AUTONOMY OR DEPENDENCE: financial relations; recent major reform efforts; INTERGOVERNMENTAL FINANCIAL and identification of distinctive and unique RELATIONS IN ELEVEN features. The economic and political COUNTRIES1 performance of these eleven financial By Ronald Watts arrangements is also assessed in terms of a variety of economic and political criteria. ACKNOWLEDGEMENTS I would like to express my appreciation for A. INTRODUCTION the indispensable assistance of the four Research Assistants who worked on this project. Andrew 1. Focus and Scope of the report Bell (India and South Africa), Winter Fedyk This study follows an earlier study by (Switzerland and Spain), Sarah McQuarrie Professors Robin Boadway and Ronald Watts on (Japan and Sweden) and Denis Silva (Australia behalf of the Institute of Intergovernmental and Brazil) gathered a great deal of useful Relations concerning intergovernmental fiscal information on the financial arrangements in the relations in Canada, the United States and respective countries assigned to them. Germany. This new study is intended to I would also like to thank Mary Kennedy supplement the previous one by providing a and Katrina Candido of the Institute staff for comparative overview of intergovernmental their skill and diligence in typing the various fiscal relationships in which a further eight drafts and rendering them readable. countries are included, thus embracing in all Ronald L. Watts eleven countries. 28 January 2005 ABSTRACT As originally envisaged the additional eight This study compares intergovernmental countries that were selected for this study financial arrangements in eleven countries. Five represented: (a) three developed federations and are mature federations (the United States, quasi-federations, Switzerland, Australia and Switzerland, Canada, Australia and Germany), Spain; (b) three developing federations and four are transitional federations (Brazil, India, quasi-federations, India, South Africa and South Africa and Spain), and two are mature Brazil; and (c) two decentralized unitary decentralized unitary political systems (Sweden systems, Sweden and Japan. In terms of their and Japan). The financial arrangements in these financial arrangements, however, as the study eleven countries are compared in terms of the has progressed, it has proved more useful to constitutional and political context; the group them into three slightly different allocation and scope of federal, state and local groupings. First is a group of “mature expenditures and revenues; the nature, role and federations”. Into this group would fall scope of intergovernmental transfers; systems of Switzerland (1848) and Australia (1901), both in tax harmonization and collection; decision- operation now for more than a century. The making processes for intergovernmental three federations considered in the earlier reports, the United States (1789), Canada (1867) and Germany (1949), would for comparative 1 This paper was first prepared under the auspices of reference fall into the same category making a The Consortium for Economic Policy Research and total of five ma1ture federations. The second Advice (CEPRA) in April 2004 -- a project of group might be called “transitional cooperation and technical assistance sponsored by the federations”. These federations or quasi- Canadian International Development Agency federations share a number of similarities, all (CIDA). The project is being carried out by the being federalized more recently and, with the Association of Universities and Colleges of Canada exception of Spain, representing countries with (AUCC), working in conjunction with experts in developing economies. In this group would be academia, government and the non-governmental India (1950), Spain (1978), Brazil (1988) and sector in both Canada and the Russian Federation. The author benefited from the comments and South Africa (1996). A third category are the suggestions of Harvey Lazar. two “mature unitary systems”, Sweden (1523)

Working Paper 2005 (5) © 2005 IIGR, Queen’s University Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries and Japan (1947), with well developed The Swiss Confederation founded in 1291 economies. existed in various forms until it broke down in the brief Sonderbund civil war of 1847. A new In the comparative analysis of these eleven constitution in 1848 converted it into a cases, the focus will be on those institutional federation. This constitution was substantially features that affect the way in which revenue revised in 1874 and 1999, but the most recent and expenditures are allocated among different revision retained the basic character of the levels of government, the role and nature of federation, taking the form largely of intergovernmental transfers, the nature and modernizing the language of the constitution extent of tax harmonization or competition, and rather than substantially modifying its content. other key elements of intergovernmental financial relationships. This review will take Switzerland is a small country of some 7 account of major recent reform efforts over the million people and now comprises 26 cantons of past five to ten years and their effects, and any which 6 are designated as ‘half cantons’ in terms unique features, including the processes through of their representation in the Council of States which decisions on these matters are arrived at. (Standerat) and in terms of their voting power as The analysis will further explain how each cantons in constitutional referendums. Despite country’s institutional features have reflected its its small size, the Swiss federation is notable for particular historical, geographical, cultural, its degree of linguistic and religious diversity. Its demographic and economic circumstances. The three official languages (German, French and report will conclude with an assessment of the Italian; a fourth, Romansh, is recognized as a economic and political performance of these ‘national’ language) and two dominant faiths examples in terms of eight criteria: economic (Roman Catholic and Protestant) are the major efficiency, equity, fiscal management and territorial cleavages. But these cleavages cut stabilization policy, autonomy of constituent across each other territorially. Although the units, coordination and degree of central German Swiss continue to dominate in overall influence on states and local governments, numbers and economic power, the fact that transparency and accountability, political among German-speaking cantons some are stability and adaptability, and the relative Roman Catholic and some are Protestant and significance of their institutions and political that among French-speaking cantons also some culture. The issues considered in this report are Roman Catholic and some are Protestant, parallel those in the earlier reports on Canada, means that on different issues cantonal the United States and Germany in order to representatives adopt different alignments and facilitate comparisons of this report with those coalitions. This has moderated any tendency to earlier reports. the cumulative polarization of differences within the federation. 2. Introductory Overview of the Eight Additional Countries Studied While under the constitutional distribution For an overview of the three mature of legislative powers a significant proportion are federations, Canada, the United States and assigned to the federal government there is a Germany, the reader is referred to the previous general emphasis upon decentralized decision- reports in this series. Here, in this section an making and cantonal autonomy. Not only do the overview of the eight additional countries unlisted residual powers lie with the cantons but included in this study is provided. the constitution leaves the federal government highly dependent upon the autonomous cantons (a) Mature federations: for the administration of a large portion of its (1) Switzerland (1848): legislation leading in practice to a high degree of Switzerland is a long-standing developed decentralization. Indeed in terms of both multicultural federation marked by a governmental revenues and of governmental substantional degree of fiscal decentralization expenditures, Switzerland and Canada are the and cantonal autonomy. two most decentralized contemporary

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 2 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries federations in the world. Furthermore, two other The Australian federal constitution of 1901 factors contribute to the decentralized character united a group of self-governing British colonies of the Swiss federation. One is the high degree on the continent. Today, the federation of cantonal consultation that the federal comprises six states (of which the two most government is required to undertake due both to populous, New South Wales and Victoria, constitutional requirements and to political comprise some 60 percent of the total federal tradition. The second is that all federal population) plus one capital territory, the vast legislation is subject to check by a referendum if Northern Territory, and seven small a specified number of citizens petition for it. administered territories.

Switzerland has had since 1959 a system of By contrast with Switzerland, Australia has equalization transfers to moderate the financial a relatively homogeneous society with a disparities among the cantons. In recent years population of about 19 million people mostly these have been the source of some controversy descended from British and European settlers. leading to the consideration of substantial However, the geographic vastness of the reforms to the system. continent and the concentrations of population in dispersed state capitals, each serving its own The principle of the separation of powers hinterland, have made federation a natural form with fixed-term collegial executive councils has of political organization. been applied to both levels of government. The Federal Council is a collegial executive body The founders of the Australian federation elected by the Swiss federal legislature for a rejected the Canadian model which they fixed term and composed of seven councilors regarded as having a relatively centralized among whom the Presidency rotates annually. distribution of powers, and followed instead the The federal legislature is bicameral composed of American model of enumerating a limited list of the National Council (Nationalrat) and Council federal exclusive powers and a substantial list of of States (Standerat) with equal powers. In the concurrent powers, leaving the substantial latter the twenty full cantons have two unspecified residual powers to the state representatives each and the six half cantons governments. In practice, however, the have one each. The electoral system based on Australian federation has over time evolved into proportional representation has resulted in a a relatively more centralized federation, multiparty system, but the fixed-term executive particularly with respect to its financial has provided stability, and the tradition has arrangements. A notably significant feature has developed that it should encompass the four been the strong revenue position of the federal major political parties representing an government, reinforced by some major High overwhelming majority in the federal legislature. Court rulings. Indeed, the federal government The predominant characteristics of the Swiss controls about three-quarters of the total federal- political processes have been emphasis upon state-local revenues. Since the states and local consultation with all groups, respect for governments are constitutionally responsible for minorities, and decisions based upon nearly half the total public expenditures, this has compromise and consensus. These processes required a system of very substantial transfers characteristically have required lengthy from the federal to the state governments to deliberations but have received widespread close the vertical financial gap. Given a political acceptance of decisions once arrived at. culture emphasizing uniformity and inter-state equity, Australia since 1933 has been a pioneer (2) Australia (1901): among federations in developing formal Australia is a long-standing developed equalization arrangements. In many respects it federation with parliamentary institutions. It has has been the model that has most influenced the been marked by a considerable emphasis upon equalization arrangements adopted in uniformity and inter-state equity in its financial subsequent federations in the developing world. equalization arrangements. A key institution in the evolution of equalization

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 3 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries arrangements since 1933 has been the practice to a federation that is only partially Commonwealth Grants Commission. centralized and is composed of powerful states. The constitution provides for three exhaustive While adopting a different form of lists of legislative powers – exclusive federal, distribution of legislative powers, the Australian exclusive provincial, and concurrent (with federation did follow the Canadian precedent of federal paramountcy) powers – and for residual combining federal with British parliamentary powers assigned to the Union government. The institutions (with cabinets responsible to the major taxing powers are assigned to the Union legislatures at both federal and state levels). At government, but there is constitutional provision the same time, unlike Canada, the Australians for the sharing of the proceeds of these. incorporated a relatively powerful directly Adjustments to these largely unconditional elected Senate with equal representation of the transfers are made on the basis of states. The impact of the parliamentary system recommendations from quinquennial Finance has, however, made the Senate in practice more Commissions provided for in the constitution. of a ‘party house’ than a regional ‘state house’. These transfers also include an equalization The parliamentary institutions which in practice element. has led to cabinet dominance within each government have also affected the character of Formally, the Union government possesses intergovernmental relations with the result that very substantial powers, especially powers of Australia has developed the institutions and intervention and preemption in emergencies, but processes of ‘executive federalism’ extensively. it now functions within an ethno-political and multi-party context that requires that those (b) Transitional federations: powers be used to preserve federalism in form (3) India (1950): and spirit. Increasingly, power-sharing as a way The Union of India is a developing country of reconciling conflict and the operation of that contains a highly diverse society. The Union coalition governments encompassing a variety of has been held together for over half a century regional parties at the Union level have come to within what began as a highly centralized quasi- predominate, despite some imperfections in the federation under the constitution of 1950, but process. which has since then been progressively decentralizing. Today the federation comprises The institutions of the Union and state 28 States, 6 Union Territories and one National governments are parliamentary in form with the Capital Territory with a total population of over principle of responsible government operating at one billion people. both levels. The formal head of state is a President elected by an electoral college India is a diverse multilingual society. consisting of the elected members of both Hindi, is spoken by some 40 percent of the houses of parliament and the state legislatures. population but there are some 18 other regional The formal heads of the states, the governors are languages recognized as official by the appointed by the Union government. But it is the constitution. Between 1956 and 1966 the states Prime Minister and the Chief Ministers of the were reorganized largely on an ethno-linguistic States who dominate the political processes. basis. Since that time there have further adjustments to the boundaries of the constituent (4) Spain (1978): units with three new states being created as Spain is a developed country which recently as 2000. relatively recently adopted a quasi-federal structure. It has been marked by considerable While the founders sought to create a asymmetry in the powers and financial centralized federation to hold this diversity arrangements for its 17 Autonomous together, the ethno-linguistic basis of many of Communities. the states and the powerful forces of regionalism within the India sub-continent have led in

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 4 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

After some forty years of totalitarian Country and Navarra which retain historically centralization, in 1978 Spain adopted a new significant residual powers and which, unlike the constitution establishing a parliamentary other Communities, have also retained (under democracy. As part of the post-Franco the Constitution Additional Provision No. 1) democratization and as a means of balancing historic tax raising and collecting powers from powerful regional interests fostered by revived which a portion is ceded to the central Basque and Catalonian nationalism, Spain has government. Despite this relatively high level of pursued a process of regionalization. This led to autonomy by Spanish standards, the Basque the development of units called ‘Autonomous country has continued to be plagued by Communities’ of which there are 17 in a country relatively intense independist terrorist violence. of nearly 40 million. The other 15 Communities have only limited taxing powers and depend heavily on transfers in Although historically a strongly centralized the other direction from the central government. unitary state, Spain has in fact contained This group itself falls broadly into two sub- considerable diversity. While the political groups differentiated according to their level of culture of the Castilians has tended to be responsibilities. The first, the ‘fast track’ group hierarchical and centralistic, the Argonese, (Article 151) Communities including Andalusia, Basques, Catalonians, Galicians, Navarrese and The Canary Islands, Catalonia, Galicia and Valencians have each had a strong interest in Valencia, have a high level of responsibilities, securing their own cultural identity. including major responsibilities for education and health, and therefore receive a substantially The Spanish response to this situation was higher level of transfers. The second, the ‘slower the adoption of a constitution in 1978, which track’ (Article 143) Communities with fewer although not officially labeled as federal, in fact devolved powers receive substantially less. has virtually all the characteristics normally Nevertheless, as the latter group over time associated with federation. At the very least it assume greater responsibilities the gap is may be called “quasi-federal”. Furthermore narrowing. There is also an Inter-Regional since its adoption there has been a progressive Compensation Fund that redistributes funds grant to each region of its own arrangements for among regions according to criteria such as autonomy based upon a particular set of population density, relative income, level of compromises negotiated between its regional unemployment, level of integration, population leadership and the central government. More dispersal and insularity. recently, however, the Madrid government has emphasized that although the different regions The central government is a parliamentary are progressing to autonomy at different speeds, monarchy with the Council of Ministers ultimately they should become less responsible to the Congress of Deputies, the asymmetrical. As a result of this process since lower house in the bicameral Cortes. The Senate, the adoption of the constitution, Spain has the second chamber, consists mainly of directly moved to a degree of decentralization elected members, but 51 of its 259 members are comparable to those found in developed appointed by the regional legislatures. federations elsewhere. This has, however, been derived less from a constitutional mandate than The relations between the governments at from party strategies, competition and the national and community level and the degree bargaining within a loose institutional of asymmetry among the Autonomous framework. Communities continues to undergo a fairly rapid evolution. In practice, the result has been that in the distribution of powers and related financial (5) Brazil, 1988: arrangements there are three groups of Brazil is a developing Latin America Autonomous Communities. The first has been country which during the 19th and 20th centuries the ‘fueros’ (foral) communities, the Basque alternated between federal and autocratic

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 5 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries regimes. This culminated in a decade of political their total revenues. This means that the levels of and fiscal decentralization in the 1970s and vertical fiscal imbalance are lower than in most 1980s, and a new federal constitution in 1988. In federations. Nevertheless, there is a measure of area the fifth largest country in the world, and federal transfers, three-fifths of which are with a population of more than 170 million unconditional. There is, however, little inhabitants, the federation encompasses 26 states equalization to correct horizontal imbalances. plus the Federal District of Brasilia. The These financial arrangements have produced two constitution also provides rules for the major characteristics: first, intense fiscal management of the over 5,500 autonomous competition and a war of tax incentives among municipalities. most of the states seeking large-scale industrial investment, and second, the continued From linguistic, ethnic and cultural persistence of sharp disparities of wealth among standpoints Brazil is relatively homogenous, but the states. its 27 constituent units are marked by great disparities in the distribution of land, population The federal institutions have been and wealth. Brazil has historically been significantly influenced by the model of the characterized by major social economic United States with a presidential and bicameral disparities and its pattern of intergovernmental congressional system. relations, even before the instituting of the federal constitution, had evolved through (6) South Africa (1996): alternating phases of centralization and South Africa is a developing country which decentralization to address these issues. The after the ending of the apartheid regime adopted primary driving force behind the pressure for in 1996 a quasi-federal structure emphasizing decentralization during the 1970s and 1980s was three ‘spheres of government’ – national, the demand from the sub-national governments provincial and local – within a relatively and provincial elites for a larger share of fiscal centralized overall legislative and financial revenues. framework.

The 1988 constitution contains detailed South Africa has a population of 44 million provisions about the political, administrative and people of whom 75.2 percent are black, 13.6 fiscal organization of the federation. The percent (composed of Afrikaaners and English- constitution provides the states with the speaking people) are white, 8.6 percent are residuary power and defines areas of concurrent coloured and 2.6 percent are Indian. But among jurisdiction including among others education, the black population a variety of languages are heath, social assistance and environmental spoken leading to the recognition of 11 official protection. However, the detailed and extensive languages in the 1996 constitution. Under the definition of the federal constitutional powers constitution nine provinces were established, but and its active use of its paramountcy powers in unlike most federations with deeply divided the areas of concurrent jurisdiction, has provided societies, these do not coincide with racial or only limited opportunity for the sub-national tribal boundaries. This was done in order to governments to exercise their legislative powers avoid emphasizing these divisions. without federal consent. On the other hand, administrative responsibilities are substantially Federalism has had a highly contested more decentralized. Sub-national governments reception in South Africa because apartheid had (states and municipalities) account for 36 been justified in part on a federalist rationale. percent of total governmental expenditures Consequently, the 1996 constitution carefully (Table 2). With this decentralization has gone a avoids the label ‘federal,’ but its characteristics strengthening under the 1988 constitution of the are in fact essentially those of a federation. It tax bases of the state and municipal governments may, therefore, appropriately be described as at with the result that own-revenues of the states least ‘quasi-federal’. The constitution recognizes and local governments account for 70 percent of not only ‘provinces’ but ‘local governments’ as

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 6 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries distinct ‘spheres’, but consciously rejects the use central government. In practice, however, its of the term ‘level’. While the constitution effectiveness in that role has been limited. formally sets out a substantial area of concurrent jurisdiction and a short list of exclusive (c) Mature unitary political systems: provincial powers, the division of powers (7) Sweden (current constitution 1975): heavily favours the national government both in Sweden became independent in 1523 and the powers assigned to it and in its ability to exemplifies a long-standing developed country over-ride the provinces in certain circumstances. with a unitary form of government. However, it The national government is given the power to is characterized by a high degree of set national standards and norms and to over- decentralization of welfare services and financial ride provincial standards which may threaten arrangements among its 289 municipal national unity or objectives. The provinces enjoy governments and 21 counties. It has a population limited revenue-raising and borrowing powers, of about 9 million and its population is relatively and therefore are highly dependent upon homogeneous. transfers from the national government. The constitution does provide for a Finance and Among unitary political systems, Sweden is Fiscal Commission to make recommendations marked by a particularly high degree of on these transfers to provide the provinces and decentralization. Indeed, in terms of local governments with an ‘equitable share’ of expenditures after transfers the Swedish central revenues raised nationally. Among the criteria government at 54 percent spends less of total the Commission considers is the need to combined expenditures than the federations and overcome income inequalities within and among quasi-federations in the United States, Spain, the provinces. Austria and Malaysia and about the same proportion as the federations of Australia and The constitution (chapter 3) emphasizes the India (Table 1). Local governments in Sweden – principle of ‘cooperative government’ requiring municipalities and county councils – are all spheres of government to exhaust “every assigned all services to the citizens: primary and reasonable effort to resolve any disputes through secondary schools, hospitals, health services, intergovernmental negotiation” (s. 41 (3)) and to care for the elderly and social assistance. Only exhaust all other remedies before approaching a police, higher education and the national court to resolve a dispute. Nevertheless, there is schemes of old age pension and unemployment a Constitutional Court to serve as an ultimate benefits remain at the central level. The Swedish arbiter. In practice, the predominance of the intergovernmental fiscal arrangements are African National Congress (A.N. C.) both in the sophisticated and have been built on a system of national government and in all but two provinces local government that has been in place for over has provided the means for coordination through one hundred years. The primary sources of party channels, and indeed for dominance by the revenue for local government in Sweden are central government. taxes (about two-thirds of the total), grants from the central government (about one-fifth) and The institutions in the national and user fees (7 percent). There is no property tax. provincial spheres, are predominantly Instead, the primary tax at the local level is a tax parliamentary, although at the national level on personal income. Local governments set their there is a President who acts both as head of own tax rates. Municipal and county councils government and head of state. There is a thus enjoy a consideral freedom in deciding on bicameral parliament with a second chamber, the their delivery of services, the financing of these, National Council of Provinces, which is and their own internal organization. Imbalances composed of representatives both from the between regions are corrected by a system of provincial legislatures and executives. Its transfers which are collected and distributed by intended function was to ensure that provincial the central government: municipalities and interests are not seriously abrogated by the county councils whose per capita taxable income level is below the national average receive a

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 7 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries grant while those above the average taxable prefectures and some 3,250 local governments income pay a fee. In addition the local within them, the Japanese central government is governments receive a block grant from the more powerful than would be the case in most central government, containing a population- federal systems, and this power has been related and age-related portion. Although reinforced by making the lower government levying of income tax is highly decentralized, levels financially dependent on the centre. the collection of these taxes on their behalf by Nevertheless, not unlike Sweden, local the National Tax Administration, and the governments in Japan are responsible for a definition of tax bases by central law has major share of public spending. Their contributed to tax harmonization. responsibilities include national land conservation and development expenditure, In terms of the organization of central education expenditure, police and fire brigades, politics, Sweden is a parliamentary democracy social welfare, sanitation and general with a constitutional monarchy. Although administration amounting in 2001 to 62 percent unitary, the constitution establishes the of combined total public expenditures. But, principles of local government. The 1991 Local unlike Sweden, the ultimate control of the Government Act defined the roles of central government is ensured by a provision in municipalities, county councils and regions and the Local Autonomy Law (article 150) that states provided extensive scope for local inhabilitants that the chief executives of the local authority to monitor and influence the local decision- act as agents of the central government to making process. Every municipality and county deliver prescribed functions, and makes has a council whose members are elected every provision for mandamus proceedings allowing four years on the same day as the parliamentary the central government to direct local elections. governments to carry out certain activities.

Among unitary political systems generally, Furthermore, the dominance of the central the Nordic countries, of which Sweden is a good government is reinforced by the centralization of example, are unique in the level of autonomy finances. The constitution establishes the Diet’s allocated to local governments both for the control over the imposing of taxes and the provision of many public services and for their expenditure of funds. In the Japanese fiscal taxation authority. system, while the majority of expenditures are done at the local level, only a very limited (8) Japan (1947): autonomy is available to local governments in Japan is a unitary country with one of the their spending decisions, and on the revenue side most homogeneous populations of any country decentralization is limited and the authority of in the world, but with a considerable tax base and rate determination lies with the administrative and financial decentralization for central government. Because local government its 47 prefectures. The population of some 127 expenditures constitute approximately 62 million people is concentrated in a relatively percent of all government expenditures but local small land mass living mostly in four main tax revenue constitutions only about 42 percent islands and 4000 smaller islands, but 80 percent of all government revenues (Table 2), the central of the population and 85 percent of the government through its transfers plays an economic activity is concentrated in the island of important role in helping local governments Honshu. meet their budgetary needs. As a result transfers form a much higher proportion of local The current constitution of Japan was in government revenues than in Sweden. effect written and imposed by the United States Moreover, about two-fifths of these take the after World War II, coming into effect in 1947. form of conditional or specific purpose grants The constitution does make specific provision which further limits the autonomy of prefectures for local government and the governors of the and local governments. There is an equalization prefectures are elected. In relation to the 47 component in the allocation of the unconditional

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 8 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries transfers which are distributed according to a and Japan. On the other hand, among the uniform formula based on basic financial need transitional federations, only India has had a half and basic financial capacity. century of experience and the other three, Spain (1978), Brazil (1988), and South Africa (1996) Under the 1947 constitution, the Emperor of have had their current constitutional and Japan serves as the “symbol of state” but has no financial arrangements in place for only three formal governmental power. Effective national decades or less. This has enabled some executive power lies with the Prime Minister innovations, but the pattern is less settled. and cabinet who depend on the confidence of the Furthermore, in most of them, concern about the House of Representatives to remain in power. fragility of the federal union has led (with the The national Diet is bicameral. The second exception of Brazil) at least initially to a greater chamber is the House of Councillors elected on concentration of powers and finances in the the basis of open list proportional representation central governments (see for instance Table 1 at from prefectural electoral districts. However, the end of this report). House of Representatives takes precedence over it. Local authorities have elected assemblies and Geography has also had a significant impact. elected chief executive officers. For most of the Most of the federations considered in this and period since 1947 (the main exception being the previous studies have been extensive in 1993-6) the dominant party in the national Diet territory or population. The only significant and government has been the Liberal exception among these federations is Democratic Party and the political struggles Switzerland, with a population of only seven have been as much between different factions million people, but the mountainous topography within that party as between parties. of Switzerland has divided these people by distributing them in pockets in their distinct B. A COMPARATIVE REVIEW OF valleys. Sweden and Japan are geographically SIGNIFICANT FEATURES OF THE more compact than most of the federations and FINANCIAL ARRANGEMENTS IN THE in both their populations are relatively ELEVEN COUNTRIES concentrated in a few urban centres rather than dispersed. 1. The Context for Intergovernmental Financial Relations Cultural and demographic factors have also (i) Significant historical geographic, cultural, been significant. Japan has one of the most demographic, and economic features homogeneous populations in the world due to an affecting financial arrangements: absolute prohibition on immigration,2 and Underlying the political and constitutional Sweden, while less so, in comparative terms also context for intergovernmental financial has a relatively homogeneous population. The arrangements in federal, quasi-federal and federations both mature and transitional are decentralized unitary political systems are the generally marked by considerably more internal similarities and differences in the character of cultural diversity. Some such as the United their societies. The historical background is States, Germany, Australia and Brazil are significant, for instance. The longevity of the fundamentally mono-national in having a mature federations such as the United States dominant national group, but nevertheless (1789), Switzerland (1848), Canada (1867), contain considerable cultural diversity as a result Australia (1901) and Germany (1949) means of extensive immigration. Others such as that these federations have had the opportunity Switzerland, Canada, India, Spain and South to develop over more than half a century and in Africa are marked by much sharper linguistic, four of these over a century, experience in the religious and racial differences in their handling of intergovernmental financial relations and to evolve and modify these in the light of 2 Richard L. Carson, Comparative Economic Systems, that experience. The same could be said of the Volume 2; Transition and Capitalist Alternatives, 2nd mature decentralized unitary systems, Sweden ed. (New York: M.E. Sharpe, 1998), pp. 133.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 9 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries composition and could even be described as legislatures, representatives of their multi-national federations. In the case of the first governments, or by referendums; an umpire in three this has led to considerably more the form of a Supreme Court or a Constitutional decentralization of constitutional and financial Court to rule on constitutional disputes between powers, whereas in the two more recent governments; and processes and institutions to examples, Spain and South Africa, fears of facilitate intergovernmental collaboration for disunity have produced considerable resistance these areas where governmental responsibilities to decentralist pressures and a tendency to insist are shared or inevitably overlap. on retaining strong central powers. Among the common constitutional and The economic character has also been a political features shared by these mature and significant factor. The existence of different transitional federations are number which regional economies, especially in countries with particularly have an impact on the financial continental scope, has helped to reinforce arrangements. First, is the constitutional federalization in many instances. Where the distribution of expenditure responsibilities and market economy has been prevalent this has also revenue sources. In each case the distribution of contributed to this trend, although in those more legislative and executive authority defined in the recent federations where the emphasis upon constitution has established the scope of economic planning has been strong, as in the expenditure responsibilities that each early years in India and South Africa, this has government in response to political led to a much greater emphasis upon providing circumstances may undertake. At the same time, the central government as the primary planning in all five mature and four transitional body with strong financial powers. federations, the constitution has also defined for each order of government their financial (ii) The Constitutional and Political Context: resources from taxation, borrowing, commercial (a) Features shared in common among the activities or intergovernmental transfers. In all federations: these federations, either explicitly or implicitly, Six of the countries examined in this study there is also provision of a “federal spending are federations or quasi-federations that share power,” unlimited in certain cases but with certain features in common with the three limits in others, enabling the federal government federations studied in the previous reports. All to spend its money through transfers on areas of nine incorporate the major characteristics of a responsibility that normally fall within state federation: the establishment of two or more jurisdiction.3 orders of government each acting directly on citizens, rather than indirectly through another Second, although the degree of sphere of government; a formal constitutional intergovernmental interdependence varies in the distribution of areas of exclusive and shared nine federations, common to all is the inevitable (concurrent) legislative and executive authority existence of some degree of interdependence ensuring at least some areas of genuine arising from areas of shared jurisdiction or constitutional autonomy for each government; a overlaps in jurisdiction. This interdependence constitutional allocation of revenue resources for has had important implications for the each order of government; provision for the intergovernmental financial arrangements. For designated representation of distinct regional instance, issues of harmonization of taxes and units within the federal policy-making their collection arise. In addition attention has institutions, including usually a federal second had to be directed in each of them to the legislative chamber designed specifically for this correction of vertical (federal-state-local) and among its functions; a supreme written horizontal (state-state) imbalances where the constitution not unilaterally amendable by either order of government but requiring the assent of 3 Throughout this report, the generic term “states” has the federal legislature and of a significant been used to cover also “provinces,” “cantons” and proportion of the constituent units through their “autonomous communities.”

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 10 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries expenditure responsibilities of each government Fourth, common to all nine federations has are not matched by its constitutionally allocated been the supremacy of the constitution and the revenue resources. These arise for two reasons. role of the courts and the rule of law as the basic First they arise because in all nine federations context within which the federal financial there has been a tendency for the major taxing arrangements have operated. Although fields to be assigned constitutionally to the invariably the taxing, borrowing and other federal governments because these taxes are revenue raising authority of the various important instruments for affecting and governments have been constitutionally regulating the economy and for performing a specified (either explicitly or through the redistributive role. Second, there has been a assigned residual authority), in some cases, most general tendency to assign constitutionally to the notably in the United States, Canada, Australia, states more substantial expenditure and Spain, only the major expenditure and responsibilities in the interest of more effective revenue responsibilities are constitutionally administrative decentralization or to meet allocated, and much of the arrangements for political pressures from the states seeking to intergovernmental financial transfers has been maintain their distinctiveness. Indeed, in all nine left to governmental practice. In other cases such federations provision has had to be made, either as Switzerland, Germany, India, Brazil and constitutionally mandated as in Switzerland, South Africa, the constitution goes into Germany, India, Brazil and South Africa, or by considerable detail about the arrangements for governmental action as in the United States, shared tax proceeds and for transfers between Canada, Australia, and Spain, for financial governments. But in all nine federations it is the transfers from the federal government to the constitution that provides the ultimate state governments to correct these imbalances. framework within which the intergovernmental The scope and form of these transfers has varied financial arrangements operate and are adjusted, and will be analysed later in this report. and in ensuring this, the courts and the principle of the rule of law have been crucial elements in Third, in virtually all these federations there providing the basic framework. have been political pressures for state consultation and participation in federal (b) Significant Differences Among Federations decisions about financial arrangements and in the Constitutional and Political transfers. These pressures have arisen because Context. no matter how carefully the original designers of While as noted above the three federations the federation have attempted to match the reported on previously and the six mature and revenue resources and expenditure transitional federations being analysed in this responsibilities to each other, over time the report have broad similarities in sharing the significance of different taxes has changed and fundamental characteristics of federal systems the costs and scope of expenditure and hence in the issues of federal finance that responsibilities have varied in unforeseen ways. they have faced, there have at the same time Consequently, all these federations have found been significant variations among them in their the need to make adjustments from time to time. political and constitutional contexts. This has invariably raised the issue of the appropriate processes and institutions for First, there is the distinction between making these adjustments and the concerns in “federations” and “quasi-federations.”4 The each federation of the state governments that former terminology refers to those political their autonomy should not be undermined by systems which have all the characteristics unilateral federal government action. The actual normally associated with the definition of a form and character of the manner in which such federation. “Quasi-federations” refers to political issues have been negotiated or dealt with in these federations has varied considerably, 4 nd R.L. Watts Comparing Federal Systems, 2 ed. however, as will be noted later in this report. (Montreal and Kingston: McGill-Queen’s University Press, 1999), pp. 7-14.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 11 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries systems which are predominantly federations in and reconstruction, the “federal” terminology their constitutions and operation, but which may was avoided in the new 1996 constitution. have some overriding federal government Analysis of its institutions, however, indicates powers more typical of a unitary system. Such that in character it is essentially federal, hybrids occur because statesmen are often more although relatively centralized and including interested in pragmatic political solutions than in central legislative powers to override provincial theoretical purity. The five mature federations, legislation under specified conditions, a clearly the United States, Canada and Germany quasi-federal feature.7 In these three transitional considered in the previous reports and quasi-federations, the constitutional emphasis Switzerland and Australia in this all now belong was upon giving their central governments in the former category. In the case of Canada, its sufficient power to preserve the federation original constitution contained some quasi- against dissolution during the transitional period. federal features,5 but these have fallen into A corollary of this has been that in their disuse in the past half-century, and so the financial arrangements, revenue raising powers operation of the federation is now fully federal were correspondingly concentrated in the central in practice. government even though expenditure responsibilities were more considerably Among the four transitional federations, devolved. however, quasi-federal features have been notable. Indeed three of them, India, Spain and Among the transitional federations Brazil South Africa, while predominantly federal in provides a contrast. The 1988 constitution their institutional character, have avoided expressly defines Brazil as the “Federative describing themselves in their constitutions as Republic of Brazil,” and although the definition federal. The Indian constitution (1950) describes of central constitutional powers is detailed and the polity as a “Union of States” and includes a extensive,8 there is no provision for central set of emergency powers6 enabling the Union powers to override state legislation. In these government in emergencies to completely circumstances, the institutional arrangements override the state governments, and the use of and current government practices of Brazilian these powers has not been infrequent. However, fiscal federalism are complex but are the tendency to invoke them has more recently characterized by a great deal of sub-national been declining. Spain too, to emphasize its government autonomy. devolutionary and indissoluble character avoids the label “federation” in its constitution, the Variations in a number of other features in central government retains extensive powers, the political and constitutional context of these and the constitutional provisions for the federations and quasi-federations have had devolution of powers to the Autonomous implications for their intergovernmental Community emphasize that this delegation in no financial arrangements. way implies a ceding of central sovereignty. However, it has most of the institutional features (1) The number and character of the that mark a federation. In South Africa, because constituent units. There is a considerable range. the previous apartheid had been justified in part The United States has 50 states (plus 2 on a federalist rationale and because of fears that federacies, 3 local home rule territories, 3 federalization would restrict the central unincorporated territories, and 130 Native government’s capacity to implement and American dependent nations), India 28 states consolidate the processes of democratic reform and 7 territories, Brazil 26 states and one federal capital district, Switzerland 26 relatively small

5 For example the federal powers of reservation and disallowance of provincial legislation and the federal 7 The Constitution of the Republic of South Africa declaratory power (Constitution Act 1867, sections 1996, section 146(2) and (3). 90 and 92(10)). 8 This is discussed further later. See for instance 6 Constitution of India (1950), articles 250, 352-360. Table 1.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 12 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries cantons, Spain 17 Autonomous Communities, federations, local government is recognized as a Germany 16 Laender, Canada 10 provinces and distinct order of government in the Indian, 3 territories, South Africa 9 provinces and Brazilian and South African constitutions with Australia 6 states (plus 1 territory, 1 capital quite detailed provisions.10 In all three cases territory and 7 administered territories). This transfers from the central government are a means that the average scale of operation at the major source of local finances. The Spanish state level in federations varies enormously (as constitution also formally recognizes local well as varying within each federation) and this governments, in this case involving two tiers, affects their capacity to undertake not only some 50 provinces and over 8000 municipalities, legislative and administrative responsibilities but both pre-existing the creation of the 17 also to take on fiscal and expenditure Autonomous Communities.11 Although the responsibilities. To emphasize the point, constitution declares that these provinces and California in terms of wealth would rank in communities within the Autonomous terms of GDP among the top ten independent Communities “shall enjoy self-government for countries within the world. Uttar Pradesh the the management of their respective interests,” largest Indian state has a population over 140 unlike the three other transitional federations millions. By contrast, Appenzel-Inner Rhodes, there is little detail in the constitution about the smallest Swiss canton has a population of them. It was left to a central government law in only 14,000. Furthermore, the degree of 1985 to reorganize and democratize local variation in size of states within a federation administration. This law sets out the jurisdiction which ranges from a ration of 343:1 in India to of local governments may delegate additional 13:1 in Australia has implications for the powers to the municipalities. Because of the horizontal fiscal imbalances likely to result. degree of authority that has been devolved by the central government to the Autonomous (2) Differences in the constitutional status of Communities, local institutions tend to be local governments. The constitutional status of politically dependent on these Autonomous local government as a third order of government, Communities, but they remain to a large extent distinct from the federal and state orders, has financially dependent upon the central varied in these federations and this has had an government. impact upon the financial arrangements affecting local governments. In three of the mature (3) Differences in constitutional allocation federations, the United States, Canada and of expenditure and revenue responsibilities. All Australia, local governments have not been the federations and quasi-federations have a formally recognized in the constitution as a formal constitutional distribution of the separate order of government, local governments legislative and executive authority to the being placed in each as subordinate units under different levels of government. These in effect the jurisdiction of state and provincial define the expenditure responsibilities and governments. In the cases of Switzerland and revenue raising powers of each order of Germany their constitutions make explicit government. But there is considerable variation references to local government as a third order. among federations in the form and scope of this In the former the autonomy of the Municipalities constitutional distribution, thus leading to is “guaranteed within the limits fixed by considerable differences in the allocation of cantonal law,” and the financial provisions in the expenditure and revenue functions. The three constitution recognize their existence. In the latter the guarantee of local self-government extends to “the bases of financial autonomy.”9 10 rd th Among the transitional federations and quasi- Constitution of India, 73 and 74 Amendment Acts 1992, inserting Part IX (arts. 243-243,0) and Part IXA (arts. 243, P-243, 2g); Constitution of 9 The Federal Constitution of the Swiss Brazil 1988, art. 29; Constitution of South Africa Confederation, 1999, arts. 50, 128 and 129; Basic 1996, chapter 7 (arts. 151-64) and Schedule 4 Part B. Law for the Federal Republic of Germany art.28. 11 Constitution of Spain, 1978, art. 137.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 13 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries federations considered in the earlier reports Canadian allocation of powers, except that the exhibited three different patterns. areas of explicitly shared jurisdiction are more extensive. Brazil ostensibly followed the United In the United States the constitution States model except that the definition of identified a very limited list of exclusive powers, exclusive federal and of concurrent jurisdiction a considerable list of areas of shared spelled out is more extensive and in much more (concurrent) jurisdiction where federal law detail (articles 20-24) shrinking the areas of prevailed over state law in cases of conflict, and residual exclusive state jurisdiction. Several a substantial number of residual authority where powers that should be exercised in common by exclusive jurisdiction remained with the states. the central, state and municipal governments are Canada adopted in effect a three-list approach: identified (article 23), and detailed rules for the the constitution listed specifically areas of management of the over 5500 municipalities are exclusive federal jurisdiction, concurrent included (article 29). The taxing powers and jurisdiction with federal paramountcy in most financial arrangements for states and cases, and a list of exclusive provincial powers, municipalities are also explicitly set out (articles with the remaining limited are a of residual 153-59). jurisdiction being assigned to the central government.12 Germany broadly followed the Two federations, India and South Africa United States pattern of identifying exclusive followed more closely the Canadian model of federal and concurrent legislative lists with identifying three extensive lists of jurisdiction residual power to the states, but transformed the with the remaining residual authority being arrangement by making the two lists much more assigned to the central government. They have extensive and the scope of residual state differed from the Canadian model in three authority therefore very much more limited, and respects, however. First, in both the area of by assigning to the states administrative concurrent jurisdiction is much more extensive. responsibility for all federal legislation in the Second, following the German model, most concurrent domain. federal legislation in the area of concurrent jurisdiction is administered by the states or These three examples have each influenced provinces thus differentiating greater the arrangements in the additional six administrative decentralization from the federations and quasi-federations considered in legislative decentralization. Third (as noted this study. The United States model has been above) both recognize constitutionally the influential in Australia, Switzerland and Brazil specific powers of the local governments. It is although with considerable modification in the worth noting that this general pattern has latter two. Australia followed the American emerged more often in the devolutionary model quite closely. In Switzerland, this basic creation of federations, whereas the United form came to be substantially modified over States model has been followed more often time such that in the new 1999 constitution there where federations have been created by are extensive constitutional provisions defining aggregating previously independent units. But what aspects in each specific functional area while the American model of broad residual should be performed exclusively by the federal authority appears to emphasize the retained government, exclusively by the cantons, or powers of the states, it should be noted that in shared.13 Thus, in explicitly defining the scope practice, particularly in the evolution of not only of federal but of cantonal jurisdiction it federations such as the United States and has come functionally to operate more like the Australia, because the state powers are not enumerated in the constitution the courts have

12 tended to interpret the “implied” federal powers In one area of concurrent jurisdiction provincial broadly at the expense of the states. By contrast, law prevails over federal law: old age pensions in those instances where exclusive state powers (Constitution Act 1867 as amended by the Constitution Act 1964). have been explicitly listed, as in the Canadian 13 Constitution of Switzerland 1999, arts. 42-135. and Indian cases, these have provided the courts

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 14 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries with a counterbalancing ground for protecting (4) State inputs to federal decisions. As in state powers. Thus, over time, the United States the three federations previously reported upon, and Australia which when originally established there have been strong political pressures for were more decentralized than Canada and India, state consultation and participation in federal have evolved now to become more centralized decisions about financial arrangements and than the latter pair. The impact of these different transfers in the additional six federations and arrangements upon financial relationships is quasi-federations considered in this report. This illustrated in a later section in the discussion of has occurred because no matter how carefully expenditures and revenues in these federations the designers of the federation have attempted to (see Table 1). match the revenue resources with expenditure responsibilities, over time the costs and scope of The pattern of the distribution of legislative expenditure responsibilities and the significance and executive authority in Spain also involves of different taxes have varied in unforeseen the definition of exclusive federal, exclusive ways. Consequently, all these federations, even Autonomous Community powers and shared the relatively new ones have had to develop powers, with residual authority remaining with appropriate processes and institutions for the central government. But the pattern in Spain making these changes, taking account of the has some unique aspects influenced by its concerns of state governments that the decisions progressively devolutionary character and by the should not be taken simply unilaterally by the asymmetrical paths for this devolution provided federal government but should involve the in the Constitution.14 Accession to autonomy has participation of state governments. The actual been regarded as a voluntary right and the way such adjustments have been handled has constitution identifies three paths by which a taken two broad patterns. Following Australia’s territory can acquire autonomy. The constitution pioneering efforts, India and South Africa have specifies some exclusive powers of the also established independent commissions to Autonomous Communities (art. 148) and the recommend adjustments in the allocation of tax extensive exclusive powers of the central shares and transfers both between federal and government (art. 149), but mechanisms have state governments and among the states. In the been provided (art. 150) for the delegation of three other federations federal-state negotiations some exclusive central governments powers and have become a regular feature, assisted from the transfer of financial resources to fund these time to time by advice from ad hoc powers. commissions. These processes are discussed more fully below. While Spain carries asymmetry among its constituent units further than any other (5) Differences in political dynamics. federation in this study, some degree of Differences in the form of the central institutions asymmetry should be noted in at least two other in each federation have affected the political cases considered in this report. In Canada and dynamics in the making of financial policies at India there have been some elements of the federal level. The United States presidential- asymmetry in the allocation of powers to the congressional institutions with the separation of states, and these have had implications for the executive and legislative powers and the checks financial arrangements.15 and balances between them has been followed only in Brazil. The Canadian fusion of executive and legislative powers in parliamentary institutions is also found in Australia, India and Spain. South Africa has adopted a presidential- 14 Constitution of Spain 1978, arts. 137, 143, 151; parliamentary hybrid, but its practices and Additional Provision No. 1 and Transitory Provision dynamics are closer to the parliamentary model. No. 2. 15 Switzerland developed its own unique R.L. Watts, “Asymmetrical decentralization: functional or dysfunctional,” Ottawa: Forum of institutions which emphasize the separation of Federations, 2000, www.forumfed.org). the executive and legislature in a way

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 15 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries distinctively different from that in the United a deliberately consultative process of States. In Switzerland, at both levels of intergovernmental financial relations. In Spain government, the executive is a collegial body the dominant characteristics of these processes elected by the legislative but for a fixed term. has been the relative dominance of a central This provides a set of checks and balances government which nevertheless, has found it which rely heavily upon coalition politics. While necessary to accommodate sub-nationalisms by all these federations have directly or indirectly intergovernmental negotiations producing elected representation (or combinations of both) asymmetrical results. as a feature of their federal second chambers, only South Africa has followed (but with (7) Mechanisms for dispute resolution. significant modifications) the German example Intergovernmental financial issues do not often of establishing a federal second chamber in lend themselves well to settlement by courts and which state or provincial delegates serve as such judicial processes. Common, therefore, to all in the deliberations of that chamber. This has federations has been tendency to rely more upon created an interlocking intergovernmental intergovernmental negotiations for the resolution character to the deliberations on matters of disputes in this area. Nevertheless, federations affecting intergovernmental fiscal issues. are fundamentally constitutional systems upheld by courts enforcing the rule of constitutional law (6) Differences in degrees of as the supreme law. Thus, with the exception of interdependence and coordination. In previous Switzerland, in the other federations ultimately it reports it was noted that in the United States, the has been the Constitutional Courts or Supreme diffused, complex and relatively uncoordinated Courts that have been the final arbiters in character of intergovernmental relationships disputes over the financial arrangements. This generally has led to a complex financial has been the case not only in the three interdependence base on a variety of ad hoc federations considered in the previous reports, arrangements, while in Germany the closely but in this additional set of federations. Indeed, interlocked legislative and administrative in Australia some of the most important High responsibilities of two orders of government and Court rulings have related to intergovernmental the focal role of the Bundesrat as an financial issues. In this respect Switzerland is intergovernmental institution has led to a much unique, however. The Federal Tribunal may rule more systematic financial interdependence on the validity of cantonal laws but not of between levels of government. Canada has federal laws. The validity of federal laws in differed from both. The dynamics of “executive determined instead through the processes of the federalism” have produced a considerably more legislative referendum, and this has been an systematic system of program and equalization important factor in the transfer of some taxing transfers than in the United States while powers to the federal government. achieving a substantially more decentralized set of financial arrangements than those in (c) Decentralized unitary systems: the Germany. differences and similarities in their political and constitutional contexts: In this respect the parliamentary federations, Sweden and Japan are both unitary systems, Australia and India, have resembled most but as we shall see in more detail later, both are Canada, but their use of regular independent highly decentralized. Indeed measured in terms finance commissions to guide adjustments has of expenditure it could be argued that they are led to a more systematic set of arrangements. as, or more, decentralized than the United States, Brazil and South Africa have each resembled Australia, Spain or Brazil. What distinguishes more the different models on which they have them from the federations or quasi-federations based their institutions, the United States and considered in the previous reports and this report Germany. Switzerland with its unique executive is not the degree of decentralization, but that and legislative institutions, and its emphasis their autonomy is not constitutionally upon cantonal and local autonomy, has exhibited guaranteed. In the federations ultimately the

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 16 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries constituent units derive their authority and financial relations deal with some 6 to 50 autonomy, not from the central government but constituent units, the federal-local financial from a constitution which is not unilaterally relations deal with some 310 units of local amendable by the central government or government in Sweden16 and over 3000 units of legislature. In decentralized unitary systems local government in Japan.17 Consequently, the such as Sweden and Japan there may even be a relative bargaining power of these individual constitutional basis for local autonomy, but local governments in relation to the central ultimately, since that constitution can be government is much weaker than in the case of amended unilaterally by the central government, the states within the federations. the local governments are subordinate. This is a difference of fundamental constitutional There are differences too in the political significance. contexts of regional and local government in Sweden and Japan. The former has a relatively Unitary political systems vary, of course, small population of 9 million whereas Japan has enormously in terms of their degree of a population of over 127 million which explains decentralization. Sweden and Japan represent why it has required many more units of regional two of the most decentralized unitary systems in and local government. In Sweden the first the world, and therefore, it is of note that in legislation on local government was in 1862 and many respects, although not constitutionally this long historical tradition was reinforced by guaranteed, their financial arrangements are their expanded role in the provision of social similar to those in federations and quasi- services in the mid-twentieth century. Japan’s federations. In each there is a definition, either system of prefectures and local governments by constitutional or statutory law of the was largely the product of post World War II expenditure responsibilities and revenue sources reconstruction under the influence the postwar available to their local governments. In each it American occupation. Furthermore, whereas in has been necessary (although to sharply Sweden, the primary emphasis for local differing degrees) to supplement local own government has been local self-rule and source revenues with transfers from the central autonomy, in Japan local government has been government to close the gap between looked upon more as providing units for expenditure requirements and revenue resources delegated administration with local governments and to equalize disparities among local serving as agents of the central government in governments. In each it has been necessary to the delivery of prescribed functions. adjust these arrangements from time to time. In each, as in the federations and quasi-federations, 2. Allocation of Federal, State and Local these arrangements have had to accommodate Revenues and Expenditures pressures from local communities for self- As in the cases of the three federations government and autonomy. previously reported on, all eight of the mature and transitional federations and the two There are, however, two significant decentralized unitary systems covered in this differences from the situation in the federations report involve a degree of decentralization of and quasi-federations. One is that (whether the fiscal responsibilities, but the extent and manner third (local) sphere is constitutionally recognized of this decentralization has varied considerably. or not) in federations federal, state and local In this report we consider in turn the assignment governments in practice represent three distinct of expenditure and revenue responsibilities, then spheres each involving particular financial the vertical and horizontal imbalances to which issues. In these unitary systems there may be these give use. several hierarchical tiers of local government, but basically they represent two orders of government: the central government and the 16 Actually 289 municipal governments, 18 county subordinate local governments. The second is councils, 2 regions and the municipality of Gotland. that while the consideration of federal-state 17 47 prefectures and 3,250 local governments

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 17 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

(i) Expenditures pressures from the World Bank and the IMF As in Canada, the United States and urging improved decentralization have in recent Germany, in the eight federations and two years been an important factor. It is noteworth decentralized unitary countries that this report here, that with the exception of Brazil, the focuses on, state and local governments perform Russian Federation emerges in expenditure a range of important functions, and these terms as less decentralized than all the others, determine the proportion of total government including the unitary systems. expenditures for which they are responsible. In the case of the federations these are largely The second point, is that while all these defined by the exclusive and concurrent examples are marked by decentralization of jurisdictions set out in their constitutions and in expenditure responsibilities there is a significant the case of the unitary systems in large measure range of variations. The full range of variations by central legislation. Tables 1 and 2 include a in percentage of total governmental expenditures listing of the current proportions of total carried out by the state and local governments (federal-state-local) expenditure in these ranges from about one-third in Brazil to two countries performed by the central governments thirds in Switzerland (Table 2). This variation (second column, Table 1) and by the states and can usually be attributed to the social, political local governments (second column, Table 2) and constitutional context described earlier. It is Two points stand out clearly. no accident that among the mature federations multilingual Switzerland and binational Canada, First, in all of these countries there is an and among the transitional federations, India extensive devolution of expenditure with its complex cultural variety, are among the responsibilities. State and local expenditures least centralized. (after transfers) range from just 46 percent (Australia and United States) to 68 percent It should be noted that tabulating relative (Switzerland) in the mature federations, and expenditures of levels of government does not, slightly less from 36 percent (Brazil) to 55 of course, give a full picture of the level of self- percent (India) in the transitional federations. rule. In most cases where legislative and Strikingly, the decentralization of expenditures administrative responsibilities coincide it does in the mature unitary systems is comparable in provide a significant indicator. In others, Japan (62 percent) and Sweden (46 percent). however, such as Germany and modeled on it, Major fields of central expenditure generally South Africa, where the substantial expenditure have been foreign affairs, defence, international relates to the constitutionally mandated state and trade, immigration, major transportation and local administration of central legislation this communications infrastructure, and currency. does represent a limitation upon state autonomy Typical fields of state and local expenditure not revealed by the expenditure figures. have been health, education (except post- secondary education), local transportation and In the previous reports the issue of the infrastructure, water, sewage, housing, federal spending power was raised. This is the community services, and delivery of social constitutional power given to federal services. Expenditures in health, education and governments to spend money (usually by social services, however, are often shared with conditional transfers to other levels of the central government, and in Brazil this has government) in areas of exclusive state or local gone so far that almost every area of constitutional jurisdiction. It was noted in the governmental activity is shared across all three previous reports that the federal governments in levels of government. The reasons for this both the United States and Canada (although it is decentralization of expenditures have been two- a controversial issue in the latter) have this fold. One has been to meet the differences in power, but that in Germany it can only be preferences of citizens in different regions. The exercised by the support of a majority in the second has been to achieve administrative Bundesrat (a federal second chamber composed efficiency. Indeed, in the transitional federations of instructed delegates of the state governments).

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In all the federations and unitary systems federations is possibly attributable to the considered here the federal government has been influence of Keynesian theories concerning granted that power explicitly (for instance in economic stability and development prevalent at Australia, India and Spain without reservations) the time they adopted their federal structures. with two exceptions.18 In South Africa, following to some extent the German model, the A second feature which emerges clearly National Council of the Provinces (NCDP) has from comparing the two columns in Table 1 is an opportunity under articles 75 and 76 to that in every one of the five mature federations, express its views, although unlike the German four transitional federations, and two mature example it has no veto over money bills. In unitary systems there has been a much greater Switzerland, both long-held traditions and the central concentration of revenue-raising powers constitutional provisions referring to than of expenditure responsibilities. Generally collaboration between the federal and cantonal there has been a tendency to concentrate such governments (articles 44-46) have led to the major taxing powers as corporate taxes, personal avoidance of unilateral federal decisions in income taxes, customs and excise taxes, and federal spending in areas of cantonal various sales and consumption taxes in the jurisdiction. central governments. Corporate income taxes have most often come under federal jurisdiction (ii) Revenues because corporations in earning their income The allocation of own-source revenues for tend to cross the boundaries of the internal federal, state and local governments is also set regional units, and the location of their out in Tables 1 and 2 above (first column). Here headquarters does not necessarily reflect the too, two striking patterns emerge. First geographical sources of their income. Personal differences in the range of revenue-raising income taxes may be more directly attributed to powers granted to each order of government are location of residences and therefore is often an even more pronounced than in the case of area shared by federal and state governments, expenditures. This was true not only of the three although in some, including Australia, India and federations reported on previously, but is even South Africa it has been exclusively federal. more the case when the additional two mature Customs and excise taxes have almost always federations, four transitional federations, and been placed under federal jurisdiction in the two decentralized unitary systems are included interests of ensuring an effective internal for consideration. In terms of own source customs and economic union. Sales and revenues in the mature federations Australia is consumption taxes are areas which in many more centralized than Canada, the United States federations both federal and state governments and Germany and Switzerland is more have shared, but even where this has been the decentralized, thus widening the range to case, the federal governments have tended to between 69 and 40 percent. Generally the predominate because of the federal power to transitional federations as a group are preempt an area of concurrent jurisdiction. substantially more centralized in terms of own- source revenues ranging between 95 percent in Two factors have been particularly South Africa to 66 percent in India. Surprisingly influential in creating this general pattern. One, the mature unitary systems are in terms of own- already noted above, was the influence of source revenues substantially more decentralized Keynesian theories regarding economic than all the transitional federations and fall close stabilization and development prevalent not only to the median point among mature federations. at the time most of the newer transitional The emphasis upon central concentration of federations were established, but also in the revenue-raising powers among the transitional mature federations, most notably in Australia, at the time that many of the current federal fiscal 18 arrangements were developed. Those theories R. L. Watts, The Spending Power in Federal Systems: A Comparative Study (Kingston: Institute of were less influential in Switzerland and Intergovernmental Relations, 1999). Germany and have to some degree lost their

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 19 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries influence now in such federations as Canada. A market has diminished the Council’s role and second factor, which still holds force, is that influence. where the federal government is expected to serve a redistributive role, this is facilitated by a (iii) Extent and character of resulting vertical concentration of financial resources in the imbalances federal government. This has been an especially Comparison of the own-source revenues (i.e. powerful argument where regional disparities before transfers) and of expenditures (after have been particularly sharp, as has been the transfers) in Table 2 (third column in the table) case in most of the transitional federations, and reveals that in all five mature federations, four in those countries where there has been a strong transitional federations and two decentralized emphasis upon inter-regional and inter-personal unitary systems there is a vertical imbalance in equity as in Australia and Germany. which state and local expenditures exceed their own source revenues (before central transfers of Another importance source of revenue open shared taxes and grants) by a significant amount. to governments at all levels in all the cases These are most significant in South Africa (45 considered here has been the operation of public percent of all combined federal-state-local enterprises and corporations, the profits of which expenditures), Spain (32 percent), Germany (27 may serve as a source of governmental income. percent), and India 21 (percent). With the The emphasis in the past decade upon exception of Brazil (5 percent), the vertical “privatization” as part of fostering a market imbalances are generally larger in the economy, has imposed a limit, however, on the transitional federations than in the mature extent to which this can be a source of revenues federations, although they are significant in all supplementing those from taxation. federations in both groups. Interestingly the vertical gaps in Japan (20 percent) and Sweden Public borrowing can also be an important (3 percent) are generally less than in the source of governmental revenue, especially for transitional federations. The Russian case is not capital purposes. In many federations, this is a the subject of this report but is included in source open to both levels of government. Tables 1 and 2 for comparative reference. However, concerns about the possible impact upon federal credit-worthiness of borrowing by The main reason for these vertical the states has led in some of the more recent imbalances lies in the preceding summary of the federations to placing foreign borrowing under allocation of own source revenues and of exclusive federal jurisdiction, India being an expenditure responsibilities outlined in the two example. Spain and South Africa have gone preceding sections. First, it has usually been even further in requiring that all public found desirable to allocate the major taxing borrowing by constituent units either be powers to the central governments because they approved by the federal government or follow are closely related to central policies for strict federal guidelines. Of the mature stabilization, development, and regional federations, the only one to have placed limits redistribution within an economic union, while on state borrowing has been Australia which in some of the most expensive expenditure 1927, early in its history, established an responsibilities, such as health, education and arrangement whereby all major public social services have usually been considered borrowing by both levels of government is best administered and delivered on a state and coordinated by the binding decisions of an local basis where differing regional and local intergovernmental Loan Council. In the early circumstances can be taken into account. A post World War II years, despite a voting rule second reason is that generally the tax sources what required the consent of at least two of the assigned to the central governments have had six states it proved a powerful device for central more growth potential than those typically control of state borrowing when the federal assigned to state and particularly local government underwrote all public borrowing, governments. It is also noteworthy that the but in recent years the greater reliance upon the biggest vertical gaps have occurred in those

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 20 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries federations such as Germany among the mature imbalances among states, there can be inter-state federations and South Africa among the imbalances on the expenditure side due to transitional federations where a large portion of differences in the ‘expenditure needs’ of state expenditures represent constitutionally different constituent units. These arise from mandated devolved administration of federal variations in sociodemographic characteristics of legislation. their populations such as population dispersion, urbanization, social composition and age Vertical fiscal imbalances can potentially be structure, and the cost of providing services corrected as long as the state and local affected by such factors as the scale of public governments have adequate own-source administration and the physical and economic revenue-raising discretion. Among the mature environment. federations the Swiss and Canadian, and to a lesser degree the United States and Australia Horizontal fiscal imbalances are even more state and local governments have considerable difficult than vertical imbalances to resolve by discretion to raise their own-source revenues, leaving them to be self-corrected by individual but in all these cases, and more particularly state and local governments action. If one state where the vertical gaps are largest, such has less fiscal capacity than another, it will not solutions may moderate the problem but be be able to provide comparable public services at incapable of correcting it totally. In the comparable tax rates. The result as noted in our transitional federations where the vertical previous report comparing Canada, the United imbalance is generally considerable larger and States and Germany, would be either a violation the state and local constitutionally assigned of horizontal equity (with identical citizens in taxing powers more restricted, such solutions are different states being treated differentially by the totally beyond reach. In the unitary systems, government sector), or an inefficient of where ultimately the central government allocation across states (with businesses and determines the taxing powers delegated to the individuals having a purely fiscal incentive to local governments there are also limits to such locate in states with higher fiscal capacities). self-correction. Consequently, in all these Consequently, this provides a motivation in political systems it has been found necessary to most federations and decentralized unitary provide for intergovernmental transfers to systems for differential transfers from the central correct or moderate the vertical fiscal to the state governments. imbalances. 3. The Nature, Role and Scope of (iv) Extent and character of resulting horizontal Intergovernmental Transfers imbalances Horizontal imbalances represent a second (i) Importance, scale and nature of transfers kind of imbalance which tends to arise where In order to correct these vertical and fiscal responsibilities are distributed between horizontal imbalances all the federations and levels of government. The vertical imbalances decentralized unitary systems reviewed here refer to the ‘expenditure–own-source revenue have had arrangements for financial transfers gaps’ relating to all state and local governments from one level of government to another. The as a group compared to central governments. relative size and structures of these transfers has But the revenue capacities for the same taxes differed considerably, but they have served a and the expenditure costs for the provision of the crucial role in the intergovernmental financial same services inevitably varies from state to arrangements. Because central governments, as state and locality to locality. Horizontal already noted, have controlled the major tax imbalances, therefore, occur when the revenue sources, adjustments have usually taken the form capacities of different states vary so that they are of financial transfers to the states, although not able to provide their citizens with services at occasionally they have taken the form of some the same level on the basis of comparable tax state transfers to central governments or for levels. In addition to horizontal revenue equalization purposes of inter-state transfers. In

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 21 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries most cases there have also been transfers from a share of the central income tax, and real the states to local governments, and in some but property and business, and local excise taxes not all federations and all unitary systems of accrues to local governments (art. 106(5-6)). transfers direct from the central governments to These are unconditional transfers. In local governments. Table 4 (first column) gives Switzerland, the constitution (art 128(3)) an indication of the significance of total central stipulates that 30 percent of the proceeds of the transfers to correct both vertical and horizontal federal personal income tax shall, based on imbalances as a portion of the total constituent derivation, accrue to the cantons unit revenues and hence the resulting state and unconditionally. The constitution (art. 131) also local government dependence on transfers. provides that one-tenth of the net yield on the These percentages are indeed very substantial federal tax on distilled spirits shall be credited to although they vary greatly from country to the cantons to fight the causes and effects of country. Germany (43.8 percent) and Australia addiction. In addition, as a product of history (45.3 percent) are the highest and Canada (19.8 and much political negotiation, 10 percent from percent) the lowest among the mature the federal withholding taxes (half on a per federations. The correspondencing dependence capita basis and half based on an index of of states on transfers has generally been much cantonal financial capacity), up to 12 percent of higher still in the transitional federations: 96.1 the custom duties on fuel (42 percent on the percent in South Africa, 72.8 percent in Spain, index basis) and two-thirds of the earnings of the 46.0 percent in India, and the lowest, 30.0 Swiss National Bank (three-eights on the index percent in Brazil. Interestingly the go to the cantons.19 Sharing of specific central corresponding figure in the mature decentralized taxes was not an element of the Australian unitary systems is more akin to those in the financial arrangements until very recently, but mature federations: 37.2 percent in Japan, and when the Commonwealth government in 2000 15.8 percent in Sweden, the lowest of all these ushered in a new Goods and Services Tax (in countries. form a VAT) it was with the commitment that all the proceeds would be transferred The central financial transfers to the states unconditionally to the states as the source for all have generally taken one or more of three forms. equalization adjustments. Thus, of the five The first is revenue sharing, i.e. shares of the mature federations, three, Germany, Switzerland proceeds from specified central taxes. The and Australia, now use revenue sharing of second is unconditional grants. The third is central taxes as one element of the transfers to conditional grants for specific purposes correct financial imbalances. requiring the recipient governments to meet certain conditions or to match from their own In the transitional federations, this mode of revenues the central grants. The extent to which transfer has been a significant feature in the each of these has been used has varied intergovernmental financial arrangements in all considerably. four countries. In India, under the constitution some duties are levied by the central government Revenue sharing has proved a relatively but are entirely collected and appropriated by the widespread device, although among the three states (art. 268: stamp duties and duties on federations studied in previous reports only in medicinal and toilet preparations), some taxes Germany has this been extensively used. There, are both levied and collected by the central however, as a result of constitutional government but the proceeds are assigned to stipulations, revenue from the central income those states in which they have been levied (art. taxes, corporation and turnover taxes are shared between the governments of the Federation and 19 Laender (art. 106(3-3)), and revenue from a R. Bird and A.V. Tarasov, Closing the Gap: Fiscal Imbalances and Intergovernmental Transfers in range of smaller central taxes such as property, Development Federations (Georgia State University, inheritance, beer and gambling taxes accrue International Studies Program, Working Paper 02-02, totally to the Laender (art. 106(2)). Furthermore, 2002, p.21.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 22 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

269: taxes on sale and purchases of goods), and taxes and transfer an amount to the central some taxes are levied and collected by the government in order to finance the services the central government, but the proceeds are latter carries out within their territory.22 In Brazil distributed between the central and state 45 percent of the revenues from the two most governments (art. 270). Into this latter category important taxes are transferred unconditionally originally came taxes on income other than to the states and municipalities. The states agricultural income. This category was receive 21.5 percent and local governments 22.5 expanded by the Constitution (Eightieth percent of the shares from the federal income tax Amendment) Act, 2000, section 3, to include all and from the federal tax on industrial products. taxes and duties on the Union list except those In addition smaller amounts of these central referred to in Articles 268 and 269 and taxes are set apart for regional funds and surcharges on a limited range of central duties compensation for export exemption. There is and taxes. Where central tax revenues are also sharing of state tax proceeds between state shared, the portion to be shared and the and local governments. In South Africa revenue- distribution among the states is based on the sharing of central taxes has been applied not to recommendations of the constitutionally specific taxes but to all central taxes proceeds. mandated quinquennial Finance Commissions.20 The constitution, article 214, provides for the Thus, from the beginning revenue sharing of ‘equitable division’ of all revenue raised centrally levied taxes has been a major element nationally both among the national, provincial in the financial arrangements under the and local spheres of government and constitution and these unconditional transfers individually among the provinces and among the have been expanded over time to increase the local governments and municipalities. This states’ shares. allocation is made by the central government after consultation with the provinces, local In Spain too, revenue-sharing has been an government organization and the Financial and important part of the financial arrangements to Fiscal Commission and after a top slice (23.1 match the progressive devolution. In the general percent of the total in 2000) has been deducted system applied to all Autonomous Communities to cover debt service costs, a contingency (except the two ‘foral’ Autonomous reserve, donor-financed spending and funding Communities, the Basque Country and Novarra), allocated to a skills development levy grant shares of central tax proceeds constituted in scheme. In 1999 47.2 percent of the remaining 1998 about a quarter of central transfers.21 resources comprised the national equitable Originally this arrangement related to a thirty- share, the provincial share was 51.9 percent, and percent of personal income tax, but in 2002 this local government received 1.0 percent. Thus was increased to 33 percent of personal income under this revenue-sharing arrangement in South tax, 35 percent of VAT, 40 percent of the major Africa, revenue raising is highly centralized, but excise taxes, and all taxes on registration and a substantial portion of government spending electricity. By contrast in the two ‘foral’ occurs in the provincial and local spheres.23 Autonomous Communities revenue-sharing has operated in the reverse direction. These Of the two unitary political systems the Communities enjoy the revenues from the major vertical fiscal imbalance is much greater in Japan and the central transfers there also include a local share of central government taxes. In 20 Twelfth Finance Commission, Fifty Years of Fiscal 2001 the central government transferred Federalism: Finance Commissions of India (New Delhi: 2003). 21 A Castells, “The Role of Intergovernmental 22 Ibid., p. 90. Finance in Achieving Diversity and Cohesion: The 23 C. Murray, “Building Unity Through Case of Spain” in R. Bird ad T. Stauffer (eds), Transformation: Intergovernmental Fiscal Relations Intergovernmental Fiscal Relations in Fragmented in South Africa” in Bird and Stauffer (eds.), Societies (Bâle: Helbing + Liehtenhahn, 2001), pp. Intergovernmental Fiscal Relations in Fragmented 90-1. Societies, op. cit., p. 516.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 23 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries unconditionally from funds derived this way federal point of view. In such cases, 14.3 percent of total national revenue and this conditionality applied to transfers is one means represented about 21 percent of total local by which a federal government can induce the government resources (after transfers).24 By states to design their programs in a way that contrast, in Sweden, where their own taxes are contributes to federal equity and efficiency the primary source of revenue for local objectives. One argument in support of government (about 67 percent of the total) the conditional transfers has particularly tended to device of revenue-sharing of central taxes has dominate discussion of the subject in the United not been used, the other major sources of local States. This, based on the principle of financial government finance being user fees and central responsibility and accountability, is that the grants.25 federal government that has the nasty task of raising the funds by taxation, should in the Because in many of these cases revenue- interests of accountability to the tax payer, sharing of central tax proceeds has been control and set the conditions for the use of these constitutionally mandated, some analysts funds by the states. The conditions may take the classify them as a form of state revenues rather form of requiring specific criteria to be met or of than as a transfer. However, that can be matching by the recipient governments of the misleading for, unlike their own taxes and user central financial contributions to those fees, the states have no control of the size of the programs. This “golden lead” as it has been revenues they will receive from revenue sharing. referred to in Germany, may however undermine The size of the proceeds the states receive in this the autonomy of the states and local way are determined by the rates and levels of governments if conditional grants constitute a central taxation. They are therefore better high proportion of the transfers and hence a classified as transfers which in most cases are significant portion of state or local revenues. In unconditional. They therefore share the benefits such situations a heavy dependence upon unconditional central grants, but have the further conditional transfers may distort state advantage that instead of being determined at a expenditures and priorities in areas of primarily fixed amount by the central government, are state responsibility. Ultimately, most federations based on a specified share of major taxes and have had to draw a balance between the therefore have growth potential as the economy legitimate aim of the central government to grows. That helps to explain why they have been achieve its objectives, and the possibility that so widely used as one element to reduce such conditionality will have too intrusive and intergovernmental fiscal imbalances. distorting an effect on state priorities and policies and detract from the accountability of A totally different form of transfer used as at state and local governments to the needs and least one element in the total scheme of desires of their own particular citizens. intergovernmental financial transfers has been the use of conditional grants. These are central Where that balance has been found has transfers to state and local governments which varied among the nine federations and two have conditions attached to them so that the decentralized unitary systems listed in Tables 3 central government may influence or even and 4. Here it is noteworthy that in terms of the control how they are spent. The issue of percentage of total central transfers represented conditionality is often a contentions one in by conditional grants, the mature federations as federations. Many of the important public a group have generally relied more on services whose provision is decentralized to the conditional transfers than have the transitional state level may also be important from a wider federations. Nevertheless, of the mature federations Canada has relied least on these. Transitional federations as a group, with the 24 Government of Japan, Ministry of Finance, Budget exception of Spain, have tended to rely less on Bureau “Understanding the Japanese Budget, 2003”. 25 Institute on Governance, Intergovernmental Fiscal conditional transfers and more on unconditional Relationships: Case Study #1: Sweden shares of central revenue sources. The two

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 24 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries unitary countries contrast with each other, with general) and the latter as unconditional. If Japan relying much more heavily on conditional applied in Tables 3 and 4 this would produce transfers. figures of the order of 33 for percentage of central transfers that are conditional and of 12 While on the subject of the distinction for percentage of provincial revenues constituted between unconditional and conditional grants, it by conditional transfers. However, since the is important to note that there have been CHST transfers are a single block grant, which differing degrees of conditionality in those since 1999 has been an equal per capita grant to federations employing conditional transfers. For the provinces, any such breakdown would be instance, most of the conditional grants in the based purely on notional assumptions about the United States, Australia and Germany have percentages of these transfers applied to the embodied precise and strict conditions or different categories. The essential comparative matching requirements imposed on the recipient point to be emphasized here is that the category governments. In Canada this was also the case of conditional grants noted in Tables 3 and 4 up to 1977, but when the Established Programs may itself embrace a considerable range from Financing (EPF) replaced the previous shared- grants with very precise conditions to block cost arrangement for health and post-secondary grants with conditions so general that they may education, these became block grants with only verge on unconditional. broad conditions applied to health transfers and no conditions to those for post-secondary The proportion of total state or local revenue education. Subsequently, when these were made up by central conditional transfers modified in 1996-7 into the Canada Health and provides one significant measure of the financial Social Transfers (CHST) in support of health, constraints upon the genuine autonomy of these post-secondary education, and social services, governments. Table 4 indicates the degree of because of the broad and largely unenforced dependence of states in different countries by conditions specified these transfers verged on indicating the extent to which all central the unconditional. Nevertheless, for the purposes transfers (first column) and conditional transfers of Table 3 and 4 of this study they have been (second column) constitute an element of their classified as conditional transfers, thus bringing total revenues from all sources. Significantly as conditional transfers to 43.6 percent of all a group the transitional federations by central transfers and 15.8 percent of total comparison are more dependent on central provincial revenues. Given the almost transfers, but with the exception of Spain are unconditional nature of CHST transfers which generally less dependent upon conditional provide the provinces with considerable transfers. Indeed, apart from Spain, the two independence in the size and design of their federations in which conditional transfers social programs, if all CHST transfers were constitute the largest portion of their total classed as unconditional, then the respective revenues are the United States and Australia. figures for Tables 3 and 4 would be radically The constituent units in Sweden, Brazil, and if altered, conditional grants becoming 4.3 percent the CHST transfers are essentially of all central transfers and 0.9 percent of total unconditional, Canada, have the least provincial revenues, much the lowest among all dependence on conditional transfers. Particularly the countries considered in this study. striking is the South African case in which the provinces are the most highly dependent on A third approach would be to break down central transfers, but the proportion of these the proportion of CHST transfers in Canada which is conditional is relatively low. notionally for health and social welfare (where there are some very broad conditions aimed at A third element often found in minimum national standards), and for post- intergovernmental financial arrangements is the secondary education (where there are no use of unconditional grants. These, like most conditions), classifying the former as conditional cases of central revenue-sharing, are (even though the conditions for these are very unconditional, but unlike tax revenue-sharing

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 25 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries their amounts are unrelated to the specific or application of state relativities to the transfers general proceeds from central taxes. These aimed at correcting vertical financial amounts are in some cases determined by the imbalances. Canada has had a system of distinct central government at its discretion, in other formal equalization grants since 1957. Germany cases by intergovernmental negotiation, and in since the inception of the federation in 1949 has yet others on the advice of intergovernmental or had a formal equalization scheme distinct from independence finance commissions. Reliance on other intergovernmental transfers. Sweden in this form of transfer has usually occurred where 1996 introduced a new formal system of there has been concern that conditional transfers equalization grants. But even in these countries would undermine the autonomy of the states and where the equalization arrangements are local governments. One area where relatively distinct, the transfers intended unconditional grants have been frequently primarily to deal with vertical imbalances may employed has been for equalization purposes also have a redistributive effect among the intended to adjust the general revenues of constituent units when they are allocated in different states to correct horizontal imbalances. equal per capita terms or on the basis of Among the mature federations unconditional expenditure needs. Apart from these four cases, grants have been used most extensively in the other countries which have formal Canada, Australia (until replaced by revenue equalization schemes (and the United States is sharing of the GST), and India (Finance the only one not to have a formal equalization Commission application of article 275 in the scheme) meet these objectives not by separate constitution). grants from the transfers correcting vertical imbalance, but by an equalization adjustment to (ii) Transfers to correct vertical fiscal the vertical transfers. imbalances The third column in Table 2 indicates the The importance of a major element of extent of the vertical fiscal imbalances in the “equalization” in intergovernmental financial nine federations and two decentralized unitary transfers arises from the widely held view in systems. The first column of Table 4 sets out the most countries that all citizens wherever they total of transfers – shared central revenues, live should be entitled to comparable services conditional grants and conditional grants, without having to be subject to excessively combined in different proportions in each case – different tax rates. The need for such transfers from the central to the state and local has arisen in most federations and decentralized governments as a proportion of total state unitary systems from a recognition that revenues. This gives a further idea of the need disparities in wealth among internal regions are for and form of the combined unconditional and likely to have a corrosive effect on internal conditional vertical transfers in each country. cohesion. Indeed it is for this reason that in most European federations equalization schemes have (iii) Transfers to correct horizontal imbalances: been labelled “solidarity transfers.” extent and character As noted in our previous report comparing The arrangements for removing or reducing Canada, the United States and Germany, it is horizontal imbalances are set out in summary somewhat artificial to distinguish precisely form in Table 5. Several points are especially transfers to correct vertical fiscal imbalances and noteworthy. First, in all these federations and those that correct horizontal ones. Indeed, decentralized unitary systems horizontal among the nine federations and two financial imbalances have been significant, and decentralized unitary systems only four have hence in all, except the United States but attempted to meet equalization needs primarily including the decentralized unitary systems, through equalization schemes distinct from the provision for some form of systematic financial other transfers. Australia from 1933 to 1973 had equalization by means of intergovernmental a separate systematic scheme of equalization transfers has been found not only to be desirable grants but in 1973 this was replaced by the but politically necessary.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 26 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

Second in the case of federations, in most of fund in which the payments to the poorer states them some specific provision has been included are provided by reductions to the revenues of the in the constitution itself for the principle of wealthier states. Such schemes by emphasizing financial equalization. Among examples are the reductions suffered by the wealthier units Switzerland, Canada, Germany, India and South tend to be politically more contentious. In both Africa. In the interests of flexibility, details cases these are supplemented by additional about processes for implementation and about central transfers, in the German case per capita criteria and formulae for equalization have payments from the Value Added Tax, to normally not been embodied in the constitution, contribute further to equalization. however. These have usually been left to be worked out by intergovernmental negotiation or Sixth, while in some federations and most by independent advisory commissions. notably Canada, the federal attempt to correct horizontal imbalances through federal Third, the extent and impact of the equalization payments has focused primarily on equalization element in intergovernmental adjusting for differences in the revenue transfers has varied considerably. All of the capacities of the provinces, others and most countries reviewed here, except the United notably Australia, India, Spain, South Africa and States, have some formal equalization scheme, Japan have based their equalization on the but the scope of such transfers has varied. Some assessment of both revenue capacities and such as Australia, Germany, India and South expenditure needs. Africa have gone the furthest in attempting to correct horizontal disparities. Canada, Seventh, there has also been a variation Switzerland, Sweden and Japan, while making between those political systems in which significant efforts have not gone so far. Spain equalization adjustments have been based on an and Brazil have gone the least distance in established formula and those based on the attempting to close the horizontal disparities. recommendations of a standing or quinquennial independent advisory commission, as occurs in Fourth, the form of the equalization element Australia, India, South Africa and Sweden. Such in the arrangements for intergovernmental commissions themselves may use a variety of transfers has varied considerably. In many it has formulae to arrive at their recommendations. In taken the form primarily of varying the basic the former case the formula for distributed used vertical transfers – revenue-sharing, may be set out in the constitution (rarely because unconditional grants and sometimes also the of the need for periodic adjustment), may be conditional grant schemes – to apply arrived at by intergovernmental agreement as in redistributive equalizing criteria to their Switzerland, Canada, Germany, Spain and allocation among states. On the other hand, in Brazil (although in some cases the federal some cases, notably Australia up to 1973, government dominates these negotiations), or Canada, Germany and Sweden separate stand- may simply be imposed by the central alone unconditional equalization grants from the government as in Japan. central government or horizontal intergovernmental payments have been the Eighth, the criteria and the relative weights methods adopted to reduce the horizontal given to them in the formulae for distribution financial imbalances. used in the determination of the equalization element of transfers have varied from country to Fifth, in most cases equalization has been country to take account of different particular effected through proportionately larger central circumstances and differing political pressures transfers to the poorer states without penalizing for equity. the wealthier ones. In two cases, Germany and Sweden, however, the primary mode of Ninth, it might be expected that the more equalization has involved inter-state transfers. decentralization there is the more it is likely that The German and Swedish schemes involve a disparities among constituent units will be

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 27 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries significant and therefore that there will be a co-occupied by both the federal and provincial greater pressure for equalizing mechanisms. levels of government, there are varying degrees Experience indicates otherwise. Indeed, where of tax harmonization. For personal income tax the greater decentralization reflects a higher which is the largest source of revenue for both degree of social and cultural diversity and levels of government nine of the ten provinces fragmentation, as in Canada and Switzerland, have tax collection agreements with the federal the stronger have been the pressures for regional government whereby the federal government distinctiveness, autonomy, resistance to collects on their behalf the different levels of dependency upon federal funding aimed at taxes levied by the provinces (on a harmonized inducing more uniformity. It is significant that base). There is also a similar corporate income both Germany and Australia with the tax collection agreement. Most other major taxes predominant emphasis on uniformity and equity are not harmonized in Canada. Four of the in their societies, have gone to much greater provinces do harmonize their taxes with the lengths towards realizing full equalization than federal GST (i.e. VAT) and in the case of have Canada and Switzerland. In the latter cases Quebec it acts as a collection agency for both the the pressures for equalization have been federal and provincial VATs. In the United counterbalanced to some degree by a greater States, there is no formal system of tax emphasis upon preserving their diversity and harmonization. Personal and income taxes are provincial or cantonal autonomy and initiative. occupied independently by the federal and state governments, although some states choose to Tenth, most federations have recognized that piggyback on the federal tax system by using the due to changing values of revenue sources and federal tax base and in some cases even the of costs of expenditure responsibilities over federal rate structure. The lack of harmonization time, regular processes for the systematic review does give rise to some inefficiencies and also and adjustment of financial equalization some instances of double taxation or of non- arrangements are necessary. These recognize taxation of some portion of incomes. that the essence of federalism is not in static structures but in the dynamic processes of Among the additional countries considered evolving intergovernmental relations responding in this report the concentration of taxing powers to changing circumstances. in the central governments and the heavy reliance for state revenues upon shared revenues 4. Systems of tax harmonization and from central taxes means that, as in Germany, so collection: in Australia, India, Spain, South Africa and Japan the need to harmonize taxation by (i) Extent of tax harmonization: governments at different levels has not been a In federations where different orders of major issue. This is further reinforced in Spain government have their own substantial taxing by the Autonomous Communities Finance Act powers an issue which often comes to the fore is which imposes severe limits on double taxation the desirability of some harmonization of their when the Autonomous Communities do exercise taxes in order to minimize the harmful effects of the limited powers of taxation bestowed upon excessive tax competition between governments. them by the constitution. It is also worth noting The three mature federations considered in the that when the Conference of State Finance previous reports, Germany, Canada and the Ministers in India agreed in 2003 that all the United States all had very different forms and States and Union Territories would introduce a degrees of tax harmonization. In Germany where VAT, it was agreed that every state legislation the states have been largely financed by sharing on VAT should have a minimum set of common of central revenues, all the major taxes features based on a model VAT bill. (comprising some two-thirds of taxes raised in the federation) are subject to a single federal tax The pattern is different in Switzerland Brazil law and therefore are fully harmonised. In and Sweden, where both levels of share Canada where the major broad-based taxes are significant taxing powers. In Switzerland, a

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 28 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries federal Tax Harmonization Law which came unrest in the more backward regions.27 This into effect in 1993 harmonizes the tax bases for example suggests than unbridled personal and corporate income taxes but does intergovernmental tax competition can be not harmonize tax rates, schedules and personal extremely harmful. allowances. This has facilitated the collection by the cantons of the direct taxes levied by the 5. Decision-making processes for federal government. In Sweden the pattern is intergovernmental fiscal relations: similar with local authorities setting the tax rate for income tax and central law defining the tax (i) Formal and informal institutions and base, but in this case it is the central government processes: that is responsible for its collection. The one Because, as already noted, the relative other country where both the federal and state values of revenue resources and expenditure governments exercise considerable taxing responsibilities change over time, federations powers is Brazil, but in this case there has been and decentralized unitary systems have found it little successful tax harmonization. necessary to establish institutions and processes to facilitate regular or periodic adjustments to (ii) Extent of tax competition: the intergovernmental financial arrangements. The degree of intergovernmental tax Table 6 summarizes the arenas in which these competition has depended largely on the extent issues have been dealt with in the different to which tax harmonization has been lacking. In countries referred to in this study. those cases where the major taxing powers have been concentrated in the central governments In some cases formal institutions and and states or local governments have depended process have been specified in the constitution heavily upon central revenue-sharing, this has itself. Germany, India and South Africa reduced the scope for tax competition. On the represent examples of this. In other cases quite other hand, in those countries where the elaborate formal institutions and processes have different levels of government levy major taxes, been established by intergovernmental but tax harmonization arrangements have been agreement. Australia has been a pioneer in this implemented, either by intergovernmental respect, but Canada also provides an example. In agreement (e.g. Canada and India) or by central some cases formal institutions have been legislation (e.g. Switzerland and Sweden) the established by federal law as in Spain and harmful effects of excessive tax competition Sweden. In many cases there has been a mixture have been moderated. At the same time, the of these processes – establishment by the Swiss authorities have considered that some constitution and also by intergovernmental inter-cantonal tax competition, kept within agreement – for establishing formal institutions bounds, outweighs the negative effects of overly dealing with intergovernmental financial issues constraining cantonal choice of tax structure.26 as exemplified in India and South Africa. In India the Finance Commission (FFC) and the The effects of intergovernmental tax Interstate Council were provided for in the competition have been most apparent in the constitution, but the National Development United States and Brazil, particularly in the Council (an intergovernmental body to oversee latter. One of the greatest problems of Brazilian economic planning) evolved by federalism has been intense “fiscal war” among intergovernmental consensus, and the Planning most of the states for large-scale industrial Commission was established by the Union investment. The “war of tax incentives” arising government. In South Africa, the National from the attempt to attract investment has led to Council of the Provinces and the Financial and a misallocation of resources and contributed to Fiscal Commission are both constitutional

26 D. Carey, K. Gordon and P. Thalmann, Tax Reform 27 J. Serra and J.R.R. Afonso, New Economic and in Switzerland (OECD Economics Department Fiscal Federalism: the Brazilian Case (Ottawa: Working Paper No. 222, 1999), p. 6. Forum of Federations, undated), p. 336.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 29 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries bodies, but the Budget Council (composed of the require central legislation. In different forms Minister of Finance, the Executive Council Canada, Germany and Spain provide examples members responsible for finance in the of this pattern, as does Australia insofar as an provinces and the chairman of the FFC) and the intergovernmental ministerial council establishes Budget Forum (made up of the Budget Council by agreement the framework within which the and local government representatives) are Commonwealth Grants Commission operates. intergovernmental bodies established under the central Intergovernmental Fiscal Relations Act, A third pattern is exemplified by the United 1997. These are supplemented by the MinMecs States, Brazil and Japan where grants to the (sectoral intergovernmental ministerial councils) states or local governments are determined by and the Technical MinMecs (sectoral the federal government with representatives of intergovernmental councils of senior officials). the states or local governments performing the role largely of lobbying the members of the In addition to the variety of constitutional central legislature. In Brazil there is an and other formal institutions and processes intergovernmental National Council for Fiscal dealing with intergovernmental financial issues, Policy (CONFAZ) to coordinate the fiscal and in most of these countries there has been tax policies of the states, but it appears to extensive intergovernmental consultation and perform largely formal functions. The general negotiation on issues related to the federal lack of institutional mechanisms to facilitate financial arrangements. intergovernmental cooperation has resulted in a patchwork of public policies. In terms of the institutions and processes for adjusting issues of federal finance, five distinct Switzerland, as is so often the case, provides patterns can be identified. In Australia, India and a fourth somewhat unique pattern. In some South Africa, although varying in precise form, respects its particular form of the separation of expert commissions established by the central powers within both levels of government government (quinquennially in the case of India) resembles the United States. But in other have been entrusted with the primary task of respects, arising both from its traditions of determining distributive formulae for allocations extensive intergovernmental consultation and among the states, and in the case of India and the provisions in the constitution of 1999 for South Africa also with recommending the intergovernmental cooperation it differs overall state share to be drawn from central significantly. There is extensive consultation revenues. In India, the unconditional allocations between the Federal Council (i.e. the federal of the Finance Commission are also executive) and the Conference of Cantonal supplemented by the substantial central transfers Governments and action has usually required a of conditional grants in support of the Five Year broad consensus. Plans of the Planning Commission. But as the contrasting experience of Australia and India on A fifth pattern relates particularly to the the one hand, and of South Africa on the other, decentralized unitary systems. In both Sweden shows, the establishment of the independence of and Japan, ultimately it is central legislation the commission and the tradition of government which determines the overall pattern and acceptance of its recommendations in the former devolution in the financial arrangements, has been crucial to their effectiveness. In the although in both local interests have a case of South Africa, the treatment of the considerable influence on these decisions. In the commission as a purely advisory body has case of Sweden an Equalization Commission has limited its influence. also been created to implement the equalization arrangements. A second pattern has been the operation of an intergovernmental council composed of central and state representatives to negotiate arrangements, although implementation may

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 30 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

(ii) Degree of central government dominance of 6. Major Recent Reform Efforts the intergovernmental processes: While intergovernmental financial The adoption of a federal political system arrangements in federations and decentralized has usually been aimed at the dual objectives of unitary systems are constantly in evolution promoting both unity and diversity by achieving under the pressures of changing economic and a balance between the institutions of shared rule political circumstances, it is noteworthy that in and those of territorial self-rule in the constituent the past five to ten years there have been some states. An important question therefore is the important major reform efforts in many of the degree to which the decision-making processes countries examined for this report. for intergovernmental financial relations contribute to that balance or distort it by making Among the five mature federations perhaps either level of government dominant in the the most significant efforts have occurred in processes. Given the general tendency in the Germany, Switzerland and Australia. A examples reviewed in this study to concentrate thorough and substantial reform of German the taxing powers and revenue resources in their federalism has been on the agenda during the central governments, it is important to consider past decade. The Länder, particularly the whether in such cases this has in practice wealthier ones, have been pushing for a more undermined the federal balance. In considering “competitive federalism” instead of the current this question it is important to distinguish interlocking “participatory federalism”.28 In between the allocation of constitutional and relation to issues of federal finance this has legal authority on the one hand and the extent to involved two thrusts. One is the demand of the which in practice both levels of government Länder for an increase of their autonomous exert a significant influence upon the key competencies and finances, combined with the decisions. reduction of federal government activities, especially in the fields of concurrent legislative In many cases it may appear that the powers. Second has been the pressure from the concentration of major taxing powers, the stronger Länder, as the net payers, for a new ultimate legal authority for decisions in the equalization scheme to reduce their burden. To adjustment of intergovernmental financial date, although there have been some adjustments arrangements, and the use of the federal to the financial arrangements, these have been spending power to employ extensive conditional modest. On the broader issue of reducing the transfers places the central government in a degree of intergovernment interlocking relatively dominant position. Indeed, this could entanglement, a “Commission for the be said, although in vary degrees, of most of the Modernization of Federalism”, composed of 16 countries reviewed in this study. This apparent representatives representing one for each Land pattern is most acute in the cases of South and 16 from the federal government, was Africa, Spain and Japan. However, even in these recently been established. Its mandate included examples and certainly in most of the others, in an examination of the financial relations practice there have been strong political between the federal government, the Länder and dynamics inducing central governments to be the communes. This attempt at a fundamental sensitive to state and local concerns. This is review has, however, run into difficulties that illustrated by the importance of have led to the suspension of its work. intergovernmental negotiation and agreement in the deliberations affecting the financial Long-standing as the Swiss federation has arrangements in most cases, particularly in been, reform of the constitution and of Switzerland, Canada, Australia, Germany and intergovernmental finance have been major India, and even in Spain, South Africa and Sweden. 28 See, for instance, R. Hrbek, “Germany” in A.L.

Griffiths, ed., Handbook of Federal Countries (Ottawa: McGill-Queen’s University Press for the Forum of Federations, 2002), p. 155.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 31 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries issues in recent years. In April 1999, three panchayats and the municipalities, constitutional decades of sporadic efforts to achieve a status. Not only were certain powers transferred comprehensive revision of the Swiss from the states, but provision was made for State constitution, last totally revised in 1874, Finance Commissions and for the principles on culminated in the approval in a referendum of which adequate financial resources would be the total revision of the constitution. Although a transferred to the panchayats and the total revision, the draft avoided substantial and municipalities. The second was the 80th controversial reforms. It took the form largely of amendment of the constitution in 2000 which, clarifying and modernizing the language rather following the recommendations of the Eleventh than the content of the constitution. Finance Commission, put the sharing of central Nevertheless, it lays out the basis of the taxes with the states on a new level. Where intergovernmental financial arrangements previously only certain specified central tax (articles 126-135), emphasizing both the proceeds were shared, henceforth virtually all elements of cantonal autonomy and of central taxes (with only a few minor exceptions) intergovernmental interdependence and were to be shared on the basis of quinquennial cooperation. It also includes reference to the Finance Commission recommendations. Third, principle of financial equalization among in order to address the growing debt burden of cantons. Discussion of further reform to the the states and supplement the efforts of the states actual details of the equalization system has in evolving their Medium Term Fiscal Reform continued and is the subject of considerable Program (MTFRP), a Debt Swap Scheme debate. facilitated by the Union government was formulated in 2003. Fourth, at the Conference of In Australia, the past decade has also seen State Finance Ministers held in 2002, a final considerable major reform. Most notable was the decision was taken that all States and Union tax reform of 2000 in which the federal Territories would introduce a VAT with a government created a new VAT tax, the Goods minimum set of common features in 2003. and Services Tax (GST), with the commitment that all the proceeds would go to the states as the In Spain there was a reassignment of state basis for unconditional equalized transfers. Thus taxing powers between 1997 and 2002 in order the previous unconditional equalized grants were to give greater taxing powers to the Autonomous now replaced by a tax that will grow with the Communities and make them more accountable economy as the basis for the equalized transfers. to the taxpayers for their expenditures. Although The Commonwealth Grants Commission has the the Autonomous Communities still rely mainly responsibility to make recommendations on the on central transfers, their taxation powers were state relativities. The arrangements are subject to substantially increased and their financial overview by a federal-state ministerial council dependence was moderated. The reforms, while including approval of changes to the rates. In described as “ceded taxes”, in fact represented sum, this arrangement has delivered a significant the ceding of the proceeds from certain central reform, shoring up the financial security of the taxes with the Autonomous Communities being states, reducing inefficiency in the tax system by given power to regulate some of these taxes – the removal of some minor state taxes, and mainly tax brackets, tax rates, and some tax introducing a unique degree of co-decision to the credits. In reality what had been a form of grants fiscal arrangements and tax policy. become a form of tax sharing.29

The transitional federations, although some By comparison with some of the other of them were established quite recently, have examples, the recent efforts to reform the also seen some major reforms to their financial arrangements. India has seen four significant 29 V.R. Almendral, “The Asymmetric Distribution of developments. The first was the coming into rd th Taxing Powers in the Spanish State of Autonomies: force in 1993 of the 73 and 74 constitutional the Common System and the Foral Regimes,” amendments giving local governments, the Regional and Federal Studies, 13(4), 2003, 52-6.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 32 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries financial arrangements have been more modest grant, revenue equalization, and cost in Brazil. The federal government did in 2000 equalization. send to Congress a Fiscal Responsibility Law (modelled on the Fiscal Responsibility Act of In Japan a Decentralization Promotion Law New Zealand) which imposed maximum limits came into effect in 2000. Its purpose was to on the debts and personnel outlays of the federal clarify the roles of central and local governments government, the states and the municipalities. and minimize central involvement in areas of Two other reforms have had some impact on local jurisdiction. The objective was to intergovernmental relations. The first was a encourage local governments to carry out their constitutional amendment in 1996 which created administration more independently so that their a fiscal fund (called FUNDEF), composed of operations will fit better the actual conditions of state and municipal revenues, to finance in particular local sectors.31 redistributive (per capita) terms, the basic public educational systems. The second was in the 7. Identification of Distinctive and Unique health sector where the federal government has Features recently instituted a fund that provides direct These federations and decentralized unitary monetary transfers based on per capita criteria systems have had in common issues such as the for basic municipal health programs. appropriate revenue and expenditure allocation among governments, dealing with vertical and Since the new South African constitution horizontal imbalances by various forms of came into effect only in 1996, the major efforts transfer including in most cases systematic there have been on implementation rather than equalization programs, some effort to avoid immediate reform. These have included a harmful tax competition, and formal and Provincial Tax Regulation Process Act in 2002 informal institutions and processes for which enables provinces to impose new taxes, intergovernmental consultation and cooperation. subject to approval by the national government. Nevertheless, each has displayed some Provinces are now in a better position to address distinctiveness and even uniqueness in its the central government’s general aim of intergovernmental financial arrangements. reducing poverty, vulnerability and inequality. Indeed, their budgets have reflected a strong Among the mature federations, the United alignment to nationally agreed government States stands out for its lack of any systematic priorities. equalization scheme and for its total dependence upon conditional grants in the transfers from the The decentralized unitary regimes have also federal to the state governments. In relation to seen some efforts at financial reform. In the latter, this has led one American critic to Sweden, the proportion of conditional central describe the result as “coercive federalism”.32 grants was reduced in 1991 so that two-thirds of the grants would be unconditional. The new Canada has been distinctive for the unconditional grant was to be distributed relatively strong taxing powers of the provinces according to three factors: revenue equalization, and the largely unconditional nature of federal structural cost equalization, and a supplement transfers in recent years, making it one of the for population reduction. There were some criticisms of the new mechanism on the lack of 31 Government of Japan, Ministry of Public “teeth” to the revenue equalization component Management, Home Affairs, Posts and and on the difficulty in understanding the Telecommunications, Local Administration Bureau, structural cost equalization component.30 In “Local Administration,” accessed from Ministry 1996, a new equalization scheme was adopted, official website: www.soumu.go.jp/english/c- based on three elements: a population-based gyousei/index.hmtl. 32 J. Kincaid, “From Cooperative to Coercive Federalism,” The Annals of the American Academy of 30 Institute of Governance, Intergovernmental Fiscal Political Social Science, vol. 509, May 1990, pp. Relationships, Case Study #1: Sweden. 139-52.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 33 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries most decentralized federations (next to expanded reliance upon revenue-sharing of Switzerland) in the world. The processes of centrally levied taxes and the role of the adaptation have relied primarily upon inter- quinquennial Finance Commissions. The general executive negotiation, “executive federalism,” acceptance of their recommendations has shaped but these processes have had no constitutional or not only the equalization among states, but has statutory basis, depending largely on pragmatic gone beyond the functions of the Australian evolution. Grants Commission in making recommendations on the overall share of the central revenue pool Germany, on the other hand, has had an that should be allocated to the states as a interlocking federal-state system of financial group.33 relationships with a heavy reliance upon revenue-sharing of central taxes. Furthermore, The most distinctive and unique feature of its closely tied executive federalism based on the the Spanish federal financial arrangements is of Bundesrat as a constitutionally mandated focal course their asymmetry in relation to different point, has provided a whole range of Autonomous Communities. To begin with there intergovernmental institutions and processes are the special arrangements relating to the governing the financial relationships among the “foral” regimes in the Basque Country and governments. Navarre whereby for historic reasons they collect all taxes within their territory (except Switzerland stands out as the most customs duties) and remit a share to the central decentralized federation in terms of allocation of government for the estimated services provided revenues and expenditures. It is also distinctive in the region by the central government. Even as a federation where the predominance of the among the “Common” regime for the other processes of direct democracy has both Autonomous Communities, where the main reinforced cantonal autonomy and yet enabled process is one of transfers from the central extensive federal, cantonal and local government, there are differences between the involvement in almost every sphere of public “slow track” Autonomous Communities and the policy. “fast track” Communities in which devolution and correspondingly the size of financial Among mature federations Australia is at the transfers is greater. other extreme, with the highest concentration of taxing powers in the federal government. Among the transitional federations, Brazil Particularly distinctive has been the degree to stands in contrast because of the lack of federal- which the processes of “executive federalism” state financial coordination and the intensity of have been embodied in a range of formal the interstate tax competition often described as institutions such as the Loan Council and the “tax wars”. Commonwealth Grants Commission created quite early on, and more recently the By contrast, in South Africa the intergovernmental Council of Australian overwhelming emphasis has been upon “co- Governments (COAG) overseeing and operative governance”. The arrangements have coordinating the operation of up to thirty formal all the trappings of a federal distribution of sectoral Ministerial Councils. In the realm of revenues and expenditures and of formal equalization arrangements, Australia, and intergovernmental consultative bodies, and even particularly its Commonwealth Grants a constitutionally mandated independent Finance Commission, have played a pioneering role and Fiscal Commission. But under these whose example has been followed and adapted constitutional provisions lies the overwhelming in a number of later federations. centralization of own-source revenues and the

Among the transitional federations India has 33 See for instance, The Twelfth Finance the most fully developed financial relations with Commission, Fifty years of Fiscal Federalism: prominent elements being the heavy and Finance Commissions of India (New Delhi: 2003).

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 34 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries predominant influence of the central leadership criteria need to be taken into account: economic of the African National Conference which so far efficiency, equity, effective fiscal management has held overwhelming sway in the central and stabilization policy, the relative autonomy of government and seven of the nine provinces. the constituent units, the degree of intergovernmental coordination and of central Sweden and Japan stand out from the other influence on the states and local governments, examples because, although in many respects the transparency and democratic accountability there is a comparable degree of decentralization, of decision-making, the influence on political this is not guaranteed constitutionally due to the stability and adaptability, and the relative unitary character of their regimes. Nevertheless, significance of institutions and of political among unitary regimes Sweden, like the other culture. The individual federations and Nordic countries, is unique in the level of decentralized unitary systems will each be autonomy allocated to local governments. Local briefly examined in turn in relation to these governments are responsible for the provision of criteria. Included in this review will be the three many public services and have significant mature federations, Canada, the United States, taxation authority including local income and Germany, but the reader’s attention is drawn taxation. This has helped to keep vertical to the much more extensive discussion of the imbalances at a low level. In addition to playing lessons to be drawn from them in the previous a relatively minor role in local public finance, comparative report on them.36 central government grants are largely provided unconditionally, further strengthening local Each of these criteria is important but the autonomy. Sweden has also provided an emphasis placed upon each and the balance example of effective cooperation and negotiation struck among these criteria has varied in the nine between central and local government thanks in federations and two decentralized unitary large part to the non-dependence of the Local systems. Government Associations.34 Economic efficiency relates to the extent to In Japan the degree of expenditure which the specific decentralized fiscal decentralization is in fact considerably more arrangements have contributed to the extensive than in Sweden, but the dependence of improvement of economic efficiency or have local governments upon transfers from the compromised the efficiency of the federal central government is much greater and the economy as a whole. As a concept it tendency for the central government to be encompasses efficiency in the allocation of directive is also much greater. As Mochida and public and private resources as well as efficiency Lotz put it, “The issue for Japan is not so much in the provision of government services. to change/enlarge the expenditure assignments themselves, but to redefine responsibilities for Equity in a federal setting relates to the designing, implementing, and financing these achievement of the objectives of equality of assignments.”35 opportunity and of economic security (social insurance) for citizens throughout the federation, C. EVALUATION OF ECONOMIC AND wherever they live, through the provision of POLITICAL PERFORMANCE public services, as well as the purely redistributive objective of equality of outcomes. 1. The Criteria: In assessing the operation of fiscal Fiscal management and stabilization policy federalism in these federations a number of refers to the extent to which the allocation of

34 Mochida and Lotze, “Fiscal Federalism in Practice, 36 R. Boadway and R.L. Watts, Fiscal Federalism in the Nordic Countries and Japan”, The Journal of Canada, the United States, and Germany: Final Economics, vol. 64 (4), 1999, p. 83. Report (Kingston: Institute of Intergovernmental 35 Ibid., p. 59. Relations June 2001) pp. 32-55.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 35 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries taxing powers has facilitated or hindered the “transparency” which refers to the degree to management of the economy to achieve which decisions taken by governments are stabilization policies. clearly open to public scrutiny. For democratic public control to operate effectively, the Autonomy of the constituent units relates to governmental, including intergovernmental, the degree of freedom from external control by processes must be easily understood by the other governments experiences by governments public. within the polity. This is important because an Political stability and adaptability are both authentic federal system involves a combination important. Political stability relates to the extent of shared rule for certain specified purposes to which the processes of intergovernmental through a common government and self-rule for fiscal relations are carried out with a minimum certain specified purposes by the governments of of conflict and have a stabilizing influence on the constituent units. In such a context, the the operation and development of the country. A extent to which the financial arrangements closely related consideration is the ability of the contribute to the genuine autonomy of the fiscal arrangements to assist the federation or governments of the constituent units in their decentralized unitary system to adapt over time areas of constitutional responsibility or to changing circumstances without destabilizing constrains such autonomy gives an indication of the polity. the degree to which the political system is in practice genuinely federal. The extent to which The relative significance of institutions and the constituent units have access to own-source of political culture refers to relative roles of the revenues or are dependent upon transfers from institutional structure and of the prevailing the central government, and furthermore the culture in shaping the character and operation of extent to which these transfers are generally the intergovernmental financial arrangements. unconditional or conditional may seriously affect their degree of autonomy. 2. The mature federations previously reported on: Canada, the United States and The degree of coordination and of central Germany: influence upon states and local governments is The financial arrangements in three of the important because of the unavoidable mature federations – Canada, the United States interdependence and overlaps in the and Germany – were previously reported upon, responsibilities of governments in any system of and therefore the application of the criteria listed divided jurisdiction and decentralization. The above will be only briefly summarized here.37 effectiveness of the machinery and processes for intergovernmental cooperation in financial In relation to the criterion of efficiency, in matters is therefore particularly significant but Germany efficiency in the common market has the degree to which the central government been virtually guaranteed because economic dominates these processes or proceeds activity faces common government policies no unilaterally may undermine the autonomy of the matter where they locate. The concentration of states and local governments. taxing powers in the central government and funding arrangements that ensure all Länder are Transparency and democratic able to provide comparable levels of public accountability of decision-making is important services at comparable tax rates has ensured this. because an underlying principle of democratic On the other hand, many of the efficiency representative government is that elected and advantages of decentralization are foregone by appointed officials should be ultimately the uniformity of fiscal policies across Länder. responsible to the citizens for their actions. This Furthermore, inter-Länder competition as a spur means that decisions about the fiscal to initiative and efficiency is generally lacking. arrangements should involve processes by which The Canadian case achieves a number of the those making the decisions are publicly and legally accountable. A precondition for this is 37 Ibid.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 36 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries efficiency advantages of the German one while taxing powers in Germany leaves the central avoiding some of the major disadvantages. The government there in a stronger position to carry decentralization of expenditure responsibilities out policies directed to these objectives. On the is accompanied in Canada by real discretion for other hand, in Canada where there was more the provinces to tailor their programs to suit the emphasis on Keynesian policies when they were needs and preferences of their constituents. The in their heyday, the greater decentralization of main issue in the Canadian case is whether there income and corporate taxes placed some limits is too much decentralization from the point of on these. In the United States too, although to a view of efficiency. While in some areas of lesser extent than Canada, sharing of such taxing provincial spending, such as health, there is powers by the states had some effect upon the some degree of harmonization, in others which scope for federal fiscal management and are important for efficiency objectives, such as stabilization policy. education, there is virtually none. The United States, like Canada has a considerable degree of There is considerable variation among these financial decentralization. However, some of the three federations in the degree to which advantages of this are undermined by the fact constituent units lack their own tax levying that a substantial proportion of grants from the powers and are dependent upon transfers from central government are conditional or are used to the federal government, particularly conditional impose mandated expenditure programs upon transfers, and these have affected the degree of the states. As well, although the tax system is autonomy experienced by the governments of not as decentralized as it is in Canada, there is their constituent unites. In terms of reliance no explicit system of tax harmonization. upon own-source revenues and of predominance of unconditional transfers, the Canadian system From the point of view of equity objectives, of fiscal federalism clearly leaves the provinces these three federations achieve quite different with the highest degree of autonomy among degrees of redistributive equity. In the case of these three federations. While the German Germany common standards of equity apply Länder are dependent upon a higher proportion across the federation. The common national of intergovernmental transfers than the United system of income and sales taxation and the States, the lower proportion of conditional great lengths to which full equalization has been transfers and the constitutionally mandated taken have ensured that full horizontal equity character of the unconditional transfers from applies nationwide. In Canada, the equalization shares of federal taxes, the size of which they system goes a considerable way to ensuring that have some influence over through the Bundesrat, the goal of horizontal equity applies at least in leaves the German Länder with a larger degree revenue-raising terms. However, the of financial autonomy than the states in the decentralization of major social programs and United States. the relative absence of federal oversight through conditionality of transfers or other means have In terms of degree of intergovernmental meant that in practice different standards of coordination and central influence upon states equity can apply in different provinces. The and local governments, the interlocking nature United States differs from both the German and of decision-making on financial issues in Canadian cases. Although the various Germany clearly stands out. Indeed some critics conditional grant schemes often embody have argued that it has been carried to excess elements intended to achieve equity objectives, and that the resulting “joint decision trap” has the absence of an explicit system of equalization reduced autonomy, initiative and freedom of transfers means that there is no systematic action of governments at all levels.38 At the attempt to correct horizontal imbalances among the states. 38 F. Scharpf, “The Joint Decision Trap: Lessons

from German Federalism and European Integration,” In relation to fiscal management and Public Administration 66 (autumn 1988), pp. 238- stabilization policy the concentration of central 278.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 37 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries other extreme is the United States where the distribution of powers and the exercise of the intergovernmental cooperation, while not federal spending power, and the negotiations by insignificant, has largely been of an ad hoc the executives usually behind closed doors have nature focused on specific projects and meant that there is very little transparency for programs. Mid-way between them comes the citizenry concerning intergovernmental Canada where the processes of “executive fiscal relations. The primary method for federalism” have led to intense interaction ensuring accountability in both federations is among officials and ministers and even on through the traditional conventions of executive occasion meetings of first ministers in relation to responsibility to the legislature within each of the financial arrangements between the federal the participating governments. The effectives of and provincial governments. As a result, while these accountability measures is, however, often the federal government may on some of these undermined by the lack of transparency and matters have the legal final word and has on clarity concerning the relative roles and occasion even acted unilaterally, in practice the responsibility of each government in relation to degree of intergovernmental consultation and financing a particular policy or program. negotiation has been extensive. Nevertheless, unlike Germany, “executive federalism” is not An important consideration in assessing formally grounded in the Canadian constitution intergovernmental fiscal relations in these and has on occasion been marked by inadequate countries is the extent to which collaboration or by federal government intergovernmental conflict is minimized and a unilateralism. Thus, where in Canada there have stabilizing influence is exerted upon the often been calls for more collaboration and operation and development of the federation. coordination, this contrasts with the calls in Closely related to and contributing to stability is Germany for some loosening of the interlocking whether the fiscal arrangements assist the financial arrangements there in order to federation to adapt to changing circumstances introduce larger elements of autonomy, more over time. An obvious measure of political intergovernmental competitiveness, and clearer stability in these three federations has been their transparency and accountability. existence under basically the same constitutional structure: in the United States for nearly 140 In relation to the criteria of transparency and years since the conclusion of the Civil War of democratic decision-making, the complexity of the 1860s, in Canada for 137 years since the the diffused system of governmental decision- formation of the federation in 1867, and in making and intergovernmental relations in the Germany for 55 years since its post World War United States has resulted in a relatively low II establishment as a federation. On the whole, transparency and public understanding of their the fiscal transfers system in the United States financial arrangements. Nevertheless, the has shown a remarkable ability to adapt to reliance upon conditional transfers makes it changing circumstances over that period. The clear that the responsibility for setting those matrix of interconnections among legislators, conditions lies in the Congress and the administrators and executives in all three levels bargaining “free for all” that takes place there is of government has produced an uncoordinated relatively open to the public to observe. Canada but flexible system accommodating the variety and Germany, unlike the United States, are of regional views in its decision-making marked by parliamentary institutions with their processes. The cumulative net effect has been executives at each level directly responsible to that, despite the rhetoric of noncentralization, their respective legislatures. A significant result the fiscal arrangements in the United States have of this has been the predominance in their over time contributed to a progressive and intergovernmental relations of negotiations cumulative centralization and relative between the executives in processes usually dominance of the federal government within the referred to as “executive federalism.” In both federation. cases the complexity of the fiscal relationships, the complicated constitutional law surrounding

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 38 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

Canada, by contrast, has over much the intergovernmental decision-making and fiscal same time evolved from a relatively centralized arrangements. The cultural homogeneity of the federal system to a more decentralized one, and United States has been a factor in the relative a key element in that trend has been the dominance of the federal government and the evolution of its fiscal arrangements. acceptance of extensive conditional Nevertheless, during the past half century two intergovernmental transfers. But compared to factors contributing to continued political Germany, the emphasis in the United States stability and cohesion have been the consensus political culture upon the variety of individual in support of a systematic equalization scheme and group interests and upon the diffusion of to assist the poorer provinces, and the general power upon multiple decision-making centres federal programs of financial assistance to the has meant that, unlike Germany, there is no provinces in support of health, post-secondary coordinated overarching system of equalization education and social welfare which have grants or of intergovernmental financial contributed to the public’s sense of Canada as “a transfers. There is instead a vast array of sharing community.” Given the difficulties and uncoordinated intergovernmental transfer rigidities of the processes for formal programs, each attempting to respond to specific constitutional amendment in Canada, its has needs and interests. The Canadian political been the adjustments in the federal-provincial culture, on the other hand, has been financial arrangements that have served as the characterized by deep linguistic and regional major factor enabling the federation to adapt to cleavages. These explain the insistence of the changing circumstances. provincial governments, and particularly Quebec, on ensuring their autonomy, and hence As in the other two federations, the the trend over time to emphasize their own processes of intergovernmental relations and taxing powers and reliance particularly upon fiscal arrangements in Germany have had both a unconditional rather than conditional transfers. stabilizing effect and have facilitated adaptation. Nevertheless, despite the existence of regional For example, the special adjustments to the and linguistic cleavages there is a high degree of financial arrangements to assist the new Länder consensus among Canadians on many social after reunification have played an important role. values. This has been reflected in the use of Despite the current pressures for a significant transfers by the federal government to assist the move towards disentanglement of the financial development of a set of Canada-wide programs arrangements between the federal and Land that are accessible to Canadians regardless of governments, the fact remains that the Federal where they live, and by a formal program for the Republic of Germany over its first fifty-five systematic equalization of provincial revenues years has proved both remarkably stable and (including Quebec as a major recipient). The remarkably adaptable. largely unconditional or only semi-conditional character of these transfers has at the same time In all three federations not only their allowed considerable discretion and variety in institutional structures but their political cultures how the provinces deliver these programs. These have played an important part in the operation of examples indicate that each of these three their intergovernmental financial arrangements. federations in developing its own particular form Of the three federations, Germany, for instance, of fiscal federalism has reflected the distinctive has in relative terms the most homogeneous character of its society and political culture. society and this has been both reflected in and reinforced by its intergovernmental fiscal 3. Two additional mature federations: arrangements. Examples are the emphasis upon Switzerland and Australia: equivalence of living conditions throughout the In relation to the various criteria, the other country, the extensive equalization program two mature federations, Switzerland and heavily based on inter-state transfers, and the Australia, in some respects provide significant generally highly integrated, interdependent and contrasts. In terms of economic efficiency indeed interlocked character of its Switzerland has emphasized the benefits that

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 39 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries flow from decentralization. Indeed as Table 2 1959. Because of the moderating impact of the indicates, it is the most decentralized of all the Swiss emphasis upon cantonal autonomy, the federations in terms both of expenditure and of Swiss equalization scheme has not been as far own-source revenues. The fundamental principle reaching in its total scope as those in Australia has been that of subsidiarity. Competencies have and Germany, or even that in Canada. generally been vested as far as possible at the Furthermore, the means of achieving local and cantonal levels and have been equalization has been less systematic, being reluctantly transferred to the federal level only applied through a number of instruments when a lower level is no longer in a position to including revenue sharing, conditional grants, provide a service “efficiently”. Despite or and the cantonal contributions to the federal because of this approach, Switzerland has government’s social expenditures. In this respect maintained a relatively prosperous economy Switzerland has been somewhat closer to the with one of the highest per capita incomes in the pattern in the United States although the world. approach has been more systematic. Consequently, the need to reform the By contrast, in Australia most of the major equalization scheme has come to the fore very taxing and revenue sources have been recently and has proved a contentious subject. concentrated in the hands of the federal government, its percent of total government Fiscal management and stabilization policy revenues being the highest among the mature as an objective for the federal government has federations. This has reduced intergovernmental been particularly prominent in Australia, and has tax competition and provided the federal been a major factor in the concentration of government with the ability to exert an nearly all the major taxing powers in the federal integrated and coherent economic policy. At the government. The desirability of a centralized same time on the expenditure side there in Keynesian approach to issues of fiscal Australia is a considerably greater degree of management and stabilization which was so decentralization to obtain benefits from prominent in Australia for a significant period providing the states with considerable room for during the twentieth century, was much weaker state initiatives. Unlike the German federation, in Switzerland, however. Consequently, the decentralization on the expenditure side does not comparatively strong decentralization of both consist of administration of federal legislation revenues and expenditures has persisted in but represents fields where the states have both Switzerland. legislative and executive responsibility. The considerable dependence on specific purpose On the issue of autonomy of the constituent conditional grants (Table 4) does, however, units, despite some pressures towards increased provide a source for central influence over state central policy-making and revenues during the policies. latter half of the twentieth century, the Swiss cantons have remained fiercely independent in These two federations also provide contrasts their outlook. As a result, as already noted, in the degree to which they have emphasized the Switzerland continues to be the most objective of equity. As in Germany, in Australia decentralized federation in the world in terms of there has been a very strong value placed upon the distribution both of own-source revenues and the goal of equity and of removing disparities of expenditures (Tables 1 and 2). Even in those among the states. This led to the first considerable areas where the cantons implement development of an equalization system in any federal laws, by contrast with Germany, the federation in the world in 1933. The cantons are left by virtue of the constitution with Commonwealth Grants Commission now takes a great deal of autonomy and the federal into account some 18 revenue categories and government is required to take into account the some 41 expenditure categories in arriving at its financial burden that is associated with recommendations. Switzerland introduced its implementing federal laws by transferring first equalization scheme somewhat later in

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 40 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries sufficient equalized funding.39 In Australia state usually carried the day in consultations and autonomy has not been revered to the same collaboration on a wide range of matters. In extent as in Switzerland or Canada. Switzerland, the fairly recent creation of a Consequently, the own source revenues of the Conference of Cantonal Governments has not states are the lowest among the mature only provided an instrument for inter-cantonal federations (Table 2), and the proportion of state collaboration but has also facilitated federal- revenue received in the form of conditional cantonal multilateral deliberations in a specific purpose grants is higher than in any federation composed of as many as 26 other mature federation except the United States constituent units. By contrast with Australia, the (Table 4). Nevertheless, concern for state relatively weaker financial position of the autonomy has meant that more than half of the federal government in relation to the cantons, federal transfers to the states are unconditional has meant that the federal government has not in form (Table 3). been in apposition to dominate federal-cantonal financial deliberations. Intergovernmental coordination has been extensive in both federations. Australia since the The financial arrangements in both Australia Loan Council was established in 1927, has gone and Switzerland, because of their complexity, on to develop one of the most extensive arrays especially in the equalization formulae and of formal coordinating bodies in any federation. indices, have been marked by a lack of The Council of Australian Governments transparency for the public at large. (COAG) established in 1992 and composed of Furthermore, because much of the financial the leaders of the Commonwealth and state arrangements have been worked out in a context governments and also representatives of local of intergovernmental negotiations and government, usually meets twice a year and bargaining, there clarity has been obscured. In oversees the intergovernmental collaborative Australia where total transfers have formed such processes embodied in a wide range of sectoral a high percentage of state revenues (highest Ministerial Councils, a number of which have among the mature federations – see Table 4), voting rules for decisions. The premiers of the this has particularly undermined democratic states also meet with each other regularly both to accountability for the expenditure of these consider inter-state collaboration and to agree revenues. On the other hand in Switzerland, not upon strategy for their relations with the only the much lower proportion of cantonal Commonwealth government. The new revenues composed of central transfers, but also equalization arrangements following the the impact of the strong traditions of direct introduction of the GST also provide for the democracy at all levels of government, have Ministerial Council on Commonwealth-State contributed to a much greater level of Financial Relations to oversee the work of the democratic accountability regarding financial Commonwealth Grants Commission and to relationships. Indeed virtually all significant agree to changes in the rates of the GST. Not changes in taxing powers have been subject to infrequently, intergovernmental discussions of approval by referendum. financial relations have proved quite contentious, but because of its strong revenue Both federations have exhibited high base, ultimately the federal government has degrees of both political stability and adaptability. In Switzerland, since the adoption in 1848 of a federal system to replace the 39 A. Linder and A. Vatter, “Institutions and previous unstable confederal structure which had Outcomes of Swiss Federalism: the Role of the culminated in a civil war, Switzerland has Cantons in Swiss Politics,” in J.-E. Lane, ed., The shown a remarkable political stability inspite of Swiss Labyrinth: Institutions, Outcomes and its deep historic, linguistic and religious Redesign (London: Frank Cass, 2001), pp. 103-4; L. diversity. Indeed, it has come to be held up Mader, Co-ordination of Powers in Federal Systems (Paper at International Forum on Federalism in widely as a model of multicultural Mexico, Vera Cruz, 2001), p. 2. accommodation. At the same time it has proved

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 41 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries capable of adaptation. This evolution by concentrated taxing powers in the central piecemeal adaptation is illustrated by the more government but decentralized expenditure than one hundred constitutional adjustments, responsibilities to promote efficient delivery of including many on financial matters, made by services (Tables 1 and 2). South Africa has formal constitutional amendments during the carried this to the greatest degree with 95 twentieth century, and by the modernization of percent of all revenue sources allocated to the the federal structure by the total revision in central government, but even India, the least 1999. Australia too has displayed over a century centralized of the transitional federations in this of political stability. However, although having respect, is comparable to the most centralized of an almost identical procedure for constitutional the mature federations (Australia) in terms of amendment as Switzerland, the process has revenue concentration. Although in India the proved much more difficult in Australia. Indeed, major taxes are levied and collected by the by contrast with Switzerland over the same Union government there is more state tax room century, of 42 proposed constitutional than in the other transitional federations. amendments sent to referendum in Australia Consequently, some vertical tax overlapping has only 8 received the necessary double majorities occurred due to the imposition of state sales for adoption. Nevertheless, the processes of taxes on items on which federal excise taxes executive federalism have provided an have been levied, causing some distortions.40 alternative means for some adaptability as These three transitional federations as a group illustrated by the implementation of the new have clearly placed a high priority upon a GST tax as the pool for equalized transfers to the coherent centralized levying and collection of states. taxes, and with it the avoidance of intergovernmental tax competition and conflict. Many of the differences between This emphasis has been understandable since in Switzerland and Australia in the evolution of each of these cases at the time the federal their financial arrangements can be attributed as structure was established there was a severe much to differences in their respective political pressure for rapid economic development to cultures as to their political institutions. The overcome their economic deficiencies. At the largely egalitarian political culture of Australia same time, the political pressures which made has played an important part in the emphasis in the adoption of federal institutions necessary its financial arrangements upon centralization were easier to accommodate while also giving facilitating uniform treatment and upon full weight to economic efficiency through the equalization of both the revenue and expenditure decentralization of expenditure responsibilities. aspects of inter-state disparities. By contrast, in The price of trying to combine these two Switzerland its linguistic and religious diversity different forms of economic efficiency for has fostered an insistence upon decentralization revenue raising and for expenditure and cantonal autonomy and has moderated the responsibilities required, however, the impulse for equalization. acceptance of substantially larger vertical financial imbalances than in most of the mature 4. The transitional federations: India, Spain, federations. This in turn has required for these South Africa and Brazil: transitional federations as a group a much higher Of the group of transitional federations, level of dependency of their states upon transfers India, Spain and South Africa have shared some from the central government. With this has gone common tendencies, while Brazil is clearly a resulting loss in incentives for responsible differentiated from the other three. The first spending. In the Indian case a further three will therefore be reviewed as a group and inefficiency has come from the failure of then Brazil separately.

40 M.G. Rao and N. Singh, The Assignment of Taxes In relation to the criteria of economic and Expenditures in India, Working Paper #435, efficiency, India, Spain and South Africa have Department of Economics, University of California, each on grounds of economic efficiency Santa Cruz, 1998, p.17.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 42 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries coordination among the two important per capita expenditures still show wide specialized institutions – the Finance variations. These differences translate into Commissions and the Planning Commission – disparities in literacy rates, health indicators and that both play a part in determining the size and standards of governance.41 In Spain, where the form of total central transfers to the states. economic disparities have not been as great to begin with, the revenues per inhabitant of the In the case of Spain, the economic different Autonomous Communities have been efficiencies gained from the different allocations broadly equivalent, and when the European of taxing powers and expenditure Funds from the European Union are included, responsibilities have been moderated by the the per capita revenues of the poorest political necessity of treating the Autonomous Autonomous Communities have been even lifted Communities asymmetrically, particularly the above those of the wealthiest.42 “foral” cases. For these various reasons, the wide variation in vertical imbalances among the In these three federations the relative Autonomous Communities have in the end concentration of taxing powers in the central counterbalanced significantly the intended gains governments has left the levers for fiscal in economic efficiency from combining management and stabilization policy clearly centralized taxation with decentralized with their central governments. In South Africa, expenditure. for instance, the national Department of Finance has moulded a system of intergovernmental In South Africa and India the disparities in fiscal relations in which, by and large, the wealth among the constituent units have been provinces are expected to follow the national much deeper than that generally found in the department’s game plan.43 Some concerns have mature federations. Consequently inter-unit arisen, however, particularly in India, about the equity has been a particular concern. In the case extent to which the largely unconditional nature of South Africa, this has been reinforced by the of the non-plan transfers has permitted states to avowed objective of reversing the inequities of develop persistent deficits, thus building up a the previous apartheid regime in relation to the deteriorating debt situation. In Spain, the 1997- Bantustans. Consequently, the notion of 2002 financing arrangements for the “equitable shares,” both in vertical and Autonomous Communities which substituted horizontal terms, permeates the constitutional some lump-sum central transfers by regionally- provisions relating to the financial arrangements raised tax revenues was an important step to (article 214), and is set out as an objective for improving fiscal responsibility at the regional the Financial and Fiscal Commission (art. 214 level, but the central government has retained (2)(d), (e), (f) and (g)). In its operation, the the final decision power on financing the Commission has developed a methodology involving an array of indices to meet this 41 objective (see Table 5). Since the constitution D.K. Srivastava, “India” in P.Smoke and Y-H Kim (eds.) Intergovernmental Fiscal Transfers in Asia: came into effect so recently in 1996, it is too Current Practices and Challenges for the Future early to judge the degree of success towards (Asian Development Bank), 2001, p.92. meeting this criterion, except to say that a start 42 A. Castells, “The Role of Intergovernmental has been made. In India, too, the disparities in Finance in Achieving Diversity and Cohesion: The wealth among states are severe and the Case of Spain,” in R. Bird and T. Stauffer (eds.), equalization of state revenues has been a major Intergovernmental Fiscal Relations in Fragmented factor in the recommendations of its Finance Societies (Fribourg: Institute du Fédéralisme, 2001), Commissions. The criteria they have used have p. 98. 43 tended to be more general (see Table 5) than the C. Murray, “Building Unity Through multiple indices used by the Australian Transformation: Intergovernmental Fiscal Relations in South Africa,” in R. Brid and T. Stauffer (eds.), Commonwealth Grants Commission since in Intergovernmental Fiscal Relations in Fragmented India the disparities are much wider. Inspite of Societies, (Fribourg: Institute du Fédéralisme, 2001), nearly 50 years of equalizing transfers in India, p.529.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 43 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries autonomous governments (through the system of In relation to fiscal transparency, India has grants) and therefore remains largely in achieved a reasonably high standard.46 control.44 Particularly noteworthy is the detailed information that is made available in the As far as autonomy of constituent units is government budgets and also elsewhere in concerned, because of the restricted range of reports by government ministries and in the own-source taxing powers and high degree of audit processes. Nevertheless, the inevitable dependency upon central transfers, the financial complexities of the intergovernmental transfer autonomy of the constituent units in these arrangements, and the conflicting impacts of the federations is much more limited than in the Finance Commission and Planning Commission mature federations generally (see tables 2 and processes have complicated the picture. In Spain 4). To some extent this has been partially the different kinds of grant mechanisms, the mitigated by a heavier reliance on unconditional added complication of the European Funds rather than conditional central transfers, but the assisting the poorest Communities, and the more genuine autonomy that comes from different arrangements relating to the ‘foral’ substantial own-source revenues whose size is Communities and the fast and slow-track determined by the constituent units has been Communities all contribute to a complicated limited. picture difficult for the public to understand clearly, and they provide fuel for inter- In these three federations, there is a Community grievances and resentments. In considerable degree of coordination of South Africa the complexity of the criteria used intergovernmental relations, largely in the form in its assessments by the Finance and Fiscal of inter-executive consultation and meetings Commission has led the Department of Finance (especially in South Africa), but this has to criticize the commission reports as at a “fairly generally been characterized by central high level of abstraction.”47 But the resultant government leadership and a top-down approach sidelining of the commission’s rather than by a spirit of cooperation among recommendations by the Department of Finance, governments of equal status.45 While this and the fact that the shares allocated to each characterized the situation in India in the early sphere of government have in the end been decades after independence, more recently the based on “a political judgement made by the replacement of Congress Party dominance by cabinet”48 has contributed to a lack of coalitions of regional political parties within the transparency concerning intergovernmental Union government has moderated the centralist financial arrangements. The limitations of bias in intergovernmental financial negotiations. transparency have affected the degree of In South Africa, on the other hand, the continued democratic accountability in decision-making on overwhelming dominance of the African financial matters in all three federations, and this National Congress at both levels of government lack has been further accentuated at the and, as the 2004 election has indicated the constituent unit level by their limited own- continued strength of the party’s central source revenues and dependency upon central organization in relation to the political dynamics transfers. Recent Indian Finance Commissions at all levels shows no sign of weakening. The have attempted to counteract this by including change of central government in Spain in 2004 among their criteria for allocation among the may moderate the heavily top-down character of states their fiscal performance (including tax the previous financial arrangements, but it is too effort and fiscal management). In Spain the early to judge the impact of the change of government in Madrid. 46 IMF, 2001, p.8. 47 J. Wehner, “Comments on ‘Building Unity 44 I.Joumard and A. Varoudikis, Options for Through Transformation: Intergovernmental Fiscal Reforming the Spanish Tax System, OECD Paper Relations in South Africa” in Brid and Stauffer, 249, 2000, p.10; 2000, p. 10; Castells, op.cit., p. 98. op.cit., 2001, pp. 542-3. 45 See, for instance, Murray, 2001, op.cit. pp. 530-31. 48 Department of Finance, 1999, p. 258.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 44 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries substitution of some lump sum central transfers of secessionist violence from the public sphere. by regionally levied tax revenues was intended The South African constitution of 1996 is still to increase the accountability of Communities to less than a decade old, and therefore it is clearly their electorates, but the effect has been limited too early to talk about long-run political stability by the continued heavy dependence on central and adaptability, but the election of 2004 has transfers. In South Africa the Fiscal and provided ample evidence that despite difficult Financial Commission has held the view that economic circumstances, the Republic has got provincial taxing powers are essential if the off to a strong political start. provincial governments are to be properly accountable,49 but taxing powers have In these three federal examples institutional nevertheless remained highly centralized. structures and the prevailing political culture have both played a part in shaping their federal Despite shortcomings in relation to a systems in general and their arrangements number of the criteria reviewed above, these governing intergovernmental financial relations. three transitional federations have performed In India the constitutional structure has defined remarkably well in terms of overall political the allocation of taxing powers, arrangements stability and adaptability. This is perhaps for financial transfers, and the role of the clearest in the Indian case. Despite the dire Finance Commission as a constitutional body. predictions of some of the critics in the early At the same time the broad eclectic and decades, the adaptability of the federal system, pragmatic nature of the underlying Hindu enabling the accommodation of its extensive culture has contributed to the adaptation of the socio-cultural diversities, has enabled the institutional structure and its accommodation of federation to hold together. The states and local the ethnic and linguistic diversity expressed governments have come to play an important through the states. In Spain, the arrangements in role, raising some 34 percent of total the 1978 constitution provided a process for government revenues and being responsible for progressive asymmetrical devolution. But the some 55 percent of total government actual shape in which that devolution has expenditures (see Table 2). The increased evolved has owed as much to the negotiations democratic decentralization which has occurred among the political leadership at different levels since the inception of the constitution in 1950 and the degree to which the population has been and particularly in the 1990s has provided an willing to accept the multi-national character of important and effective answer to subnational Spain and the moderate nationalist groups in and ethnic conflicts.50 In Spain while the preference to such extremist groups as ETA. The asymmetrical devolution has been highly constitutional structure of South Africa complex, especially in relation to the financial emphasizing “cooperative governance” and its arrangements, they have enabled the promotion detailed provisions relating to the financial of self-government for its minority nations. arrangements have clearly been important, but Public debates on federalism and the nature of equally important has been the post-apartheid the Spanish constitution continue, but at a time prevailing public emphasis upon “equitable when the constitution of 1978 has reached its shares” throughout the country. The dominance quarter-century, the Spanish democracy now of the ANC as a party and the national priority it appears relatively stable, particularly since the has given both to equity and to fiscal stability ETA ceasefire of 1998 which removed the threat has been a major factor in the intergovernmental financial relations.

49 Murray, 2001, op.cit., p.517. Among the four transitional federations, 50 H. Bhattacharyya, “Federalism, Decentralization Brazil has clearly been an outrider. While also and State-Building in India: Aspects of Centre-State relatively centralized in terms of concentration Fiscal Relations,” in R. Bird and T. Stauffer, (eds.), of taxing powers in the central government – a Intergovernmental Fiscal Relations in Fragmented Societies (Fribourg: Institut du Fédéralisme, 2001), p. similar level to India but considerably less than 278. South Africa or Spain (Tables 1 and 2) – it has

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 45 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries differed in two major respects. First the degree large extent these have been insufficient to of expenditure decentralization is much less, reduce the disparities. indeed the lowest of all the countries listed in Tables 1 and 2. Second, this means that the With regard to fiscal management and vertical imbalances are much less than in any of stabilization policy, the federal government does the other countries examined in this report levy personal (IRPF) and corporate (IRPJ) (Table 2), and the dependence of the states on income taxes and a VAT (IPI). It therefore does central transfers (Table 4) is much less than in have major levers for fiscal management and any of the other transitional federations stabilization policy. On the other hand, unlike (although comparable to the United States and most of the other transitional federations, it has more than is the case in Switzerland or Canada). far less leverage over the taxation levied by the This has meant that in relation to the criterion of states (including the states’ VAT (ICMS) which economic efficiency it has moderately achieved account for about 25 percent of the total amount the benefits of centralized revenue raising, but in of taxes levied in Brazil) and over the comparison to the other cases far less those of expenditures of the states. expenditure decentralization. Efficiency has also been hindered by the lack of a clear division of In the process of disorganized responsibilities across levels of government on decentralization that has occurred under the health and security issues, education, social 1988 constitution, the main concern of the states welfare, agriculture, food distribution, has been upon guaranteeing their tax autonomy, sanitation, housing and policing. This has led to especially in relation to their main tax, the ICMS duplication of spending assignments.51 (a state VAT). The states are responsible for a wide and expanding range of activities and raise A particularly distinctive feature of the significant amounts of revenue themselves. This Brazilian federation has been the pronounced has given them a wide-ranging budgetary socio-economic disparities among the sub- autonomy, and despite numerous federal national units. These fiscal disparities have attempts to restrict their borrowing activities, hindered the creation of new forms of federative they have also had access to credit through a coordination within the decentralized regime. wide range of sources and instruments. For example, the City Government of Sao Paulo Important factors have been that the states are collects more municipal service tax (ISS) than well represented in the Senate (whose approval the combined value tax (ICMS) revenues of 17 is needed for all legislation) and that the political states.52 Given that, unlike the other transitional autonomy of the states and municipal federations, the states in Brazil receive much governments is protected by tight constitutional smaller proportion of their revenues from central restrictions. Furthermore, the states preside over transfers and therefore are much more dependent large, powerful militias that counterbalance the on their own-source revenues (Table 4), the need threat of federal intervention. The net effect is to correct of these sharp differences among the that the states and municipalities often behave states in revenue capacity has continued largely like predators of a politically weak and wounded unbated. Brazil’s major redistributive program federal government. does concentrate on the poorest regions – 85 percent goes to the northest region53 – but to a In Brazil the only institution established to coordinate intergovernmental fiscal relations is the National Council for Fiscal Policy 51 OECD, Economic survey: Brazil, 2001, p.145. (CONFAZ). Originally established during the 52 J. Serra and J.R.R. Afonso, New Economic and military regime to coordinate the fiscal and tax Fiscal Federalism: the Brazilian Case, (Forum of policies of the states, it still operates but today it Federations, Ottawa, undated), p.326. 53 A. Shah, “Comment on ‘Dencentralization and Reform of the State: The Brazilian Federation at the Crossroads,” in R. Bird and T. Stauffer, eds., Societies (Fribourg: Institut du Fédéralisme, 2001), p. Intergovernmental Fiscal Relations in Fragmented 350.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 46 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries performs purely formal functions.54 Relations 5. The decentralized unitary systems: between the federal government and the states Sweden and Japan: and municipalities, and between the state Both these unitary systems have sought the governments and their respective municipalities objective of economic efficiency through are characterized largely by mutual substantial decentralization. Indeed, as Tables 1 independence and competition, and the and 2 indicate, the extent of decentralization has federation lacks effective institutional been comparable to that in many federations. mechanisms to facilitate cooperative The major difference between them and the intergovernmental relations. The result is that a federations has not been in the degree of distinctive characteristic of the Brazilian has decentralization, but rather in the fact that in the been intergovernmental tax competition which federations the decentralized authority of the often goes to the length of ‘tax warfare’. A high constituent units is conferred and guaranteed by degree of party fragmentation and weak party the constitution rather than by the central discipline at the federal level has contributed to government. producing a relatively weak federal government. In terms of economic efficiency both these Nevertheless, in 2000 the federal decentralized unitary systems have, like the government sent to Congress a Fiscal federations, attempted to combine the Responsibility Act inspired by the Fiscal efficiencies of centralized taxation enabling Responsibility Act in New Zealand. This Act fiscal management and stabilization policy with introduced new concepts such as responsibility the efficiencies to be obtained by decentralized and transparency and was intended to create a expenditure responsibilities. There is, however, responsible fiscal management at all three levels a significant difference between Sweden and of government. It required all levels of Japan. The scope of expenditure that has been government to formulate and publicize three- decentralized is substantially greater in Japan year targets, prohibited the federal government (Table 2), but the degree of autonomy granted to from bailing out state and municipal debts, and local governments, especially in terms of own- applied hard sanctions to those responsible for source revenues, is much greater in Sweden. The misuse of government funds. OECD has given positive reviews of the Swedish economic reforms of the 1990s, Although the current federal constitution has indicating that decentralization has contributed been in operation for only a decade and a half, in to the long-term economic performance of that brief period the tax system seems to have Sweden.55 Japan has been in the midst of a undermined rather than contributed to political decade of economically troubling times, but stability. It has encouraged ‘fiscal warfare’ there have been some signs in 2004 that its among vertically and horizontally among economic performance has begun to pick up. governments, and this has if anything intensified Moreover, despite the problems of the past in recent years. decade, it should be noted that Japan has remained one of the world’s most economically It would appear that to a considerable extent powerful countries, ranking eleventh out of 102 the institutional structures established by the countries in the World Economic Forum’s 1988 constitution have been distorted by the global competitiveness rankings.56 At the same socio-economic pressures that have been time a desire for equity in the provision of public inherited from the preceding regimes in Brazil. goods has distinguished both Japan and Sweden The major social and economic disparities have among decentralized polities. created intense inter-state and federal-state rivalries and fiscal competition at the expense of any efforts at coordination. 55 OECD, Economic Surveys 2000-1: Sweden (Paris:

OECD, 2001). 56 World Economic Forum, Global Competitiveness 54 Costa, op. cit., p. 50. Report 2003-04.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 47 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

Sweden has been unique among to its remarkable political stability. In the earlier decentralized unitary systems in the level of decades these arrangements also contributed to autonomy granted to local governments. Local its adaptability, but in the past decade their governments are responsible for the provision of bureaucratic character seems to have been a many public services and, what is more, have factor blocking responsiveness and fresh significant taxation authority. This has reduce initiatives in the face of economic stagnation. the vertical fiscal imbalance to the lowest of all Sweden’s long history of local decentralization eleven countries referred to in this report (Table has been a factor in its renowned political 2, third column). In addition what limited central stability, but these arrangements have not been grants have been necessary have been largely inflexible. Not only were there reforms in local provided unconditionally, further strengthening governments in 1952 and in 1962-74, but in the local autonomy. This has led Mochida and Lotz 1990s, after a period of poor economic to commend highly Sweden’s intergovernmental performance in the 1970s and 1980s marked by financial arrangements, both for the autonomy high inflation, currency crises, and rising public they promote and for the transparency and and foreign debt, the significant reforms in the democratic accountability of financial decision- financial decentralization and deregulation of making that these arrangements have achieved. local governments have produced benefits now While the Japanese decentralization has in terms manifested in improved economic of extent gone somewhat further (Table 2, performance.59 How much of the political second column), this has not been accompanied stability and adaptability of these two examples by the same degree of local autonomy. Due to can be attributed to their political institutions the heavy reliance on central tax sharing and and how much to their respective political grants, central control has reduced local cultures in difficult to say. In federal systems accountability, and the complicated formulae where the constitutions lay down the specific involved in determining local allocations have allocations of powers and finances and reduced transparency. This has led Mochida and established the institutional structures, the Lotz to conclude: “The Japanese system seems modifications of these in practice under the to attempt to combine North European (i.e. pressures of the prevailing social values Scandinavian) expenditure decentralization with illustrates the relative impact of political Continental style centralized methods of cultures. In unitary systems where a central financing. This is a problematic match”.57 The government does not have the same result has been a high degree of central constitutional constraints upon it, it is harder to government influence and control over local determine the precise extent to which the governments through the financial transfers and evolution in political practice is due to the subsidies it provides for centrally assigned tasks. influence of the institutional structure or to the In Sweden on the other hand there has not been impact of prevailing social values. Over the long the same top-down dominance. Due to the course of the evolution of local government and relative independence of the Local Government finance in Sweden these arrangements would Associations, the relations between central and appear to have influenced and been influenced local government have been characterized more by the wide public acceptance of the desirability by cooperation and negotiation.58 of decentralized and autonomous local government. In Japan, the new institutional Despite the problems that have been structures established in the post-war occupation identified, in long-run terms the degree of period clearly represented a break with Japan’s decentralization implemented in Japan under its past political culture. Those institutions have, post-war constitution appear to have contributed however, put down roots and appear to have become widely accepted by the public. The institutions were to some extent the product of 57 N. Mochida and J. Lotz, “Fiscal Federalism in Practice: The Nordic Countries and Japan,” The Journal of Economics, 64(4), 1999, p.61. 59 Swedish Institute, “Fact Sheets on Sweden: Local 58 Ibid., p. 83. Government in Sweden,” 2001.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 48 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries an occupying power. Nevertheless, in the This has usually resulted in a narrower vertical process of accepting them, after the shock of the financial imbalance to be corrected by a more way in which the war ended the operation of modest scale of transfers from the central these institutions has been modified in subtle government. With variations, this has been the ways by traditional Japanese values. This general pattern in Canada, Switzerland and the explains the complex nuanced relationships United States among the mature federations, between the central and local governments. Brazil among the transitional federations, and Sweden among the decentralized unitary D. CONCLUSION systems. The disadvantage of this approach is Although there is considerable individual that if there is inadequate intergovernmental variation the federations and decentralized cooperation and collaboration it may lead to unitary systems considered in this report fall into harmful tax competition between the various two broad groups in terms of their governments in the polity. These effects are intergovernmental financial relations. In one most apparent in the tax wars occurring in the group, there has been an emphasis upon the Brazilian example. In the United States, to economic benefits of relatively centralized recognize the principle of financial revenue-raising combined with substantially responsibility (that control over expenditures be more decentralized expenditure responsibilities. placed with the taxing authority) there has been With this has gone the need for massive a heavy reliance upon conditional central grants, transfers from the central government to correct placing responsibility for shaping expenditures both the resulting vertical and also the horizontal funded by transfers in the hands of Congress as financial imbalances by means of extensive the taxing authority. The result has, of course, sharing of the proceeds of central taxes and the been a considerable diminution of state use of unconditional and conditional grants. Into autonomy and a constraining of the benefits of this broad group fall Australia and Germany decentralized own-source revenues. The other among the mature federations, India, Spain and three countries following this general approach South Africa among the transitional federations, have achieved a better balance of autonomy and and Japan among the decentralized unitary constituent unit financial responsibility. They systems. The drawback of this approach has have done this by combining an allocation of been the general dependency of the constituent substantial own-source revenues to the units upon the central government in order to constituent units with some tax harmonization meet their expenditure needs and the lack of arrangements and significant elements of incentives for fiscal responsibility in their intergovernmental cooperation and collaboration operation. To offset these disadvantages there in their financial arrangements. In addition in has usually been an attempt to foster state these three cases horizontal imbalances in autonomy by an emphasis upon the revenue capacity have been moderated by a unconditionality of the central transfers, system of equalization grants, usually including in Australia, India and South Africa unconditional in nature, in order to reduce the use of independent finance commissions. In disparities in the own-source revenues of the the case of Germany and South Africa there constituent unites. have been attempts to counter the limited autonomy of the states by giving them some role Finally, it emerges clearly from this through such institutions as the Bundesrat and comparative analysis that intergovernmental the National Council of the Provinces in the financial relations are not determined simply by making of central policy that affects the states. economic analysis and technical adjustments alone, but are at their essence the product of A second broad approach has been to emphasize the importance of a sufficiently substantial allocation of own-source tax and other revenues at the state level to achieve the benefits of autonomy and fiscal responsibility.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 49 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries political compromises.60 Thus understanding of the intergovernmental financial relations in any country requires an understanding of the political context which shapes them.

60 R. L. Watts, “Introduction: Comparative Research and Fiscal Federalism”, Regional and Federal Studies, Special Issue: Money matters: Territorial Finance in Decentralized States, vol 13 (4), Winter 2003, pp. 1-6.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 50 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries

TABLE 1: CENTRAL GOVERNMENT SHARES OF TOTAL (ALL GOVERNMENTS) REVENUE AND EXPENDITURES1

Percent of Total all Percent of Total all Country Governments Revenue Governments Expenditure Mature Federations:

Australia 69 54

United States 67 54

Germany 65 37

Canada 44 37

Switzerland 40 32

Transitional Federations:

Spain 83 51

South Africa 95 50

Brazil 69 64

India 66 45

Mature Unitary Systems:

Japan 58 38

Sweden 57 54

Russia: 91 46

1. Revenue shares are before transfers of shares of central taxes and grants to state and local governments. Expenditure shares are after transfers of shares of central taxes and grants to state and local governments. Figures are rounded to the nearest percent. Countries in each category are listed broadly in descending order of centralization. Depending on source figures are for 2000 or 2001.

Sources: Government Finances Statistics Yearbook (various years); R.L. Watts, The Spending Power in Federal Systems: A Comparative Study (1999), pp. 52-3; S. Yilmaz and Bindebir, Intergovernmental Transfers: Concepts and Policy Issues (World Bank Institute, 2003); Japan, Ministry of Finance “Understanding the Japanese Budget” 2003; Mochida and Lotz, “Fiscal Federalism in Practice, the Nordic

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 51 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries Countries and Japan,” The Journal of Economics, 64(4) 1999; Sweden, Ministry of Finance, Budget Bill (2003); South Africa, Financial and Fiscal Commission, “Towards a Review of the Intergovernmental Fiscal Relations System” (2003); B. Dafflon and S. Perritez, “Federal-Cantonal Equalization in Switzerland: An Overview of the Present System and Reform in Progress” (BENIFRI, Fribourg, 2003); Supplement to 2002 Government Finances Statistics Book (IMF); A. Castells, “The Role of Intergovernmental Finance in Achieving Diversity and Cohesion: The Case of Spain” in R. Bird and T. Stauffer, eds., Intergovernmental Fiscal Relations in Fragmented Societies (Fribourg). Russian figures are derived from R.L. Watts, Russian Fiscal Federalism in Comparative Perspective (Kingston: Institute of Intergovernmental Relations, Queen’s University, 2005), Tables 1 and 2.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 52 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries TABLE 2: STATE AND LOCAL GOVERNMENT SHARES OF TOTAL (ALL GOVERNMENTS) REVENUE AND EXPENDITURES1

Percent of Total Percent of Total all Vertical Country all Governments Governments Revenue Imbalance Expenditure Mature Federations:

Australia 31 46 15

United States 33 46 13

Germany 35 63 27

Canada 56 63 07

Switzerland 60 68 08

Transitional Federations:

Spain 17 49 32

South Africa 05 50 45

Brazil 31 36 05

India 34 55 21

Mature Unitary Systems:

Japan 42 62 20

Sweden 43 46 03

Russia: 9 54 45

2. Revenue shares are before transfers of shares of central taxes and grants to state and local governments. Expenditure shares are after transfers of shares of central taxes and grants to state and local governments. Figures are rounded to the nearest percent. Countries in each category are listed broadly in ascending order of decentralization. Depending on source figures are for 2000 or 2001. 3. Vertical imbalances are identified by difference between total state and local expenditures and total state and local own source revenues (before transfers of shares of central taxes and grants).

Sources: As for Table 1.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 53 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries TABLE 3: CONDITIONAL GRANTS AS PERCENTAGE OF TOTAL CENTRAL TRANSFERS (Total Transfers = shares of central taxes plus unconditional grants plus conditional grants)

Country Year Percentage

Mature Federations:

Australia 2000 47.1

United States 1996 100.0

Germany 1996 64.5

Canada 1996 43.6*

Switzerland 1997 73.1

Transitional Federations:

Spain 1998 66.1

South Africa 2001/02 11.5

Brazil 2000 25.0

India 2001 40.7

Mature Unitary Systems:

Japan 2003 43.5

Sweden 2003 15.7

Note: Figures are mostly for 2000 and 2001 except for those for Canada, United States and Germany which are for 1995 or 1996 (derived from previous studies for this project).

* If CHST transfers are considered as unconditional, the percentage for Canada would be 4.3%.

Sources: Government Finances Statistics Yearbook various years; R.L. Watts, The Spending Power in Federal Systems: A Comparative Study (1999), p.56; see also sources for Table 1.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 54 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries TABLE 4: CENTRAL TRANSFERS AS PERCENT OF TOTAL CONSTITUENT UNIT (States and Local) REVENUES

Total Conditional Country Transfers Transfers Mature Federations:

Australia 45.3 21.3

United States 29.6 29.6

Germany 43.8 9.8

Canada 19.8 15.8*

Switzerland 24.8 17

Transitional Federations:

Spain 72.8 41.9

South Africa 96.1 11.0

Brazil 30.0 7.5

India 46.0 18.7

Mature Unitary Systems:

Japan 37.2 16.2

Sweden 15.8 4.4

Note: Figures are mostly for 2000 and 2001 except for those for Canada, United States and Germany which are for 1995 or 1996 (derived from previous studies for this project).

* If CHST transfers are considered as unconditional, the percentage for Canada would be 0.9%.

Sources: Government Finances Statistics Yearbook; R.L. Watts, The Spending Power in Federal Systems: A Comparative Study (1999), pp.53, 57; see also sources for Table 1.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 55 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries TABLE 5: EQUALIZATION ARRANGEMENTS

United States No generalized equalization scheme: some equalization occurs from cumulative effect of provisions in specific federal grant-in-aid schemes as approved by Congress.

Switzerland Federal transfers based on formulae involving a range of criteria ranking cantons by financial capacity as the basis for tax-sharing and conditional grants, but the equalizing transfer system is smaller than in Germany, Canada and Australia.

Canada Federal transfers: stand-alone equalization scheme based on formula (adjusted from time to time) assessing provincial revenue capacity in terms of 33 provincial tax and non-tax revenue sources against a middle range five-province standard and providing unconditional grants representing 42% of all transfers.

Australia Federal transfers: based between 1933 and 1981-82 on recommendations derived from determination of needs of claimant states by a standing independent Commonwealth Grants Commission; after 1981- 82 took the form of adjustments to the general Adjustment Grant transfers based on calculation of relativities of expenditure needs among states; since 2000 based on application of relativities to distribution of central GST tax. Allocation by CGC based on calculation of revenue capacity and expenditure needs from comparisons of 18 revenue categories and 41 expenditure categories.

Germany Primarily inter-state transfers (62%): equalization through an inter-state revenue pool to which rich L@nder pay and from which poor L@nder draw according to a formula; plus federal transfers (38%): Federal Supplementary Payments of 1.5% of value-added tax (VAT). The primary per capita distribution of the shares of the L@nder of a portion of the VAT also has an equalizing effect.

India Federal transfers from a pool of all union taxes supplemented by unconditional grants, based on the recommendations of quinquennial Finance Commissions recommending both the share to be allocated to the states as a group, and the allocation among states taking account of population, per capita income, area, economic and rural infrastructure needs, and tax effort.

Spain Federal transfers: since 1987 criteria including population, size, personal income, fiscal effort, number of internal provinces within Autonomous Community, and distance to state capital; applied by federal government to shares of federal tax revenue transferred to Autonomous Communities.

Brazil Distribution of state participation fund (state share of three main federal taxes) with participation coefficient for each state based mainly on redistributive criteria (85 percent of fund goes to poorer regions in the North, Northeast, and West-West). A similar fund for municipalities is less redistributive and more population based.

South Africa General national revenue-sharing transfer, with National Government distribution of “equitable shares” among provinces following recommendations of Financial and Fiscal Commission based on demographic profiles of provinces comprising an education share, a health share, a social security share, and population, backlog, economic activity and institutional components.

Sweden Cost equalization transfers based on 15 indices: municipalities and country councils whose per capita income is below national average receive a grant and those above pay a fee (i.e. scheme is self- balancing), plus a supplementary block grant from the central government containing a population- related and age-related portion. Implemented by an Equalization Commission.

Japan Local Allocation Tax (the main central government unconditional revenue-sharing transfer) is distributed to local governments on a uniform formula based on basic financial need and basic financial capacity.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 56 Ronald Watts, Intergovernmental Financial Relationships in Eleven Countries TABLE 6: ARENAS FOR RESOLVING ISSUES OF INTERGOVERNMENTAL FINANCE

United States Congress: negotiations among representatives of different states within Congress over allocation of grant-in-aid programs: representatives of state administrations act as lobbyists.

Switzerland Federal Parliament: negotiations within Federal Council (i.e. federal executive) and Parliament (containing cantonal representatives), but with extensive consultation of the Conference of Cantonal Governments, and assisted from time to time by commissions.

Canada Processes of executive federalism predominate. Ultimate decision lies with federal government and federal legislation, but in practice for each five year period renewal is preceded by extensive federal-provincial negotiations through officials and federal and provincial finance ministers to arrive at an agreed program.

Australia Processes of executive federalism predominate. Ultimate decision lies with federal government and federal legislation, but equalization transfers from GST pool are based on recommendations of an independent expert Commonwealth Grants Commission (CGC), whose recommendations are usually implemented, the recommendations being made within a context established by an intergovernmental Ministerial Council.

Germany Executive federalism: ultimately fiscal arrangements require endorsement of the Bundesrat composed of representatives of the executives of the L@nder.

India Ultimate decision lies with Union government, but constitutionally mandated independent Finance Commissions make recommendations for total state share of shared central taxes and for unconditional grants to states, and for distribution of both among states. Recommendations have in practice usually been implemented. These transfers are supplemented by substantial conditional grants allocated on the recommendation of the Planning Commission.

Spain Executive federalism: regional financial arrangements are negotiated every five years in the Fiscal and Financial Policy Council, an intergovernmental ministerial body with the decisions made by a qualified majority vote in which the vote of the two central government ministers is equal to that of all the regional councillors. Legally an advisory body but in practice decisive.

Brazil General lack of institutional structures for financial arrangements expect for National Council for Fiscal Policy (CONFAZ) for coordinating the fiscal and tax policies of the states, but in practice this performs purely formal functions.

South Africa Ultimate decisions lie with the national government, but an independent Financial and Fiscal Commission (FFC) of 22 members, of whom 9 are appointed by provinces and two by local governments, is mandated by the constitution to make recommendations on the “equitable shares” for state and for local governments and on the formula for distribution. These are reviewed by the Budget Council and the Budget Forum (both intergovernment councils). In practice, the FFC has been treated by the Finance Ministry of the national government largely as an advisory body.

Sweden Decisions relating to transfers lie with national government, with implementation of equalization arrangements being carried out by an independent Equalization Commission. The Swedish Association of Local Authorities and Swedish Association of Country Councils handle the contacts and annual negotiations between the local and central governments.

Japan Decisions lie with the central government but prefectoral governors and administrators spend a great deal of time lobbying the central government and Diet members.

Working Paper 2005 (5) © 2005 IIGR, Queen’s University 57