_j_pS t315 POLICY RESEARCH WORKING PAPER 13 85 Public Disclosure Authorized Fiscal Federalism This paper presentseconomic principles and practical Dimensions of Tax Reform guidelines for the assignment in Developing Countries of revenueraising responsibilitiesamong Public Disclosure Authorized different levelsof government Robin Boadway for countrieswith morethan Sandra Roberts one levelof government.It Anwar Shah alsooutlines tax ~ n n s 9harmonizationand aSifg,t t ^Ut~ j coordinationstrategies to avoid inefficienciesand inequities arising from Public Disclosure Authorized decentralizationof revenue raisingauthority. Public Disclosure Authorized The World Bank PolicyResearch Departmnent Public EconomicsDivision November 1994 IPOLICY RESEARCH WORKING PAPER 1385 Summaryfindings Boadway, Roberts, and Shah propose four economic Thus progressive redistributive taxes, stabilization principles for use in deciding taxing responsibilities for instruments, and resource rent taxes would be suitable various levels of government. These are: for assignment to national government; while tolls on * Efficiency of the internal common market. For intermunicipal roads are suitably assigned to state efficiency in internal common market, taxes on mobile governments. Some resource taxes, such as royalties and factors and tradable goods should either be assigned to fees and severance taxes on production and/or output, the national government or coordinated among are designed to cover costs of local service provision and subnational governments. could be assigned to subnational governments. In * National equity. Progressive redistributive taxes addition, subnational governments could also impose ought to be assigned to the level of government having taxes to discourage local environmental degradation. In responsibility for redistribution, usually the national countries with a federal level VAT, it may be too government. Subnational governments could levy cumbersome to have subnational sales taxes. In such supplementary flat rates on the federal tax base. circumstances, the fiscal need criterion would suggest * Administrative costs. To minimize collection, allowing subnational governments access to taxes which administration, and compliance costs, a tax should be are traditionally regarded as suitable for national assigned to the level likely to be best informed about its administration, such as personal income taxes. base. This suggests assigning real property taxation to The authors also stress the importance of tax local governments and corporate income taxation to the harmonization and coordination in preserving internal national government. common market, reducing collection and compliance - Fiscal need. To ensure accountability, revenue means costs and helping to achieve national equity objectives should be matched as closely as possible to revenue and suggest methods of achieving such coordination needs. Thus tax instruments intended to further specific vertically (between the federal and subnational policy objectives should be assigned to the level of governments) and horizontally (among subnational government having the responsibility for such a service. governments). This paper-a product of the Public Economics Division, Policy Research Department-is part of a larger effort in the department to reform fiscal systemsin developingcountries. Copies of the paper are availablefree from the World Bank, 1818 H StreetNW, Washington, DC 20433. Please contact Carlina Jones, room N10-063, extension 37699 (29 pages). November 1994. The Policy ResearchWorking Paper Seroes disseminates the findingsof work in progressto encouragethe exchangeof ideas about development issues. An objective of the series is to get the findings out quickly, even itfthepresentations are less than fullypolished. The papers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors' own and should not be attributed to the World Bank, its Executive Board ofDirectors, or any of its member countries. Produced by the Policy Research Dissemination CenterI Table of Contents FISCAL FEDERALISM DIMENSIONS OF TAX REFORM IN DEVELOPING COUNTRIES by Robin Boadway, Sandra Roberts and Anwar Shah* I. INTRODUCTION 1 II. REVIEWOF THE PRINCIPLESOF FISCAL FEDERALISM 2 III. TAX ASSIGNMENT 6 1. Principles of Tax Assignment 7 2. Assignmentby Type of Tax 8 3. Co-occupationof Tax Bases 18 IV. TAX HARMONIZATIONAND COORDINATION 19 1. The Objectivesof Tax Harmonization 19 2. Methods of Tax Harmonization 21 V. IMPLICATIONSFOR TAX REFORM 23 Table 1: ConceptualBasis of Tax Assignment 27 Table 2: Tax Assignmentin Selected DevelopingCountries 28 References 29 *This paper was prepared for the project on Fiscal Reform and Structural Change sponsored by the InternationalDevelopment Research Centre, Ottawa, Canada. FISCAL FEDERALISM DIMENSIONS OF TAX REFORM IN DEVELOPING COUNTRIES by Robin Boadway, Sandra Roberts and Anwar Shah* I. INTRODUCTION Many countries, especially in the industrialized world, can be considered to be fed- erations in a practical sense that significant fiscal functions are undertaken by lower level jurisdictions, both on the expenditure and on the tax side. Federal economies have developed elaborate forms of fiscal arrangements between the central (federal) and lower (state and municipal) levels of government which jointly determine the way in which tax bases are allocated and shared among the various levels of govern- ment as well as the transferring of funds from one level to another. The existence of multiple levels of taxing authority gives rise to issues of tax design not found in unitary states. As the public sectors of developing countries evolve to provide more and more of the sorts of public services found in industrialized countries, the benefits of de- centralized decision making are likely to become more apparent. The reform of tax systems required to streamline the raising of revenues will need to take account of the revenue needs of lower levels of government. This will naturally put constraints on the types of tax reforms which are both feasible and desirable. It is the purpose of this paper to review the special issues that arise in reforming taxes in federal states. The conceptual guidance presented here should, however, be more generally applicable in a multi-jurisdictional setting regardless of the constitutional structure of the country. In doing so, we draw heavily on the experiences in industrialized countries where federal fiscal arrangements have evolved over a long period of time. Practices in these countries, though highly developed, are far from uniform. They differ because of different institutional, political and geographical circumstances of the country. Nonetheless, there are a number of economic principles of taxation in a federal setting that have been developed in the literature and that can be applied to any federal economy. Their implications for any given country will depend upon the features of the economy, such as the extent of decentralization of functions, the degree of heterogeneity of the population, and the extent of government intervention in the economy. Our review will concentrate on these principles. We begin with a brief review of the economics of fiscal federalism as it relates to the fiscal arrangements, that is, to the combination of the system of transfers * This paper was prepared for the project on Fiscal Reform and Structural Change sponsored by the International Development Research Centre, Ottawa, Canada. 1 and the system of tax sharing and harmonization in a federation. Next, we discuss the issue of tax assignment: which taxes ought to be made available to which levels of government? The decentralization of revenue raising inevitably gives rise to problems of inefficiencies and inequities in the internal economic union. Ways of avoiding these through tax harmonization and coordination are next discussed. Finally, we outline some of the implications for tax reform, especially in developing countries. II. REVIEW OF THE PRINCIPLES OF FISCAL FEDERALISM There is a large literature on fiscal federalism. Our purpose here is simply to summarize the basic lessons to be derived from that literature.' Federal structures of government allow for the decentralization of the provision of public services to lower levels of government. It is argued that, as in the private sector, decentralized decision making generates more efficient allocations of resources. It does so by enabling governments to provide a mix of services most suited to the needs and tastes of local consumers, by making governments more accountable to their citizens by devolving decisions to governments which are closer to them, and by instilling greater responsiveness by competition among governments. A reasonable working principle is to decentralize all functions except those for which it can be demonstrated that central provision is needed because of economies of scale, because the benefits of a particular type of service are highly public in nature, or because uniformity of provision is an important objective, for example to maintain the efficiency of the internal economic union or to achieve national equity objectives. 2 This principle leads to the following suggested division of powers among levels of government: i. Public Goods and Services Public goods and services which are national in nature should be assigned to the federal government. These include such things as national defense, control