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Fiscal federalism own-source revenues to finance the services logi- cally assigned to them. Richard M. Bird Given the greater interjurisdictional mobility of University of Toronto the base of the income tax relative to that of the con- sumption tax, and of the latter relative to that of the The analysis of the problems that give rise to, property tax (and the efficiency problems arising and arise from, the existence of more than from tax exportation, when not precisely offset by one level of government within the same benefit spillovers), most analysts suggest that the lo- geographical area. cal public sector should be financed basically by user charges and “local” taxes, especially the prop- erty tax, and states by consumption taxes, with the As originally developed by Musgrave (1959) and income tax being left largely to the central (federal) Oates (1972), the “theory of fiscal federalism” con- government (Musgrave 1983). But this division of cerns the division of public-sector functions and fi- revenues means that state and local governments are nances in a logical way among multiple layers of likely to end up with greater expenditure responsi- government (King 1984). Much of the literature of bilities than can be financed from their own reve- fiscal federalism consists of relatively unrelated nues. An important element of fiscal federalism treatments of such issues as the “decentralization from the beginning has thus been recognition of the theorem” (Oates 1991), models for the assignment probable need for intergovernmental grants to close of powers (McLure 1993), discussions of inter- the revenue gap. Considerable attention has been governmental spillovers and intergovernmental devoted to the appropriate design of such grants grants (Break 1980), fiscal mobility and migration (Wilde 1971; Ahmed 1997), as well as to empirical (Wildasin 1991), and vertical fiscal imbalance and analysis of their effects on local spending patterns dependence (Hunter 1977). The theoretical discus- (Gramlich 1977; Rubinfeld 1987). sion of local public goods that has taken place in the The theory of fiscal federalism applies as well, context of the Tiebout model (Wildasin 1986) is not or as badly, to local service units in a metropolitan part of “fiscal federalism” as defined here because it area as to states in a federation. In principle, how- is concerned only with governmental relations at the ever, there are important analytical and policy dif- same jurisdictional level. A more general, and rele- ferences, not only between local-metropolitan vant, theoretical framework to approach some of problems and federal-state problems but even be- these problems might be the theory of overlapping tween “tight” federations such as Germany and clubs (Cornes and Sandler 1996), but as yet this has “loose” federations such as Canada—with the been little developed (Casella and Frey 1992). United States somewhere in between (Bird 1986). Initially, stabilization and distribution were con- These differences arise in part from the differing sidered to be essentially “central” functions, with nature and rigidity of the constraints imposed by the only role for “subcentral” (state and local) gov- political institutions. The question has attracted con- ernments arising in the allocative sphere. From siderable attention in recent years, in part because of this perspective, the main analytical task of fis- the emergence of nascent “federal” institutions in cal federalism is to define the appropriate functions the European Union. However, fiscal federalism has and finances of local governments as efficiently as little to say as yet about the dynamics of institutional possible—that is, in such a way as to maximize change in emerging (or disintegrating) federations. community welfare (often represented, for analytical Moreover, it offers little guidance in dealing with convenience, by the Median Voter Theorem). In a such important real-world intergovernmental fi- territorial variant of the Benefit Principle, it was nance problems as the appropriate size and scope of suggested at an early stage that each jurisdiction operation of local and intermediate-level govern- could be most efficiently mapped in terms of the ments in the newly emerging countries of the former spatial dimension of the services it provided. Thus, Soviet bloc (Bird, Ebel, and Wallich 1995), where, there would be “local public goods,” “state public for example, the potential impact on stabilization goods,” and “national public goods,” with the pre- (Gramlich 1987) is a major concern. sumed beneficiaries of each financing their provi- In contrast, much good work has been done sion in an appropriate way (Olson 1969). In prac- within this analytical framework on some of the tice, the overlapping and multidimensional nature of problems arising from the common metropolitan most public-sector activities makes it difficult to ap- area situation of divided political jurisdictions ply this approach very rigorously, particularly be- within an economically integrated region. A struc- cause few lower-level governments have sufficient ture that puts people’s places of work and residence 152 Fiscal federalism in separate political jurisidictions, while making the Local governments rely heavily on property latter primarily responsible for the most important taxes for revenue, while state governments rely on a local expenditure, education, has obvious implica- mixture of sales and income taxes, and the federal tions for both efficiency and distribution (Wildasin government mainly on income (and payroll) taxes. 1986), as has been much explored in the literature The division of revenues differs in other countries: on education finance. There is still much to be done, Although almost everywhere local governments get however, to satisfactorily explain local redistribu- property taxes and central governments most in- tive policies (Tresch 1981)—through, for example, come taxes, in some countries local income taxes— education—and their impact on migration and other like national sales taxes—are much more important important economic variables (Wildasin 1991). than in the United States (Owens and Panella 1991). Much has been written about the virtues of de- Such taxes are invariably “piggybacked” on national centralized government, from both a political and an taxes—that is, they take the form of surcharges. economic perspective (Tullock 1994), but most of Only Switzerland comes close to matching the di- these supposed virtues can, in the conventional fis- versity of the state and local income and sales taxes cal federalism framework, be achieved as well by found in the United States. Most other countries, regionally based central officials as by locally whether formally federal or not, have much more elected politicians. Perhaps some of the answers lie territorially uniform fiscal systems. Although there in the new “supply-side” theories of government is clearly vertical competition between levels of (Breton 1996) that are beginning to be developed in government for revenue, most attention has been the broad “public choice” framework (Mueller paid in the literature to horizontal tax competition, 1992), because there is considerable similarity be- perhaps because as a rule local governments have tween the assumptions underlying public choice access only to those revenue sources that higher- theory and federalist theory (Ostrom 1971). As yet, level governments do not want for themselves. however, little progress has been made with respect Local governments almost invariably depend in to articulating these arguments in either normative part, and sometimes very heavily, upon transfers or positive terms in the conventional fiscal federal- from upper-level governments to finance the ser- ism analysis, other than as simple assertions. vices for which they are responsible. The appropri- Nonetheless, some important lessons have ate level and design of such transfers has been an emerged from the fiscal federalism literature (Inman important concern in the fiscal federalism literature. and Rubinfeld 1997). In particular, considerable Some argue, for example, that a system of uncondi- progress has been made with respect to the appro- tional fiscal equalization grants is an essential com- priate assignment of tasks and finances in multilevel ponent of an efficient (and equitable) fiscal federal governments, especially with respect to the design system (Boadway and Flatters 1982). Others assert and effects of intergovernmental grants (Wildasin that there is no place for such transfers (Oakland 1997). While there is considerable variation in detail 1994). The theoretical literature suggests that the from state to state—let alone across countries—on only clear efficiency case for intergovernmental the whole the observed assignment of functions to payments is to compensate local governments for local and state governments accords broadly with benefit spillovers to ensure that they provide the op- the dictates of theory, with local governments being timal amount of the public service in question. In broadly responsible for “place-specific” services practice, however, virtually no examples of the such as streets, water and sewerage works, refuse open-ended conditional matching grants called for disposal, and fire and police services. In addition, in by this theory are to be found in any country (Ah- the United States, local governments are also gener- med 1997). On the contrary, most countries (other ally responsible for providing primary and secon- than the United States) have some system of un- dary education, although as a rule with substantial conditional transfers intended to equalize some con- fiscal assistance from state governments; in other cept of fiscal capacity. Moreover, most conditional countries, education is often provided primarily by matching grants are limited in amount and probably intermediate-level (state) governments and some- best interpreted in a principal-agent framework (Fer- times even by central governments. A common pat- ris and Winkler 1991)—that is, as the equivalent of tern everywhere is for one level of government to be mandated functions being paid for, in large part, by involved in delivering a certain service while other transfers but with some local payment being called levels are involved to varying degrees in financing for. The latter is to ensure that local fiscal effort is and regulating it (Ter-Minassian 1997). Work on maintained and also that, at the margin, local politi- understanding the desirability and effects of alterna- cians remain electorally accountable for their ac- tive institutional structures of providing particular tions to their constituents, as well as to the granting services is still in its infancy, though. authority. Fiscal federalism 153

At the policy level, the Advisory Commission Several Levels of Government, edited by Remy Prud’homme. on Intergovernmental Relations (ACIR) (1990) car- The Hague/Koenigstein: Foundation Journal of Public ried out pioneering studies on fiscal disparities Finance, 1991 (sometimes referred to as “horizontal imbalance”), Gramlich, Edward M. “Intergovernmental Grants: A Review fiscal capacity, and fiscal effort. Curiously, this of the Empirical Literature.” In The Political Economy of work has had its greatest policy impact in other fed- Fiscal Federalism, edited by Wallace E. Oates. Lexington, Mass.: Lexington Press, 1977. eral countries such as Canada, where since 1967 a version of the ACIR’s “representative tax system” Gramlich, Edward M. “Subnational Fiscal Policy.” Perspec- concept has formed the basis of the federal- tives on Local Public Finance and Public Policy 3 (1987): 3Ð27. provincial equalization system—which itself was based in large part on a system developed in Aus- Hunter, J.S.H. Federalism and Fiscal Balance. Canberra: tralia in the 1930s (and since extended from revenue Australian National University Press, 1977. to expenditure equalization). Similar systems of fed- Inman, Robert P., and Daniel L. Rubinfeld. “The Political eral-state transfers, often based on formulas and Economy of Fiscal Federalism.” In Perspectives on Public usually unconditional in nature, are characteristic of Choice: A Handbook, edited by Dennis C. Mueller. Cam- bridge, U.K.: Cambridge University Press, 1997. most federal countries (Shah 1994). Apart from the brief experience with a small “revenue-sharing” Juster, F. Thomas, editor. The Economic and Political Impact system in the 1970s (Juster 1977), the United States of General Revenue Sharing. Ann Arbor, Mich.: Survey Re- search Center, Institute for Social Research, University of is unique among federal countries in that it has Michigan, 1977. never had a system of federal-state equalization transfers—although there are, of course, many fed- King, David. Fiscal Tiers: The Economics of Multi-Level eral-state conditional transfers, as well as some Government. London: George Allen and Unwin, 1984. experience with fiscal equalization at the state and McLure, Charles E., Jr. Vertical Fiscal Imbalance and the local levels. Assignment of Taxing Powers in Australia. Stanford: Hoover Institution, 1993. Additional readings Mueller, Dennis C. Public Choice II. Cambridge, U.K.: Cambridge University Press, 1992. Advisory Commission on Intergovernmental Relations. 1988 State Fiscal Capacity and Effort. Information Report M-170. Musgrave, Richard A. The Theory of Public Finance. New Washington, D.C., 1990. York: McGraw Hill, 1959. Ahmad, Ehtisham, editor. Financing Decentralized Expen- Musgrave, Richard A. “Who Should Tax, Where, and ditures: An International Comparison of Grants. Chelten- What?” Tax Assignment in Federal Countries, edited by ham, U.K.: Edward Elgar, 1997. Charles E. McLure, Jr. Canberra: Australian National Uni- versity Press, 1983. Bird, Richard M. Federal Finance in Comparative Perspec- tive. Toronto: Canadian Tax Foundation, 1986. Oakland, William. “Fiscal Equalization: An Empty Box?” National Tax Journal 44 (1994). Bird, Richard M., Robert D. Ebel, and Christine I. Wallich, editors, Decentralization of the Socialist State: Intergovern- Oates, Wallace E. Fiscal Federalism. New York: Harcourt mental Finance in Transition Economies. Washington, D.C.: Brace Jovanovich, 1972. World Bank, 1995. Oates, Wallace E. “The Theory of Fiscal Federalism: Reve- Boadway, Robin, and Frank Flatters. “Efficiency and Equali- nue and Expenditure Issues—A Survey of Recent Theoreti- zation Payments in a Federal System of Government: A cal and Empirical Research.” Public Finance with Several Synthesis and Extension of Recent Results.” Canadian Jour- Levels of Government, edited by Remy Prud’homme. The nal of Economics 15 (1982). Hague/Koeningstein: Foundation Journal of Public Finance, 1991. Break, George F. Financing Government in a Federal Sys- tem. Washington, D.C.: The Brookings Institution, 1980. Olson, Mancur. “The Principle of Fiscal Equivalence: The Division of Responsiblities among Different Levels of Breton, Albert. Competitive Governments: An Economic Government.” American Economic Review Papers and Pro- Theory of Politics and Public Finance. Cambridge, U.K.: ceedings 59 (May 1969): 479Ð87. Cambridge University Press, 1996. Ostrom, Vincent. The Political Theory of a Compound Casella, Alessandra, and Bruno Frey. “Federalism and Clubs: Republic. Blacksburg, Va.: Public Choice Society, 1971. Towards an Economic Theory of Overlapping Political Ju- risdictions,” European Economic Review 36 (1992): 639Ð46. Owens, Jeffrey, and Giorgio Panella, editors. Local Govern- ment: An International Perspective. Amsterdam: North- Cornes, Richard, and Todd Sandler. The Theory of External- Holland, 1991. ities, Public Goods and Club Goods. 2d ed. Cambridge, Rubinfeld, Daniel. “The Economics of the Local Public U.K.: Cambridge University Press, 1996. Sector.” In Handbook of Public Economics, vol. 2, edited by Ferris, James M., and Donald R. Winkler. “Agency Theory Alan J. Auerbach and Martin Feldstein. Amsterdam: North- and Intergovernmental Relationships.” Public Finance with Holland, 1987. 154 Fiscal federalism

Shah, Anwar. The Reform of Intergovernmental Fiscal Rela- Wildasin, David E. “Income Redistribution in a Common tions in Developing and Emerging Market Economies. Policy Labor Market.” American Economic Review 81 (1991): and Research Series 23. Washington, D.C.: World Bank, 757Ð74. 1994. Wildasin, David E., editor. Fiscal Aspects of Evolving Fed- Ter-Minassian, Teresa, editor. Fiscal Federalism in Theory erations. Cambridge, U.K.: Cambridge University Press, and Practice. Washington, D.C.: International Monetary 1997. Fund, 1997. Wilde, James E. 1971. “Grants-in-Aid: The Analytics of De- Tresch, Richard W. Public Finance: A Normative Theory. sign and Response.” National Tax Journal 24 (1971): Plano, Texas: Business Publications, 1981. 143Ð55. Tullock, Gordon. The New Federalist. Vancouver: Fraser Cross references: benefit principle; education Institute, 1994. financing, state and local; fiscal disparities; fiscal Wildasin, David E. Urban Public Finance. London: Har- equalization; median voter theorem; tax and revenue wood Academic Publishers, 1986. effort; tax exportation.