., a
“conditional”, “matching”, and “open-ended” grant) on its public good
whose magnitude is equal to the marginal benefit of the externality along
the same lines of the Pigouvian tax/subsidy (Oates, 1972; Alm, 1983;
Gordon, 1983).
In practice, few countries follow rigidly these norms, although the broad
pattern of tax assignment is often consistent with these policy prescriptions. In
addition, local governments use numerous miscellaneous taxes and fees that may
be important to their finances. For example, many local governments impose taxes
on various forms of entertainment (e. g., restaurants, hotels, movies, and
gambling). Municipal governments also employ a wide variety of “nuisance”
taxes. These include license fees, and taxes on advertisements, construction
activities, non-motorized vehicles, and the like. Many of these taxes neither rate
high in terms of revenue performance, administrative ease, efficiency and
distributional effects; nor are they important sources of revenue. However, these
sundry taxes continue to be used in a routine manner.
In addition to the power of levying taxes, some of the goals of fiscal
federalism can also be achieved by tax sharing among governments, although tax
sharing does not typically give local governments any real authority in the
selection of local tax rates and therefore does not promote accountability and
efficiency in local expenditures. Surcharges have been increasingly recommended
as part of decentralization efforts around the world where it is necessary to find
some quick way to give cities a significant fiscal capacity. Of course, tax systems
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are designed to achieve multiple objectives and a trade off is expected among
various objectives. An obvious purpose is to raise the revenues necessary to
finance government expenditures (“adequacy”), and also to ensure that the growth
in revenues is adequate to meet expenditure requirements (“elasticity”). Another
concern is to distribute the burden of taxation in a way that meets with a society’s
notions of fairness and equity. Equity is typically defined in terms of “ability to
pay” such that those with equal ability should pay equal taxes (“horizontal
equity”) and those with differential ability should pay unequal taxes (“vertical
equity”). Taxes can also be used to influence behavior of those who pay them; in
choosing taxes, a common objective is to minimize the interference of taxes in the
economic decisions of individuals and firms. It goes without saying that taxes
should be simple to administer and to comply with, as a complicated tax system
wastes the resources of both tax administrators and taxpayers.
Local tax systems in most of the countries were originally designed for a
world in which production and consumption were primarily of tangible goods, in
which the sale and consumption of these goods generally occurred in the same
location, and in which the factors of production used to make the goods were for
the most part, immobile. In such a scenario, taxation was a fairly straightforward
exercise. Sales and excise taxes were imposed by the government on the tangible
goods that were consumed in the jurisdiction in which consumption (or
production) occurred. Similarly, income and property taxes were imposed on
factors where they lived and worked without apprehension that these taxes would
drive the factors elsewhere. In making these tax decisions, a government in one
jurisdiction never felt the need to consider how its actions would affect the
governments in other jurisdictions and vice versa as tax bases were largely
immobile.
The world has now moved on from a largely immobile to highly mobile
factors of production. There is little doubt that decentralization and other
associated trends (especially competition among local governments and
“globalization”, defined loosely as increased factor mobility across jurisdictions)
had changed the ground rules. In some nations, a trend toward fiscal
decentralization has put more pressures on local tax systems, widening disparities
across regions and increasing the importance of local taxes in the choice of
location of mobile factors. In a global economy, financial capital, firms, and even
households are more mobile, making it harder for local – and even central –
21
governments to raise revenues by increased rates and broadening the base beyond
a point. For example, businesses have more flexibility in choosing where to locate
because communication and transportation costs had been slashed. Further, some
forms of production activity require little in the way of traditional capital and
labor, so that physical location becomes less important. Labor, especially skilled
labor, has become more mobile in this environment. Likewise, financial capital is
able to flow quickly across local, state and national boundaries.
Clearly, if factors of production move easily from one location to another, the
ability of a government, especially local government to tax these factors gets
greatly diminished. A government that raises its tax rates above those of other
jurisdictions risks losing its tax base to other areas. Particularly in the case of
income from capital, there is much speculation that taxation will become
increasingly problematic (Mintz, 1992). In fact, there is some empirical evidence
(even if not conclusive) that factors respond to these tax considerations (Grubert,
1998; Hines, 1999).
Increased mobility is not limited to factors of production alone. Consumers are
also able to plan their preferences according to tax considerations, and
consumption does not necessarily occur in the jurisdiction in which a taxpayer
resides. A jurisdiction that attempts to tax, say, petroleum product more heavily
than surrounding areas finds that consumers resort to purchase elsewhere.2
Similarly, individuals can now purchase many types of products over the internet
and thereby avoid paying some (or even all) sales taxes. Additionally, there has
been increased consumption of services and intangible goods (e.g., computer and
knowledge based services) that are much more difficult to tax than tangible goods.
The once-close link between the location of sales and the location of consumption
has now become quite loose.
Keeping these trends in view, the measurement, identification, and assignment
of tax bases are now much more difficult. Let us consider a typical multi-
jurisdictional business. The product that the firm makes may be designed in one or
more jurisdictions; the firm may use inputs purchased in multiple jurisdictions; the
components may be produced in several places and assembled in a still different 2 In India petroleum products are taxed differently across states, as a result it is common to observe that when tax rate is higher in a state, then consumers start to buy the products from the other states where the tax rate is lower. Recent example is the increase in sales tax rate in Delhi.
22
location; and again the final product may be sold in multiple locations. Because
the business operates in multiple jurisdictions, the firm has considerable leeway to
manipulate prices to minimize its tax liabilities. This problem is well known and
its severity has increased with the enormous expansion in the number of firms
operating in multiple jurisdictions. Likewise, consider an individual whose income
comes from multiple sources. A global income tax requires that income from these
sources be aggregated. However, it is easy for an individual to hide, say, interest
income from multiple areas. In the absence of information sharing across
governments, the ability of a local government to identify incomes from other
jurisdictions is quite limited. Similarly, a consumer can purchase goods and
services in several different ways: from traditional local merchants or from
company websites and may be able to dodge the tax authorities.
How do various local governments respond to these concerns in their tax
choices? As discussed earlier, the ability of any government to choose its tax
policies independently of those in other jurisdictions had now been greatly
curtailed. In the presence of mobile tax bases, a single government’s choice of tax
policies will have effects beyond its own borders and will be affected by the
actions of other jurisdictions. Accordingly, the analysis of tax choices by local
governments must recognize responses by other local governments in a strategic
manner. These strategic interactions can lead to a number of consequences
(intended as well as unintended) leading to overall decline of tax rates. In
particular, if tax bases can move from one jurisdiction to another, they will switch
over from high to low-tax areas.
Owners of capital, skilled labor, and consumers are also increasingly sensitive
to tax differentials in their choices of destination. As a consequence, it is argued
that governments face increased pressure to compete with one another by reducing
tax rates or by offering special tax incentives to attract and to retain tax bases. For
example, when a government reduces its tax rates on capital income, it thereby
attracts capital flows from other jurisdictions, and in doing so the government
benefits its own jurisdiction. However, such actions also impose costs on the
jurisdictions that lose factors of production, and it risks generating similar tax-
cutting responses from those governments. With tax competition, there could well
be a “race-to-the-bottom”, in which overall tax collections decline precipitously as
local governments compete to attract or to retain their tax bases. To date, however,
the evidence in this regard is mixed and inconclusive (Wilson, 1999).
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The composition of local taxes could also change as a result of increased
difficulty in taxing mobile tax bases. The overall tax burden from income taxes on
mobile tax bases like capital and skilled labor will decline across local
governments; tax rates on these factors would also flatten and converge. In
contrast, taxes on immobile bases – unskilled labor, physical capital, and property
– in turn would increase. Consequently, local governments are likely to turn more
to environmental or “green taxes”, as well as to “sin taxes” (on alcohol, cigarettes
and lotteries) within their purview, to replace lost revenues from mobile bases.
These compositional changes imply that local tax systems are likely to
become more regressive than at present. If taxes on capital and skilled labor
decline, and if fees and charges, sin taxes, income taxes on unskilled labor all
increase, and if marginal income tax rates get flatten; local governments will find
it quite difficult to maintain progressive looking tax systems. Together with an
expected decline in overall revenues, the ability of local governments to
redistribute income to lower income individuals also gets diminished.
Not only is income tax, the form of local sales taxes is also changing. Local
(and other sub-national) governments may well decide that a destination-based
consumption tax that is collected by the federal government and distributed to
them would be preferable to further erosion in their sales tax collections.
Alternatively, they may agree among themselves to apply a uniform local sales
tax. They may even radically reform the sales tax by moving toward a
consumption-based, uniform-rate, destination-principle sales tax, as advocated by
McLure (1997) and Fox and Murray (1997), among others.
These changes suggest that local governments may attempt greater
harmonization (or at least some coordination) of their tax systems and
environmental policies, in an attempt to reduce the negative (fiscal) externalities
that one government’s decisions impose upon other governments. Such
harmonization implies convergence in tax rates across local governments, and also
in the definitions of tax bases. With harmonization, local autonomy in tax policy
obviously gets diminished (Tanzi, 1991, 1995, 2001). Central governments may
also effectively induce such harmonization through a system of intergovernmental
transfers. If local governments cannot or do not provide adequate environmental
protection, say because of competition for mobile capital or because they do not
adequately account for inter-jurisdictional environmental spillovers, central
24
governments can increase the level of protection via several instruments including
provision of matching grants (Alm, 1983; Gordon, 1983).
Whether all these changes are good or bad is obviously difficult to determine.
We have to live with them as changes are certain. Most of the previous discussion
has been focused mainly on the negative fiscal externalities of tax competition
(e.g., the race to the bottom). With greater factor and tax base mobility, local
governments have more power to influence the locational decisions of firms,
workers, and consumers. The governments that succeed in these choices will be
the ones that are able to match taxes with expenditures, able to give taxpayers the
services – including environmental protection – which individuals wish and
deserve for the taxes they pay. Previous research has focused mainly on the
negative fiscal externalities of tax competition. It is only recently that these
positive effects of tax and, especially, of expenditure competition has begun to be
considered in analytical models of local government behavior (Wilson, 1999).
Of course, complete mobility does not exist now, and is unlikely to be a reality
in the near future. However, individuals and firms do value the goods and services
that local governments provide, and they are willing to pay for them. As originally
argued by Tiebout (1956) and more recently by Zodrow and Mieszkowski (1989),
individuals will “vote with their feet” by moving to those jurisdictions in which
governments provide services that residents value. Indeed, local governments will
be required to make their communities as attractive as possible: by providing
uncongested roads, a clean environment, pleasant parks, quality schools, safe
neighborhoods, and the like, all with a tax burden that individuals deem
responsible and appropriate. Firms too, will not object because they also benefit
from safe neighborhoods and quality infrastructure, as well as from the availability
of workers who get attracted by such positivity.
To sum up this section, it is important to state that we need to have a delicate
balance between revenue and expenditure responsibilities among different tiers of
the governments that leads to a functional federal system.
2.3.3 Concept of Equalization
In many federal countries including India (Twelfth Finance Commission),
the concept of ‘equalization’ is the guiding principle for fiscal transfers as it
promotes ‘equity’ as well as ‘efficiency’ in resource use. Equalization transfers in
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a sense, neutralize deficiency in ‘fiscal capacity’ but not in ‘revenue effort’. Under
such an approach, transfers are determined on a normative basis instead of merely
filling-up the gaps arising from the projections of revenues and expenditures based
on historical trends. As against ‘devolution of taxes’ that is more often than not is
a matter of right, ‘grants-in aid’, as more effective transfer instrument for
administrative unit specific and purpose specific targeting, are mainly used
towards achieving a degree of equalization (Shah, 2006).
2.4 DETERMINANTS OF FISCAL POSITION
Fiscal diversity is reflected in the differentials in fiscal position of various
jurisdictions, i.e., in their ability to meet the needs of their respective communities.
The ability of a jurisdiction to carry out its fiscal tasks (its fiscal position) depends
on its tax base (its capacity) relative to the outlay required for rendering public
services (its need). When jurisdictions with relatively high capacity are faced with
low needs, their fiscal position is strong and vice versa.
Available literature also mentions that a standard level of services can be
provided with a low ratio of tax revenue to tax base (a low – tax effort); meaning
thereby that a standard level of tax effort will generate a high service level relative
to need (high fiscal performance). Where the opposite holds, a high effort may be
needed to provide only a substandard performance level (Musgrave and Musgrave,
1989). In the Indian context, there is a wide variation in ‘capacity’ and ‘needs’ of
various states and union territories (UTs), making intergovernmental fiscal
transfers a delicate and sensitive political issue.
As explained above, the ‘fiscal capacity’ and ‘fiscal need’ are two
important parameters for determining fiscal position. The fiscal capacity of
jurisdiction j or Cj could be defined as
Cj = ts Bj (2.1)
where Bj is the tax base in j and ts is a standard tax rate. Cj thus measures the
revenue which j would obtain by applying that rate to its base. In real situations,
there are different bases and tax rates charged by administrative jurisdictions. On
the similar lines, we can also define the fiscal need of jurisdiction j or Nj as
Nj = ns Zj (2.2)
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where Zj is the target population, while ns is the cost of providing a standard
service level per unit of Z. Nj thus measures the outlay in j required to secure a
standard level of performance or service. This is again oversimplification as it
allows for one service Z rather than for a mix of services, the importance of which
will vary among jurisdictions. Moreover, a detailed analysis would have to allow
for variations in n.
The fiscal position of j or Pj is defined as
Pj = Cj / Nj = ts B j /ns Zj (2.3)
Fiscal position thus equals the ratio of capacity to need. Setting P for
jurisdictions on the average equal to 1 is a necessary condition for meeting the
needs with own capacity, while a value of Pj > 1 implies a strong fiscal position
and a value of Pj < 1 a weak fiscal position. The value of P, properly defined, is
the index to which distributional weights in grant formulas are often linked.
In this discussion, the concept of ‘tax effort’ is equally important. We
define jurisdiction j’ tax effort Ej as
Ej = tj B j/ ts Bj = tj / ts (2.4)
The ratio of actual revenue in j is obtained by applying j’ tax rate tj to
what would be raised by applying ts (standard rate). This leads to the definition of
performance level Mj as
Mj = nj Zj / ns Zj = nj / ns (2.5)
or the ratio of actual outlay obtained by applying j’s outlay rate nj to that required
to meet the standard level at rate ns.
Assuming a balanced budget, we have
tj Bj=njZj (2.6)
An alternative definition of fiscal position with some mathematical
manipulation could be stated as follows:
Pj = (nj/ns ) / ( tj/ts) (2.7)
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Fiscal position may thus be defined as the ratio of capacity to need or as the ratio
of performance to tax effort.
These concepts and problems which arise in comparing fiscal positions
both among states and among jurisdictions within states pose one of the principal
issues in fiscal federalism. They are of concern both to the federal governments,
called upon to deal with excessive differentials among states, and to state
governments, called upon to deal with excessive differentials among local
jurisdictions (Musgrave and Musgrave, 1989). ‘Fiscal need’ and ‘fiscal capacity’
of a jurisdiction are thus important concepts and in practice ‘fiscal capacity’ based
determination are preferred world over.
In the intergovernmental fiscal transfers, grant received by a jurisdiction
depends on it ‘fiscal capacity’ (Musgrave and Musgrave, 1989).
Gj = tj Bj (Bj / Ba – 1) + tj Bj (Bj /Ba - 1) (Cj / Ca – 1) (2.8)
In this formula Gj is the grant received by the jurisdiction j; Bj is the per
capita tax base and tj is the tax rate which j chooses to impose. Ba is tax base in
average jurisdiction. Cj is the cost of accomplishing a given service level in j and
Ca is the cost of doing so in the average jurisdiction. Cj may differ from Ca either
because the required resources are more or less costly or because the need is
greater in the jurisdiction j. The first term of the equation (2.8) equalizes the
revenue to be achieved from a given tax rate, while the second term equalizes the
service level to be achieved with a given outlay (Musgrave and Musgrave, 1989).
2.5 STRATEGIC INTERACTIONS
In a federal structure, lower levels of governments could be thought of as
interacting with one another along three main channels: preferences, constraints
and expectations (Revelli, 2005). According to the ‘preference interaction
hypothesis’, an action chosen by a government affects directly the preferences of
other governments as certain public services provided by a jurisdiction enter the
welfare function of other jurisdictions (Gordon, 1983). On the similar lines, in the
presence of tax base mobility, the fiscal policy by a local government affects the
budget constraints of other governments, by means of a policy – driven resource
flow (capital migration). As a result, a jurisdiction’s policy affects indirectly the
policies of other jurisdictions, giving rise to fiscal competition for mobile
28
resources (Wilson, 1999). ‘Yardstick competition theory’ based upon the existence
of an informational externality amongst neighboring jurisdictions affects the
beliefs of an electorate with respect to the competency of their own government
(Besley and Case, 1995). As a result of the information spill-over, the electorate in
a local jurisdiction learns more about the quality and efficiency of their own
incumbent in local public service provision, by using other governments’
performances as a yardstick (Besley and Smart, 2002).
2.6 FISCAL EXTERNALITIES
Fiscal functions in a federation may lead to different types of
‘externalities’. Interjurisdictional fiscal externalities occur when a government’s
tax and expenditure decisions affect the well-being of taxpayers in other
jurisdictions either:
• Directly by changing their consumer and producer prices or their public
good provisions, or
• Indirectly by altering, the tax revenues or expenditures of other
governments.
Within the federal context, fiscal externalities could further be categorized
as ‘tax externalities’ and ‘expenditure externalities’. Coming to ‘tax externalities’,
they have been classified as ‘tax exporting’ (direct horizontal), ‘tax competition’
(indirect horizontal), and ‘tax base overlap’ (indirect vertical). On the similar
lines, there are three basic types of ‘expenditure externalities’ namely, ‘benefit
spillovers’ (direct horizontal), ‘spending competition’ (indirect horizontal), and
‘expenditure interdependence’ (indirect vertical). Table 2.1 provides us with the
types, typical examples, and their fiscal implications for both the ‘tax externalities’
and ‘expenditure externalities’ (Dahlby, 1996). Relationship between grant
objective and other parameters such as matching, earmarking and redistribution is
captured in Table 2.2.
Given that different tiers of governments have their own tax systems and
expenditure needs, it is important to determine the optimal magnitude of transfers
between various levels of government. It is common for central governments to
transfer fiscal resources to lower-level governments in order to close a perceived
fiscal gap between the desired level of expenditures by lower-level governments
and the level of revenues that they collect.
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Table 2.1 Interjurisdictional Fiscal Externalities
Types of Externality Examples Fiscal Implications
Direct Horizontal Tax Exporting: A hotel tax which is borne by visitors from other states
Increased reliance on taxes where at least part of the burden is borne by residents of other jurisdictions
Indirect Horizontal
Tax Competition: A sales tax which causes consumers to purchase the taxed commodities in another state
The potential mobility for the tax base leads to downward pressure on tax rates.
Indirect Vertical Tax Base Overlap: Federal and state excise taxes on cigarettes.
State governments, and possibly the federal government, will impose excessive tax rates on the shared tax base. Both levels of government could end up on the “wrong” side of the Laffer curve for total tax revenue.
Expenditure externalities Types of
Externality Examples Fiscal Implications
Direct Horizontal
Benefit Spillovers: Pollution abatement activity which benefits the downstream residents of other states.
Under-provision of activities which generate beneficial externalities
Indirect Horizontal
Spending Competition: Economic development grants which attract investment that would otherwise have occurred in other states.
Over-provision of activities which reduce the tax revenue of other state governments.
Indirect Vertical
Expenditure Interdependence: State education expenditures which increase the federal government’s income, payroll, and sales tax revenues because of the increase in students’ lifetime earnings.
Under-provision of activities which have a positive effect on the net revenues of other levels of government.
(Source: Dahlby 2006 Tax externalities)
Substantial academic work had been done covering various aspects of
fiscal federalism. Boadway and Keen (1996) had analyzed the problem of optimal
transfers in a framework where each level of government sets the instruments at its
disposal in such a way as to promote its own objective. According to them, the
fiscal interactions between the state and central governments deriving from the
30
sharing of a common tax base can lead these governments to choose policies that
are inferior, from a welfare viewpoint, to those that a unified central government
would choose.
Cremer et al. (1996) worked on informational aspects of fiscal federalism
challenging the assertion that local governments have “better information” than
central governments and that fiscal decentralization therefore facilitates efficiency
in public-sector activities. In their model of informational asymmetries between
central and lower-level governments, Cremer et al had shown that its
intergovernmental transfers and the tax system that finances them must be
incentive compatible.
Walz and Wellisch (2000) focus exclusively on horizontal interactions
analyzing tax competition for mobile capital. The allocation of both portfolio
capital and direct investment among jurisdictions depends, in general, on net-of-
tax rates of return, and individual jurisdictions may be able to stimulate local
investment through tax concessions or other fiscal incentives. Nechyba (1997)
researched on analyzing the simultaneous interaction of market and political
decision making in local public finance through a computable general equilibrium
(CGE) model. In Nechyba’s model, decision about local public good provision
are made through simple majority voting by residents, with property taxes (other
fiscal instruments) used to finance local spending.
Kappeler and Valila (2008) carried the empirical analysis of the
relationship between fiscal decentralization and the composition of public
investments. Their results suggest that decentralization increases economic
productive public investment, especially investment in public spillover goods. On
the other hand, there is no statistically significant impact of decentralization on
public investment in consumption-oriented local public goods (redistribution).
Based on the theoretical framework of fiscal federalism as discussed in this
Chapter, methodology and tools adopted by various countries in practice are dealt
with in the following section.
31 Figure 2.1 flow diagram of different types of grants deployed for intergovernmental fiscal transfers, Source: (By the author)
Grants
Specific Grants (Conditional/ earmarked)
General Grants (Unconditional/ Block)
Lumpsum Grants (Specific grants)
Matching Grants (Financial contribution)
Effort related
Non-effort related
Effort related
Closed ended
Open ended
Non-effort related
Closed ended
Open ended
Lump sum Grants (General)
Matching Grants (Financial Contribution)
Effort related
Non-effort related
Effort related
Non-effort related
Closed ended
Open ended
Closed ended
Open ended
32
Table 2.2 Relationship between Grant Objective and other Parameters
S. No. Grant Objective Matching Earmarking Redistributive
1. To share revenue from central tax sources
No No No
2. To reduce inequality in per capita income across states
No No Yes
3. To increase the overall level of public services to be provided by state-local governments
Yes No Optional
4. To equalize the terms at which state and local governments may provide public services
Yes Yes Optional
5. To increase the level of provision for particular public services
Yes No Optional
6. To equalize the terms of provision for particular public services
Yes Yes Optional
7. To correct for benefit spillovers Yes Yes No (Source: Musgrave and Musgrave, 1989)
2.7 FISCAL FEDERALISM: INTERNATIONAL EXPERIENCES
There is a wide variety of international experiences in fiscal federalism on
the basis of (a) the division of functions amongst different tiers of government, (b)
the design of fiscal transfers, (c) principles of assessment and (d) the institutional
arrangements (Ma, 1997). Intergovernmental fiscal transfers are either
constitutionally or legally mandated. Different countries have distinct institutional
mechanisms for deciding about the quantum and the mode of intergovernmental
fiscal transfers. Such empowered bodies either have a permanent presence, or they
are brought into existence periodically to make recommendations. A comparative
statement of intergovernmental fiscal relations in some important countries is
given at Table 2.3. The detailed exposition of the experiences of some such
important federal countries is presented in subsequent sections.
2.7.1 Australia
Australian federalism is characterized by the high degree of imbalance
between the revenue sources and the expenditure responsibilities of the state
governments, largely due to centralization in tax revenue at the federal level.
However, differences in fiscal capacity among the states do not cause a high
degree of horizontal fiscal imbalance (Vithal and Sastry, 2001). In Australia, the
tax bases of the federal and lower level governments are divided in such a way
that the federal government receives about two thirds of the total government
revenues. In terms of expenditure, however, the federal government spends only
33
one third of the total government revenues. This means about half of the federal
government revenues are distributed through various forms of transfers to the state
and local governments (Rye and Searle, 1996).
The basic outlines of the Australian federal system empowers the
Commonwealth (Central) government with functions such as foreign affairs,
foreign trade, defence, immigration, interstate trade and commerce, currency and
banking, maritime activities, posts and telegraphs and social security payments.
The states are vested with the responsibilities of providing education, health,
public and social services. The states have also been given the control of their
local governments though some responsibilities such as maintaining the road
system, recreation and cultural services and public services such as water supply,
sewerage, garbage disposal, etc. have been delegated by them to the local
governments.
While the Commonwealth government can levy all taxes, the states have
been given concurrent powers of taxation except in the case of customs and excise
duty. The majority of state taxes are dependent upon property taxes (Vithal and
Sastry, 2001). The Australian federal system provides for correction, both of
vertical and horizontal imbalances, through tax sharing arrangements and specific
purpose grants.
The Commonwealth Grants Commission (CGC), Statutory Grants
Commissions (SGCs) and the Australian Loan Council (ALC) are the three main
institutions looking after intergovernmental fiscal relations in Australia. While the
tax sharing is distributed on the basis of relativities determined by the CGC, SGCs
administer the specific purpose grants measuring the states' fiscal capacities and
fiscal needs using broad judgments and sampling services. In addition, the ALC
raises and distributes loan funds among the States, local governments and
autonomous bodies. The Australian federal government grants to lower level
governments include general purpose grants and specific purpose grants.
The CGC has been commented by some observers as, "a model in the
international context for the objective appraisal of spending needs" (Bird, 1986).
The CGC is a statutory and permanent authority, though not a constitutional body.
Originally designed to report for special assistance by states, over the years CGC
has taken over the responsibility of recommending tax sharing grants by
34
computing ‘relativities’. It conducts extensive research for estimating the
‘disabilities’ and makes changes in equalizing provisions from time to time.
Although a large amount of transfers are unconditional (tax sharing), specific
purpose transfers are neither insignificant.
Table 2.3. Comparison of Inter-Governmental Fiscal Relations
India Australia Canada USA
Division of functions
1
Important functions like defence, foreign affairs, communications with the Centre
Yes Yes Yes Yes
2
Functions relating to education, law and order, health, etc. with the States
Yes Yes Yes Yes
Division of tax powers
1 Important and elastic taxes with the Centre Yes Yes Yes Yes
2 Centre has overriding powers over States Yes Yes No No
3 Centre can levy all taxes No Yes Yes Yes
4 Considerable degree of overlapping No No Yes Yes
Inter -governmental fiscal relations
1 Formal Yes Yes - -
2 Informal - - Yes Yes
3 Vertical imbalances Large Large Large Large
4 Horizontal imbalances High Low High High
5 Correction of imbalances Partial Very High High Not
High Source: Vithal and Sastry (2001)
‘Tax sharing grants’ are determined as a fixed share of tax revenues of
the Commonwealth and distributed unconditionally among the states. Besides
correcting the vertical imbalance, these grants are used effectively to equalize
fiscal capacities and needs among the States. Tax sharing by the CGC is done on
the basis of a distribution model that involves the calculation of each state’s per
capita share of tax sharing funds, consisting of three elements: (1) the basic
entitlements; (2) the revenue disability: and (3) the expenditure or cost disability.
35
‘Specific purpose grants’ are another important mechanism for the transfer
of resources from the Commonwealth government to state governments in
Australia. The SGC distributes general purpose grants using a comprehensive
equalization program. The ALC consisting of the Prime Minister and the State
Premiers had been created for the centralized supervision of increased capital
accounts of States and local bodies. The entire public sector borrowings in
Australia are formally subject to the control of the ALC, as to amounts, forms,
terms and conditions.
One of the most important aspects of Australian fiscal federalism is the
extent of equalization achieved through federal transfers. However, the amount
required for equalization is not very large, as the capacity differences between
different states are not very large. The two essential elements of the norms
adopted in the computation of tax relativities are: the ‘revenue disability’ and the
‘cost disability’ factors. As a result of the use of these factors, all the states are
enabled to provide such standards of public services in physical terms at least as
an average state would provide. This ensures that every citizen, irrespective of the
state of residence, is enabled to have a certain minimum standard of public
services.
2.7.2 Canada
A striking feature of the Canadian economy is the substantial inter-
Provincial and intra-Provincial variations. The essential difference between the
advanced and backward provinces in Canada is in the presence and exploitation of
natural resources. In keeping with their economic dominance, the provinces of
Quebec, Ontario and Alberta have played a major role in the development of
Canadian fiscal federalism. The specific purpose transfers from the federal
government in Canada to all ten provinces and two territories are similar. But for
equalization transfers, the territories receive more than the provinces on a per
capita basis, as the equalization scheme reflects the greater needs and costs that
arise from the territories' remoteness and sparse populations (Broadway and
Hobson, 1993).
The Canadian constitution specifies the exclusive powers of both the
National (Federal) and Provincial governments. Most of the residual powers rest
with the federal government, although matters of merely local or private nature are
assigned to the provinces. Federal power covers issues relating to the nation as a
36
whole such as internal trade, railway, harbors and canals that are the sinews of
economic development. The provinces have been given jurisdiction over
education, health, welfare, property and civil rights, and ownership and
exploitation of natural resources. Historically, the provinces have guarded their
constitutional powers and have been relatively successful in asserting their rights
to the point where Canada is considered as one of the most decentralized
federations in the world (Vithal and Sastry, 2001).
While the federal government can raise money ‘by any system or mode of
taxation’, the provinces are given access to all forms of ‘direct taxation’, to raise
revenues for provincial purpose. Both the national and provincial governments
have constitutional access to all major forms of taxation. The major taxes of the
federal government are income tax on personal and corporate incomes, succession
and estate taxes, manufacturer’s sales taxes, customs, excise taxes and duties. It
also obtains some revenues through resources rents, most notably from export tax
on oil. The main provincial taxes consist of retail sales tax on ‘tangible personal
property’ (covers all commodities), tax on personal and corporate incomes,
succession and gift tax, health and social insurance levies, and property taxes.
The result of the severe vertical and horizontal imbalances has been the
evolution of an equalizing and liberal system of federal transfers in Canada (Shah,
1995). These transfers can be broadly classified as:
(1) Statutory subsidies: The subsidies paid to each Province as part of the
terms of confederation take several forms including grants in support of
Provincial Legislature, per capita grants, debt allowances and certain
special grants.
(2) Transfer under the Federal–Provincial Fiscal Arrangements and
Established Programmes Financing Act, 1977:
(a) Equalization Payments: Equalization payments to less endowed
Provinces are made under this Act essentially to raise the fiscally
deficient governments to the average level based on the per capita
revenue potential of the province. The consequence of these
equalization payments is that the difference between the provinces
in providing public services is remarkably small considering their
capacity differences.
37
(b) Stabilization Payments: The earlier tax agreements between the
national government and the provinces assured the later a revenue
‘floor’. The 1977 financial arrangements saw the national
government surrendering to the provinces, one percentage point of
its revenue from personal income tax on a one time only basis. It
also protects each province against a reduction in revenue due to
any subsequent changes in the national personal income tax
structure.
(c) Established Programme Financing: It covers the national
government’s contribution to provinces towards the cost of three
programme areas namely, hospital insurance, medical care and post
secondary education. The national government’s contributions
under EPF are not directly related to the provincial expenditures,
but to the rate of growth of the economy.
(3) Specific Purpose Transfers: Besides the three activities which are
supported under EPF, specific matching grants are given under the
Canadian Assistance Plan (CAP), primarily to provide adequate
assistance to persons in need. The unique feature of the scheme is that the
schemes for assistance are started entirely with Provincial initiative and
federal government accommodates it. Under the CAP, the national
government meets 50 per cent of the operating costs of the programmes
in each province. The Province may itself administer the programme,
designate a municipality or make use of agencies operated by private
groups.
Besides the above, the National and Provincial governments, over the
years, share costs through conditional matching grants on a wide variety of
activities. The inter-governmental fiscal problems in the course of implementing
fiscal policy are hammered out within an elaborate structure of consultations. This
process of consultation in Canada is carried out on virtually at every level of
federal and provincial administration. The annual meetings of the First Ministers
(the Prime Ministers and the Provincial Premiers) and regular meetings of the
ministers in the many areas of inter-governmental concern provide a prime forum
for solving the problems.
38
As regards fiscal policy, the most important roles are played by the
Federal and Provincial Relations Officer (FPRO) and the Department of Finance.
The FPRO is responsible for the important meetings of the First Ministers, and
together with Department of Justice, for matters relating to the Canadian
Constitution. The Department of Finance, through its Federal Relations Division
and Social Policy branches, is responsible for the fiscal arrangements agreed to by
the National government and the Provinces. The Economic Council of Canada
contributes inputs to this consultation process through its studies and annual
reports. In the end, the inter-governmental process culminates in a Federal and
Provincial conference. In fact, the inter-governmental consultation/conference
process has been the chief architect of the fiscal arrangements and equalization
programmes affected in Canada. Availability of constitutional access to all major
forms of taxation to both Federal and Provincial governments is a notable feature
of Canadian federalism (Vithal and Sastry, 2001). There are no constitutional
solutions to the fiscal transfers in Canada; they depend on political solutions.
2.7.3 European Union
In the European Union, fiscal decentralization is connected to the term
“subsidiarity”, the roots of which are found in 20th century Catholic social
philosophy (Doring, 1997). According to the subsidiarity principle, as
consolidated and adopted by the Maastricht Treaty of 1992, public policy and its
implementation should be allocated to the smallest jurisdiction with the
competence to achieve the objectives.
The constitutional arrangements for relationships between the different
levels of government vary considerably between EU countries. Some members
are federations while many other are unitary states. Coming to the local tier of
governance, some members have ‘strong’, while others ‘weak’ and the rest have
‘intermediate’ type of local governments (CTPA, 2002). In a large number of EU
member countries, the most common categories of sub-national government
expenditure are education, health, social security and welfare, housing and
community amenities, recreation, cultural and religious affairs, and transport and
communication. But the relative importance of these items varies widely between
countries. Similarly, the relative importance of taxes, non-tax revenues and grants
also varies greatly between EU member countries. Coming to sources of revenues
39
for sub-national entities in EU member countries (CTPA, 2002), they could
broadly, be categorized as follows:
i) Taxes, which include revenue from social security contributions as well as from
taxes on income, payrolls, consumption, wealth and property, and any other
taxes.
ii) Grants, which include any non-repayable payments received from other levels
of government.
iii) Non-tax revenues, which includes any other sources of non-repayable income,
including surpluses of trading enterprises, property income, administrative
fees and charges, fines and forfeits, and contributions from both employees
and other levels of government to employee pension and welfare funds.
As a representative member country of EU, we shall now discuss salient
features of fiscal federalism in Germany in the next subsection.
2.7.4 Germany
The German federation consists of sixteen Landers with a linguistically
homogeneous population having considerable economic disparity and difference
in political cultures between the former West and East Germanies. A notable
characteristic of the German federation is the extensive constitutional and political
interlocking of the federal and state governments. The federal government has a
very broad range of exclusive, concurrent (with federal law prevailing) and
framework legislative jurisdiction. But the Landers in turn have a mandatory
constitutional responsibility for applying and administering most of these federal
laws (Watts and Hobson, 2000). Another significant feature of the German
federation is that the Landers are more directly involved in decision-making at the
federal level than the states or provinces in virtually any other federation. This is
achieved through the constitutional requirement that the second chamber, the
Bundesrat, is composed of Land first ministers and senior ministers serving as ex
officio delegates of their Land governments. The Bundesrat possesses an absolute
veto on all federal legislation affecting the Lander. This makes the Bundesrat a
key institution in the highly integrated legislature, administrative and financial
interdependence of the two orders of government.
There are two fundamental features of the distribution of powers in
Germany worthy of note. First, the Basic Law allocates legislative jurisdiction on
40
the basis of an exclusive list of federal powers and a list of concurrent powers,
with the residual power remaining with the Lander. Exclusive federal legislative
power is granted in areas which include foreign affairs and defence, citizenship
and immigration, rail and air transport, criminal policing and foreign trade. An
extensive list of areas of concurrent legislative jurisdiction includes such areas as
civil and criminal law, the regulation of nuclear energy, labour relations,
environmental protection, and road transport (Watts and Hobson, 2000).
There are also two additional special categories of concurrent powers in
the Basic Law, First, the federal government may under its ‘framework’ powers
restrict the exercise of Lander legislative authority, to a limited extent, in certain
fields. In these fields, the federal government has the right to enact framework
legislation aimed at providing a degree of uniformity of action across the
federation; within these parameters, the Lander have the right to enact customized,
detailed laws. Framework legislative fields include areas such as higher
education, nature conservation, and regional planning. Second, there is a
constitutional provision for the federal and Land governments to carry out ‘joint
tasks’ together. These areas include university construction, regional policy,
agricultural structural policy and coastal preservation, education planning and
research policy.
2.7.5 Japan
The fiscal relations between the central and local governments in Japan
are markedly a vertical financial imbalance requiring transfers from the central
government to the local governments. In Japan, there are five types of transfers
from the central government to local governments: the local allocation tax, central
government disbursement, local transfer taxes, special traffic safety
disbursements, and transfers as a substitution for fixed-assets tax (Ma, 1994;
Yonehara, 1993; Fujiwara, 1992; and Ishi, 1993). Of these transfers, the local
allocation tax and central government disbursements are the most important of the
total transfers from the central government to local governments. The local
allocation tax is allocated to local governments to equalize their fiscal capacity
and to ensure sufficient funds for the public services that local governments are
required to provide.
41
The number of central government disbursement programs covers almost
all fields of local government activities. The local transfer taxes are levied by the
central government, which imposes them as local rather than as central taxes. The
central government collects these taxes on behalf of local governments because of
the advantages in assessment and collection. The local allocation tax aims to
equalize the fiscal capacities of local governments by supplementing the shortage
of their tax revenues, thereby, enabling local governments to provide public
services at the standard level prescribed by the central government. When a local
government does not maintain the level prescribed for public services, or has paid
an excessive amount for the services, the central government may reduce the local
allocation tax for that local government. Compared to other transfer schemes, the
local allocation tax is the only equalization scheme in Japan. It is allocated both to
prefectures and municipalities in the same way.
Like many other countries, basic fiscal need is a standardized amount
necessary to provide public services at the level prescribed by the central
government in Japan. Because the cost of providing public services is affected by
various factors such as geographical, social, economic, and institutional
characteristics of each locality, modification coefficients are applied to the
equation to adjust for these factors. The unit costs are calculated each fiscal year,
taking into account the change in price levels and the change in the people's
demand for the particular public service.
2.7.6 Korea
Intergovernmental fiscal transfer in Korea is administered through five
major transfer mechanisms. They are (1) Local Shared Tax; (2) National Treasury
Subsidy; (3) Local Transfer Fund; (4) Adjustment Allocation Grant; and (5)
Provincial Government Subsidy (Kim, 1985). The first three transfers are
distributed from the central to provincial governments, while the latter two are
transfers from major cities or provinces to lower level governments.
The Local Shared Tax and National Treasury Subsidy are the traditional
means utilized by the central government to transfer certain fiscal resources to
local governments. The Local Transfer Fund, introduced in 1991, can also be
categorized as a mechanism to transfer a portion of the fiscal base of the central
government to local governments except that the transfer is made directly out of
42
national tax revenue without having the revenue accounted for first in the central
government budget. Local Shared Taxes in Korea are divided into Ordinary Local
Shared Taxes (distributed on the basis of the pre-determined equalization formula)
and Special Local Shared Taxes (allocated on the basis of special needs of local
governments).
The objective of Ordinary Local Shared Taxes is to equalize the fiscal
capacities of local governments. The equalization formula used to distribute Local
Shared Taxes in Korea calculates for each local government the standardized
fiscal needs, the standardized fiscal revenue, and their difference signifies the
standardized fiscal shortage of the local government and becomes the basis of
actual allocation of Ordinary Local Shared Taxes. The results of these calculations
and the actual allocation of Local Shared Tax among local governments are
published annually for public inspection and scrutiny. While Ordinary Local
Shared Taxes are unconditional grants to the local governments, Special Shared
Taxes are conditional grants to supplement the operation of the Ordinary Local
Shared Taxes. Korea's National Treasury Subsidies are categorical grants provided
by the central government to local governments for specific projects. National
Treasury Subsidies are classified into three categories: (a) National Treasury
Share, (b) Promotion Subsidies, and (c) Specific Grants. National Treasury Share
is provided on the matching basis for natural disaster recovery projects and other
construction projects. Promotional Subsidies are allocated to local governments to
encourage them to undertake certain projects or to provide financial assistance for
certain projects. Specific Grants are provided usually for the full cost of
administering national functions (Kim1994).
2.7.7 The United States of America
The American system of public administration is an extremely complex
governmental organism with multiple layering as the striking feature of the
American government (Vithal and Sastry, 2001). The US Constitution allocates
the functions of national importance such as defence, international relations, postal
service, space research and technology exclusively to the Federal government. In
all other areas, Federal, state and local bodies hold concurrent powers to spend
though the states have ‘reserved’ powers to organize their own governments
without national interference, legislate for health, welfare, safety and morals of
their residents and assume responsibility for and the control of local governments.
43
All governmental bodies concurrently exercise most expenditure
functions. On social insurance, the roles of the federal and state governments are
almost equal. The local governments are primarily concerned with the provision
of education, health and hospitals, housing and urban renewal services. Because of
the concurrent powers in case of almost all the important taxes, the tax system in
the US looks uncoordinated and overlapping. The only co-coordinating device, in
case of individual income tax, is the deductibility of most State and local taxes for
federal tax purposes. All the three levels of government utilize many of the same
tax sources.
There is a considerable degree of variation in terms of potential and
degree of urbanization among the state and local governments leading to the
significant fiscal disparities noticed among the states. Although concurrent
powers of taxation are vested in different levels of government, imbalance
between revenues and expenditures at lower levels of government persists in the
USA. Originally, the federal special grant programmes started as conditional
school land grants. These transfers, over the years, gave birth to cash grants for
specific purpose programmes. After the depression and the Second World War, a
number of new federal grants were initiated; as a percentage of State-local
expenditures and in terms of numbers, the federal grant programmes increased
enormously (Vithal and Sastry, 2001). Almost all these grants, except revenue
sharing grants, are conditional in nature. Basically, three kinds of instruments are
used for the transfer of resources:
(1) Categorical (Conditional) Grants: are preferred in the USA to ensure that
important public services are provided more or less uniformly across the
country. The two important types of categorical grants are:
(a) Formula based categorical grants are given to achieve the prescribed
targets on a clearly defined population of eligible recipients for whom the
grant is intended. Most grants are made only to state governments while
some are made to state and local governments or to local governments
only. The most common formula grants are in the area of ground
transportation, education, training and employment, etc.
(b) Project-based grants are used when neither a well-defined beneficiary
population nor responsible objective measures of fiscal need and capacity
44
are available. In such cases, grants are made available for particular
projects in some specified area of public service. Project grants require
competitive applications from potential recipients.
(2) Block Grants: They are provided for use in a broad functional area. The
use of the funds is largely at the recipient’s discretion. Presently there are
five block grants in the broad functional areas of community
development, partnership for health, law enforcement assistance,
comprehensive employment and training, and social services. These
grants are distributed on the basis of specific statutory-based formula,
with population and certain other indices of need being the most
prominent factors used (Vithal and Sastry, 2001).
(3) General Revenue Sharing: Under revenue sharing, funds are distributed
to the States and local bodies for general purposes. Some important
features of revenue sharing grants are: (i) they are the shares of a fixed
sum of money and do not vary with federal revenues; (ii) revenue sharing
in the US does not involve inter-state equalization; and (iii) the inclusion
of the effort component and the requirement to pass two-thirds of the
funds to local governments diminishes their importance as a means of
rectifying inter-State imbalances between own revenues and expenditures.
As taxation and expenditure decisions in the USA are shared among
diverse units of government, and different levels of government are vested with
concurrent powers, this makes an intensive inter-governmental consultation
process inevitable. Essentially, the structure of inter-governmental relations is
built on the edifice of an informal cooperative consultation process. Inter-
governmental consultations in the USA mostly result from continuous day-to-day
contacts, knowledge and evaluation by government officials at both national and
State levels. The enactment of a number of Acts has helped in evolving better
administrative procedures, brought about improvements in personnel
administration, and enabled sub-national units to obtain more than one kind of
assistance from the national government.
Each of the lower level governments also has institutional arrangements
within its governmental structure to serve a liaison and information role with
officials at the state and national levels. Inter-governmental policy-making is
45
further aided by a number of nationwide associations fostering regular
consultations and discussions among the public officials of different levels of
government (Vithal and Sastry, 2001). Institutional mechanisms, such as the
Advisory Council on Inter-governmental Relations (ACIR), helps in providing
essential inputs to the process of solving inter-governmental fiscal problems. In
spite of a long, democratic history and a multi-layered institutional framework, the
USA seems to be less federal in fiscal matters than many other countries.
The American system of revenue raising shares with the Canadian one the
range of discretion that the states have over their own taxes. Most states levy their
own corporate and personal income taxes as well as their own retail sales taxes.
Their municipalities use property taxes extensively as well as taxes on natural
resources. The federal government shares many of the same tax bases, with the
notable exception of the sales tax. It also uses the payroll tax for financing a
specific program, the Social Security system (Boadway & Watts, 2006).
In the United States the vertical fiscal gap is closed by a wide array of
conditional transfers, both block and specific. This widespread use of conditional
transfers is a relatively unique feature of the US federal system. It arises at least
partly as a device to inducing accountability in state executive branches that,
unlike in parliamentary systems, are not accountable to state legislatures.
In the United States, there is no formal system of tax harmonization. The
major taxes co-occupied by the federal and state governments are personal and
corporate income taxes. In both cases, states have their own independent systems.
Some states choose to piggyback on the federal system by basing state tax
liabilities on the federal tax base, and sometimes also the federal rate structure.
However, other states define their taxes independently. In the case of the
corporate tax, there is the additional problem that different states apply different
conventions for allocating to themselves taxable income earned by firms that
operate in more than one state. This gives rise not only to inefficiencies but also
to instances of double taxation or of non taxation of some portion of incomes.
Sales taxes are used only at the state level, and here too there is no harmonization.
State sales taxes are single staged retail taxes (for those that use this tax source),
where bases and rate structures can vary considerably across states. Thus the tax
system in the United States is highly differentiated across states, though the
46
significance of this is somewhat diminished by the fact that states collect a
relatively smaller proportion of total tax revenue than in Canada (Boadway &
Watts, 2006).
The aforesaid discussion on fiscal federalism clearly brings out a variety
of approaches adopted by different countries for correcting vertical and horizontal
imbalances. As discussed earlier, in some countries, institutional mechanism
dealing with fiscal federalism is formal while in many others, it remains informal.
Table 2.3 captures comparison on the basis of division of functions, division of tax
powers and inter-governmental fiscal relations in some select countries. There are
certain common threads (equity, efficiency, equalization etc.,) running across
countries to achieve overall goals of fiscal federalism; however, each country
adheres to its unique model. After analyzing fiscal federal structures of few
representative but important countries, we will now focus mainly on Indian
federalism in the subsequent Chapters.