Fiscal Federalism 151
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Fiscal federalism 151 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