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Comparative Conclusions
on Fiscal Federalism
anwar shah1
Fiscal federalism is concerned with the public finances of the various orders
of government in a federal system. Federal countries differ a great
deal in their choices – specifically, how the division of fiscal powers is allocated
among various orders and the associated fiscal arrangements.
Further, some aspects of fiscal arrangements, such as intergovernmental
fiscal transfers, resulting from these choices can be subject to periodic
review (e.g., the five-year sunset clause in Canada) and redefinition in
order to adapt to changing circumstances within and beyond nations.
Changes in these arrangements may also occur simply as a result of how
various constitutional provisions and laws are interpreted by courts
(as in Australia and the United States) or by various orders of government,
as in all federal countries. In recent years, these choices have
come under significant additional strain from the great changes arising
from the information revolution and the emergence of a “borderless”
world economy. This chapter reviews the practice of fiscal federalism in
twelve case study countries and highlights the findings and lessons from
these experiences.
Section 1 of this chapter provides a general discussion of the fiscal federalism
features of selected federations. This is followed by comparative reflections
on the division of fiscal powers in section 2. The allocation of
spending and regulatory responsibilities is discussed, and attention is paid
to issues in revenue-raising responsibilities, including the financing of capital
investments. Issues in macroeconomic management and economic coordination
are discussed in section 3. Section 4 highlights the practice of
intergovernmental fiscal transfers and pays special attention to transfers
whose purpose is to reduce regional fiscal disparities. A final section draws
some general conclusions from these experiences.
Comparative Conclusions 371
1 salient f e ature s of selected federations
The twelve federations (of these Spain and South Africa have unitary
constitutions but are considered quasi-federations in practice) reviewed
in this book represent a diverse sample in terms of demographics, level of
economic development, affinity with stylized models of federalism, and
features of fiscal federalism. In our sample, Switzerland is the smallest
and the second richest federation with a population of 8 million and a
per capita gdp of $37,465 (2002). India is the largest and poorest federation,
with a population of 1.1 billion and a per capita gdp of $666
(2004) (see table 1). The sample federations also present diverse models
of federalism. Australia, India, and Russia bear affinity to the layer-cake
model of dual federalism, with a strong national-government role in the
federal system. Under such a model, the responsibilities of the federal
and state governments are distinct and separate, and there is a hierarchical
relationship among the various orders of government, with the federal
government at the apex. In India, the federal government has the
residual powers and paramountcy on the shared rule, and it can even
change state boundaries. Both Spain and Malaysia can be characterized
as asymmetric layer-cake models of dual federalism. In Spain, Navarre
and the Basque country and, to a lesser extent, the states of Sabah and
Sarawak in Malaysia enjoy autonomous status and are treated more
equally than are other constituent units of the federation. Canada, Switzerland,
and the United States resemble the coordinate-authority model
of dual federalism. Under the coordinate-authority model of dual federalism,
states enjoy significant autonomy, and local governments are simply
creatures of the states with a limited or no direct relationship with the
federal government. Germany and South Africa embody features of cooperative
federalism with interdependent (hierarchical) spheres of government,
but in these countries the federal government assumes an
almost exclusive role in legislative authority for policy and standards, and
the intermediate order primarily acts as the implementing agent. Nigeria
has a three-tier hierarchical system with a strong federal government.
Brazil, by contrast, presents itself as a cooperative-federalism model with
three independent spheres of government. Brazil, India, Nigeria, and South
Africa have constitutionally recognized local governments, whereas in
all other federations local governments are creatures of the regional
(province/state) governments.
Countries with a federal form of government vary considerably in
terms of federal influence on state governments. Such influence is very
strong in Australia, Germany, India, Malaysia, Nigeria, Russia, Spain, and
South Africa; it is weak in Brazil, Canada, Switzerland, and the United
Table 1
A comparison of selected fiscal systems
Selected indicators Australia Brazil Canada Germany India Malaysia Nigeria Russia Spain South Africa Switzerland United States
2004 Population
(million)
20 184 32 82 1090 24 130 144 40 47 8 296
Area
(000 sq. km.)
7687 8512 9985 357 3288 330 924 17075 505 1223 41 9631
2004 gdp
per capita
(us$000)
32 4 35 33 0.7 5 0.5 4 24 5 37 (2002) 42
Character of
federalism*
Dual lc Cooperative,
independent
Dual ca Cooperative
interdependent
Dual ca Dual lc,
asymmetric
Cooperative,
interdependent
Dual lc Dual lc
asymmetric
Cooperative
interdependent
Dual ca Dual ca
The character
of fiscal federalism
2-tier
centralized
3-tier
decentralized
2-tier
decentralized
2-tier
centralized
integrated
3-tier
centralized
2-tier
centralized
3-tier
centralized
2-tier
centralized
2-tier
centralized
3-tier
centralized
2-tier
decentralized
2-tier
decentralized
Local government
constitutional
status
No Yes No No Yes No Yes No No Yes Yes No
Actual state
control of local
government
Strong Weak Strong Strong Strong Strong Strong Strong Strong Strong Strong Varies from
fairly strong
to fairly weak
Range of local
government
responsibilities
Limited Extensive Extensive Limited Limited Limited Limited Limited Limited Limited Extensive Extensive
Federal/
interstate
equalization
performance
Strong;
revenue
and expenditure
Fair Strong;
revenue
disparities
reduced
Strong;
revenue
and some
expenditure
Fair Fair Fair Fair Fair Fair Fair Weak
disparities
reduced
substantially
substantially
disparities
reduced
substantially
Output-based
conditional
transfers
No Yes Yes No No No No No No No No Yes
State tax performance
Weak Strong Strong Strong Fair Weak Weak Fair Fair Weak Strong Strong
Local fiscal
autonomy
Fair Fair Strong Fair Weak Weak Weak Fair Fair Fair Strong Strong
Equalization
formula
Paternal
capacity
and need
Implicit
and
piecemeal
Paternal
fiscal
capacity
Fraternal
fiscal capacity
Implicit
and
piecemeal
Paternal
capacity
and need
Implicit
and
piecemeal
Paternal
fiscal
capacity
Implicit Paternal
capacity
and need
Mixed
capacity
and need
Implicit and
piecemeal
Equalization
standard
Implicit Implicit Explicit Explicit Implicit Iimplicit Implicit Explicit Implicit Implicit Implicit None
State tax base
conformity
Yes No Yes Yes No Yes Yes Yes Yes Yes No No
State tax rate
uniformity
Yes Yes No Yes No No Yes No No Yes No No
State-local gross
revenues more
or less match
responsibility
Yes Yes Yes Yes No No No No Yes Yes Yes Yes
Note: * – constitutionally recognized fiscal tiers; lc – layer cake model; ca- coordinate authority model
Source: Author’s impressions
Table 1
A comparison of selected fiscal systems (Continued)
Selected indicators Australia Brazil Canada Germany India Malaysia Nigeria Russia Spain South Africa Switzerland United States
374 Anwar Shah
States. In the latter group of countries, federal influence over state expenditures
is quite limited, and state governments have considerable
authority to determine their own tax bases and tax rates (see tables 2
and 3). In centralized federations, conditional grants by the federal
government play a large role in influencing the priorities of regional
and local governments. In Australia, a centralized federation, the federal
government is constitutionally required to follow regionally differentiated
policies.
Federal countries also vary according to the process of provincial/
state influence on national policies. In some countries, there is a clear
separation of national and state institutions (“executive” or “interstate”
federalism) and the two levels interact through meetings of officials and
ministers, as in Australia, Brazil, Canada, India, Malaysia, Nigeria, Spain,
and Switzerland. In Germany and South Africa, state governments have
a direct voice in national institutions; that is, in both these countries,
state governments are represented in the second house of parliament –
the Bundesrat in Germany and the Council of the Provinces in South Africa
(“intrastate” federalism). This is to be expected in view of the primacy
of national legislation in all functions and the need for state
government inputs for such legislation in these countries. Such arrangements,
however, limit the autonomy of both the federal and state governments
in Germany, creating an indecision trap associated with this
“spaghetti-bowl” politics, as suggested by Feld and von Hagen (see chapter
on Germany). In Russia, the Federation Council (upper chamber),
as envisaged by the Constitution, was expected to have the governor and
the speaker of the legislature of each region represented in it. The
Constitution has now been amended to have the one executive member
nominated by the governor and the one legislative assembly member
nominated by the legislative assembly of each region represented in the
Federation Council, thereby weakening the regional influence at the
centre. This comes in the wake of an important change in the election
of governors – no longer directly elected but nominated by Russia’s
president and appointed by the regional legislature. In Brazil, India,
Malaysia, and the United States, regional and local coalitions play an important
role in the second chamber of the national legislature. This role
may not support the positions taken by states’ executives and therefore
works to diffuse regional tensions. In Brazil, because all states have
equal representation in the Senate, small states in the northeast have a
disproportionate influence on the federal system. In Canada, the members
of the second chamber are nominated by the prime minister; therefore,
the Senate is considered to be more technocratic in its orientation
as members are often appointed based upon recognition of their service
achievements in government, politics, or business.
Table 2
Fiscal decentralization to provinces/states
Federal-state intergovernmental
transfers:
Fiscal
capacity
equalization
Expenditure
needs
equalization
Ability to
borrow from
domestic
banks/
higher
orders of
government
Ability to
issue
domestic
bonds
Ability
to borrow
from foreign
banks
Ability to
issue
foreign
bonds
Overall
fiscal
decentralization
to
provinces/
states Country
Range of
provincial/
state government
responsibilities
Provincial
government
influence
on
national
policies
National
government
influence on
provincial
policies
Provincial/
state
revenues
finance
majority of
provincial
expenditure
Important/
unimportant
Predominant
emphasis on
conditional grants/
unconditional grants/
tax sharing/revenue
sharing
Australia Extensive Weak Strong No Important Unconditional
grants and conditional
grants
Yes Yes Yes Yes Yes Yes High
Brazil Extensive Fair Fair Yes Important Revenue sharing
and conditional
grants
No Yes No Yes No Yes High
Canada Extensive Strong Weak Yes Important Equalization and
conditional grants
Yes No Yes Yes Yes Yes High
Germany Extensive Strong Strong Yes Important Equalization and
conditional grants
Yes No Yes Yes Yes Yes Medium
India Extensive Fair Strong Yes Important Revenue sharing &
conditional grants
No Yes Yes Yes No No Medium
Malaysia Limited Weak Strong No Important Revenue sharing No Yes Yes Yes No No Low
Federal-state intergovernmental
transfers:
Fiscal
capacity
equalization
Expenditure
needs
equalization
Ability to
borrow from
domestic
banks/
higher
orders of
government
Ability to
issue
domestic
bonds
Ability
to borrow
from foreign
banks
Ability to
issue
foreign
bonds
Overall
fiscal
decentralization
to
provinces/
states Country
Range of
provincial/
state government
responsibilities
Provincial
government
influence
on
national
policies
National
government
influence on
provincial
policies
Provincial/
state
revenues
finance
majority of
provincial
expenditure
Important/
unimportant
Predominant
emphasis on
conditional grants/
unconditional grants/
tax sharing/revenue
sharing
Nigeria Extensive Fair Strong No Important Revenue sharing
and conditional
grants
No Yes Yes Yes No No Medium
Russia Extensive Weak Strong No Important Equalization and
conditional grants
Yes Yes Yes Yes Yes No Medium
Spain Extensive Fair Strong Yes Important Revenue sharing,
and conditional
grants
No Yes Yes Yes Yes Yes Medium
South Africa Extensive Weak Strong No Important Unconditional
grants and conditional
grants
No Yes Yes Yes No No Low
Switzerland Extensive Strong Weak Yes Important Equalization and
conditional grants
Yes Yes Yes Yes Yes Yes High
United States Extensive Fair Fair Yes Unimportant Conditional grants No No Yes Yes Yes Yes High
Table 2
Fiscal decentralization to provinces/states (Continued)
Table 3
Fiscal decentralization to local governments
Country
Local
governments
are creatures of
provinces/
states
Range of local
government
responsibilities
Local
government
influence on state/
provincial policy
Local
government
influence on
federal policy
Local fiscal
capacity
equalization
Local
expenditure
needs
equalization
Ability to
borrow from
domestic banks
Ability to
issue domestic
bonds
Overall fiscal
decentralization
to local
governments
Australia Yes Limited Weak Weak Yes Yes Yes No Low
Brazil No Extensive Weak Weak No Yes No Yes High
Canada Yes Extensive Weak Weak Yes Yes Yes Yes High
Germany Yes Extensive Weak Weak Yes Yes Yes Yes High
India Yes Limited Weak Weak No Yes No Yes Low
Malaysia Yes Limited Weak Weak No Yes No No Low
Nigeria No Extensive Weak Weak No Yes Yes Yes Medium
Russia Yes Extensive Weak Weak Yes Yes Yes Yes Medium
Spain Yes Extensive Weak Weak Yes Yes Yes Yes Medium
South Africa No Extensive Weak Fair No Yes Yes Yes High
Switzerland Yes Extensive Fair Fair Yes Yes Yes Yes High
United States Yes Extensive Weak Weak No Yes Yes Yes High
378 Anwar Shah
In some federal countries, constitutional provisions require all legislation
to recognize that ultimate power rests with the people. For example,
all legislation in Canada must conform to the Canadian Charter of Rights.
In Switzerland, a confederation by law but a federal country in practice,
direct-democracy provisions empower citizens to hold government to account
(e.g., all major legislative changes require approval by referendum).
In Malaysia, the Clients’ Charter empowers citizens to hold governments to
account in the event specified public service standards are not met.
Regional income disparities, however, are significant in most of the case
study countries. These disparities are the largest for South Africa and the
smallest for the United States.
2 division o f f i s cal powers
Allocation of Spending and Regulatory Powers
The constitutional division of power on the spending and regulatory responsibilities
in the case study countries generally conforms to the subsidiarity
principle. India, Malaysia, and South Africa are the exceptions,
where, responding to historical legacies, a dominant federal role was carved
out by the constitution and, in the case of India, further cemented by a
centrally appointed unified civil service. The practice in most federal
countries, as a result of historical, cultural, and institutional factors and
legal-judicial interpretations varies widely, and most federal countries,
with the exception of Canada, have allowed a wider federal role than
originally envisaged by the framers of the constitution. The original federal
role was largely limited to services of national scope such as “peace,
order and good government.” This role was later expanded due to wars
and judicial interpretation of the constitution, as in Australia and the
United States; threats of secession, as in India and Russia; issues in combating
terrorism and promoting racial equality, as in the United States;
natural-resource management and environmental protection, as in
Brazil, Nigeria, and the United States; debt management and fiscal discipline,
as in Brazil; protection of the indigenous majority, as in Malaysia;
or, more commonly, federal use of regulatory or spending powers in
order to achieve national objectives in securing a common economic
union, as in most of the case study countries. The use of federal regulatory
powers often results in unfunded or underfunded mandates,
whereas the use of conditional matching grants can lead to fiscal stress
for regional and local governments.
The overall role of the intermediate orders of government is the strongest
in Switzerland and Canada; fairly strong in the United States, Brazil,
and Australia; and relatively weak in other federations, with the weakest
Comparative Conclusions 379
being in South Africa. However, this role remains large in all the case study
countries with regard to the delivery of social and infrastructure services,
with the exceptions of Malaysia and South Africa, where such services are
centralized. In Canada, provinces have a role in immigration policy and in
regulating securities and labour markets, thus creating the potential for inefficiencies
in the internal common market.
Local government responsibilities are extensive in Switzerland, the
United States, Brazil, and Canada; quite restricted in Spain, India, Russia
and Malaysia; and highly constrained in Australia (see figure 1). In Spain,
basic education and basic health care are intermediate-order responsibilities.
In Russia, several local services, such as public transit, roads, and fire
prevention, are regional government functions, whereas local police protection
and local tax collection are federal responsibilities. In Australia, local
governments play an insignificant role in public service delivery and are
primarily responsible for property-oriented services such as garbage collection
and street maintenance and cleaning.
Figure 1
Subnational expenditure as a% of total government expenditure
Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington,
dc: International Monetary Fund.
380 Anwar Shah
Overall, with the exception of Spain, Brazil, Australia, and Malaysia, subnational
expenditures in the case study countries account for 50 percent
or more of consolidated public expenditures, with state and local governments
in Switzerland and Canada accounting for more than 60 percent of
such expenditures (see Figure 1).
Shared rule is sometimes a source of confusion and conflict. In Canada,
the provinces have attempted to limit the federal spending power in social
services by entering into a social union framework agreement with the federal
government. In Germany, where the intertwining of federal and state
powers is an issue, the Federalism Reform Act, 2006, limits federal laws requiring
the consent of the Bundesrat (second chamber) to specified areas
and also gives states flexibility to deviate from a federal law in its implementation.
In Switzerland, ambiguity with regard to shared rule is avoided by
having intergovernmental agreements and contracts. In the United States,
Russia, and South Africa, unfunded or underfunded federal mandates represent
sources of concern for state (province/region) governments.
Allocation of taxing Powers
Taxing powers (tax base and rate determination and tax collection) are
highly centralized (75 percent or more central revenues) in Malaysia,
South Africa, and Australia; centralized (60 percent to 75 percent of revenues
collected by the centre) in Brazil, India, Russia, and the United
States; highly decentralized in Switzerland (37 percent of total revenues
collected by the centre); and decentralized (40 per cent to 50 percent at
the centre) in Canada and Nigeria. Other countries fall in the intermediate
range. In Russia, the centralization of tax administration has resulted in
a weaker effort in collecting state (regional) and local taxes.
The tax powers of state governments are wide in Switzerland, Canada,
the United States, Brazil, and Nigeria and are quite restrained in South
Africa, Australia, Spain, and Malaysia (figure 2). Expenditure autonomy
as determined by the percentage of expenditures financed by the ownsource
revenues of states is high in Malaysia, Nigeria, Switzerland, Germany,
Canada, and the United States but low in India and Spain (with the
exception of the two regions) (figure 3). State tax autonomy (having
responsibility for base and rate determination of own taxes) is high in
Australia, Canada, Switzerland, the United States, Nigeria, India, and
Brazil but constrained in Germany, Spain, Malaysia, and Russia. In the latter
countries, states may be given some discretion in setting tax rates but
tax-base determination is a federal responsibility. Further, regional governments
in Russia do not have revenue autonomy. Taxing e-commerce
and mobile factors are important issues imposing limitations on state finances
in the United States and India.
Comparative Conclusions 381
The income and the sales tax system is harmonized in Australia, Canada,
Germany, Malaysia, Russia, Spain, and Switzerland; it is not harmonized in
Brazil, India, and the United States. The lack of a harmonized tax system
leads to high compliance costs for firms and individuals operating in a multistate
environment. In the United States, the federal Constitution’s interstate
commerce clause acts as a break against state taxes distorting interstate commerce;
in addition, states are prohibited from taxing internal and external
trade. In India, on the contrary, taxes on the interstate trade of goods is an
important source of state revenues. In Brazil, sales taxation is uncoordinated
among the federal, state, and local governments. The Brazilian Council of
State Finance Ministers (confaz) has attempted to harmonize the state
vats but with limited success. Fiscal incentives through the state vat system
in Brazil have resulted in fiscal wars among states. In Canada, income tax
harmonization was achieved through offering federal incentives to follow a
common tax base. Sales tax harmonization through similar incentives had
only partial success. Canada also introduced an important innovation in the
Figure 2
Subnational own-revenues as a% of subnational expenditure
Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington,
dc: International Monetary Fund.
382 Anwar Shah
institutionalization of tax administration by creating an independent agency
with oversight by federal and provincial orders and the private sector. In
other countries, tax harmonization has been achieved by centralizing taxbase
determination and/or tax collection.
The case study countries, with the exception of Nigeria, follow the golden
rule principle in borrowing (i.e., borrowing for capital spending only), and
they primarily depend on capital-market discipline to restrain such borrowing
by state and local governments. In Nigeria, all borrowings by state and
local governments require prior federal approval. In Malaysia, local borrowing
is subject to state government supervision. Such direct borrowing is
typically discouraged; instead, private-sector participation in infrastructure
provision is encouraged. In Brazil, external debt requires approval by the
federal Senate, and all borrowing is subject to legislated fiscal rules. Several
federal countries have special arrangements to assist state and local borrowing
for capital projects. In Australia, the Australian Loan Council facilitates
such borrowing by making data on public finances available to the capital
Figure 3
Subnational own source revenues resources as a% of total government revenues
Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington,
dc: International Monetary Fund.
Comparative Conclusions 383
markets. In Canada, provincial Crown corporations that run on commercial
principles assist local borrowing. In the United States, state bond banks (private
agencies) collate local borrowing demands and issue bonds for the
pooled demand. Also in the United States, interest on such borrowing by
state and local governments is deductible against federal income-tax liability –
providing a direct federal subsidy for such borrowing. In Switzerland, the
Cooperative Centre of Swiss Local Communities provides capital finance to
local governments.
There is no evidence of a race to the bottom due to state and local tax
autonomy in the case study countries. Most countries do not show any serious
tax competition, and where such competition has surfaced – such as in
Brazil, Switzerland, and, to a more limited extent, India, Canada, and the
United States – it has not resulted in a lower tax effort and lower quality of
state and local public services.
In general, taxing powers in the sample countries are more centralized
than dictated by fiscal federalism principles. Many factors may have been involved
in achieving this result. This may have happened partly because most
nations placed a premium on tax harmonization. Also, shifting expenditures
downward was politically more feasible than allowing finance to follow function,
and state and local politicians were less than enthusiastic about assuming
taxing powers but very interested in receiving fiscal transfers from the
national government with little accountability to local taxpayers.
Vertical Fiscal Gaps
A downside of over-centralized tax powers with decentralized expenditure
responsibility is the creation of vertical fiscal gaps, or the mismatch between
revenue means and expenditure needs among state and local governments
(see table 4 for details). Vertical fiscal gaps and revenue autonomy in subnational
governments remain concerns in those federal countries where the
centralization of taxing powers is greater than is necessary to meet federal
expenditures and federal fiscal transfers to meet national objectives as this
results in extensive use of conditional transfers to exert undue influence on
subnational policies. Further, such large gaps create democratic accountability
deficits as state and local governments experience the pleasure of spending
money without having to justify additional spending to their taxpayers.
This is a concern for state governments in Australia, Germany, India, Malaysia,
Nigeria, Russia, Spain, and South Africa. In Nigeria, there is a special
concern about the central assignment of resource revenues. In Germany,
these concerns are prompting a wider review of the assignment problem and
a rethinking of the division of powers among federal, Land, and local governments.
A consensus is yet to be formed on a new vision of fiscal federalism
in Germany.
384 Anwar Shah
Table 4
Vertical fiscal gaps
Country
Revenue share Fiscal gap
Level of
government
Before
transfer
After
transfer
Expenditure
share
Before
transfer
After
transfer
Australia (2003–04) National 0.76 0.56 0.61 0.15 −0.06
Provincial/state 0.18 0.37 0.34 −0.16 0.04
Local 0.06 0.07 0.05 0.01 0.02
Brazil (2003) National 0.68 0.55 0.60 0.08 −0.05
Provincial/state 0.25 0.27 0.26 0.00 0.01
Local 0.06 0.18 0.14 −0.08 0.04
Canada (2005) National 0.46 0.42 0.36 0.10 0.06
Provincial/state 0.44 0.48 0.52 −0.08 −0.04
Local 0.10 0.10 0.12 −0.02 −0.02
Germany (2002) National 0.52 0.40 0.41 0.11 −0.01
Provincial/state 0.34 0.37 0.37 −0.03 −0.01
Local 0.14 0.23 0.22 −0.08 0.02
India (2002) National 0.61 0.42 0.45 0.17 −0.03
Provincial/state 0.36 0.53 0.50 −0.15 0.03
Local 0.03 0.05 0.05 −0.02 0.00
Malaysia (2003) National 0.91 0.85 0.90 0.01 −0.05
Provincial/state 0.06 0.09 0.07 −0.01 0.02
Local 0.03 0.06 0.03 0.00 0.03
Nigeria (2004) National 0.48 0.43 0.46 0.02 −0.03
Provincial/state 0.36 0.40 0.38 −0.02 0.02
Local 0.16 0.17 0.16 0.00 0.01
Russia (2004) National 0.63 0.55 0.47 0.15 0.07
Provincial/state 0.26 0.28 0.29 −0.03 0.00
Local 0.12 0.17 0.24 −0.12 −0.07
Spain (2002) National 0.53 0.27 0.51 0.02 −0.24
Provincial/state 0.29 0.49 0.31 −0.03 0.17
Local 0.18 0.24 0.18 0.01 0.07
Comparative Conclusions 385
3 f i s cal federalism and macroeconomi c
management
Federal fiscal systems aspire to provide safeguards against the threat of centralized
exploitation as well as decentralized opportunistic behaviour while
decision making remains close to the people. In fact, federalism represents
either a “coming together” or a “holding together” of constituent geographic
units to take advantage of the greatness and littleness of nations.
But federal fiscal systems whose purpose is to accommodate such “coming
together” or “holding together” may pose some risks for macro stability.
Two main issues raised by the case study countries on this count are (1) fiscal
discipline and (2) intergovernmental competition.
Fiscal Prudence and Fiscal Discipline under “Fend-for-Yourself” Federalism
Fiscal lack of discipline among subnational governments is a matter of concern
in federal countries in view of significant subnational autonomy combined
with an opportunity for a federal bailout. In mature federations,
fiscal policy coordination to sustain fiscal discipline is exercised through
both executive and legislative federalism as well as by instituting formal
Country
Revenue share Fiscal gap
Level of
government
Before
transfer
After
transfer
Expenditure
share
Before
transfer
After
transfer
South Africa (2002) National 0.82 0.36 0.49 0.33 −0.13
Provincial/state 0.01 0.46 0.36 −0.34 0.10
Local 0.16 0.18 0.15 0.01 0.03
Switzerland (2002) National 0.37 0.30 0.31 0.06 −0.01
Provincial/state 0.38 0.42 0.42 −0.03 0.00
Local 0.24 0.28 0.27 −0.03 0.01
United States (2004) National 0.55 0.44 0.46 0.09 −0.02
Provincial/state 0.25 0.29 0.24 0.01 0.05
Local 0.20 0.27 0.30 −0.10 −0.03
Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington,
dc: International Monetary Fund.
Table 4
Vertical fiscal gaps (Continued)
386 Anwar Shah
and informal fiscal rules. In recent years, legislated fiscal rules have come
to command greater attention. These rules take the form of budgetary balance
controls, debt restrictions, tax or expenditure controls, and referendums
for new taxing and spending initiatives. Most mature federations also
specify “no bailout” provisions in setting up central banks. In the presence
of an explicit or even implicit bailout guarantee and preferential loans
from the banking sector, printing of money by subnational governments is
possible, thereby fuelling inflation. Recent experiences with fiscal adjustment
programs suggest that, while legislated fiscal rules are neither necessary
nor sufficient for successful fiscal adjustment, they can help forge a
sustained political commitment to achieve better fiscal outcomes, especially
in countries with divisive political institutions or coalition regimes.
For example, such rules can be helpful in sustaining political commitment
to reform in countries with proportional representation (Brazil) or multiparty
coalition governments (India) or in countries with a separation of
legislative and executive functions (United States and Brazil). Fiscal rules
in such countries can help restrain pork-barrel politics and thereby improve
fiscal discipline, as has been demonstrated by the experiences in
Brazil, India, Spain, Russia, and South Africa.
Brazil’s success with fiscal rules from 2001–07 is particularly remarkable.
Germany, however, could not achieve fiscal discipline on the part of the
Länder, even with fiscal rules, because the federal Constitutional Court
had blessed federal bailouts, thereby creating soft budget constraints for
them. A more recent decision (November 2006) by the same court to disallow
a requested bailout by Berlin indicates a reversal of such policies. In
the United States, fiscal conservatism on the part of states ensures fiscal discipline,
but pork-barrel politics in the federal government has not been restrained
by fiscal rules. Australia and Canada achieved the same results
without having any legislated fiscal rules, whereas fiscal discipline continues
to be a problem even though Germany has legislated fiscal rules. The
Swiss experience is the most instructive with regard to sustained fiscal discipline.
Two important instruments create incentives for cantons to maintain
fiscal discipline. First, fiscal referendums allow citizens the opportunity to
veto any government program; second, the legal provision enacted in
some cantons to set aside a fraction of a fiscal surplus in good times works
like a “debt brake” for rainy days (in the United States, these are called
rainy-day funds).
Intergovernmental Competition
Competition among state and local governments is quite common in most
federal systems. It occurs through lobbying for employment by: generating
federal or private-sector projects, including military bases; encouraging
Comparative Conclusions 387
domestic and foreign direct investment; providing incentives and subsidies
for attracting capital and labour; supplying public infrastructure to facilitate
business location; providing a differentiated menu of local public
services; offering one-stop windows for licensing and registration; and pursuing
endless other ways of demonstrating an open-door policy for new
capital and skilled labour. State and local governments also compete
among themselves by erecting trade and tariff walls to protect local industry
and business. They also try to out-compete each other in exporting tax
burdens to non-residents and obtaining a higher share of federal fiscal
transfers where feasible.
Preserving intergovernmental competition and decentralized decision
making are important for responsive and accountable local governance in
federal countries. The Swiss and the American experiences demonstrate
the positive impacts of such a competition. “Beggar-thy-neighbour” policies
have the potential to undermine these gains from decentralized
decision making, as demonstrated by the recent “race to the bottom” experience
in Spain and the so-called “fiscal wars” in Brazil and Switzerland.
State inheritance taxes have been eliminated through interjurisdictional
competition for rich residents in Australia, Canada, and Switzerland. In
Switzerland, such competition is further advanced through regressive
income tax schedules. Mergers of cantons to abate such competition in
Switzerland have been ruled out by referendums. To limit the adverse effects
of such competition, a partnership approach that facilitates a common
economic union through the free mobility of factors by ensuring
common minimum standards of public services, no barriers to trade, and
wider information and technological access offers the best policy alternative
in regional integration and internal cohesion within federal nations. It
is not a matter of “to compete or to cooperate” but, rather, of how to make
sure that all parties compete and cooperate but do not cheat.
4 intergovernmental f i s c al transfers
In all the case study countries, the federal government collects more revenue
than is needed to satisfy its own expenditure/regulatory responsibilities.
Such fiscal surplus enables the federal government to use its spending
power to pursue national objectives through the use of fiscal transfers.
These transfers help achieve national objectives while supporting decentralized
decision making. Federal government fiscal transfers finance
nearly two-thirds of subnational expenditures in Spain and South Africa
and less than 20 percent of such expenditures in Canada, Switzerland, and
Nigeria (figure 4). The design of such transfers plays a critical role for
efficiency, equity, and accountability in a federal system. Three important
objectives of such transfers in the case study countries are (1) bridging
388 Anwar Shah
vertical fiscal gaps, (2) bridging the fiscal divide within nations, and (3) securing
a common economic union through establishing national minimum
standards in social and infrastructure services. The following
paragraphs discuss how these objectives are addressed through fiscal transfers
in the case study countries.
Bridging vertical fiscal gaps
Vertical fiscal gaps, at least at the conceptual level, are largely a non-issue
in Canada, the United States, and Switzerland because state governments
have sufficient fiscal powers to overcome such gaps. In Canada, the federal
government used tax abatement as well as incentives for tax-base sharing to
overcome such a gap in the past. These vertical gaps represent a significant
issue in the remaining case study countries as they have centralized tax administration
and constrained state and local taxing powers. To overcome
such gaps, general revenue sharing, with a multitude of equalization
Figure 4
Transfers as a % of subnational expenditure
Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington,
dc: International Monetary Fund.
Comparative Conclusions 389
components, is being used in Brazil, India, Malaysia, and Nigeria. Ironically,
in India such revenue sharing uses 1971 population data as the basis
for allocating finds among states; in Brazil, state and municipal coefficients
are frozen at 1988 levels. Tax-base sharing and tax-by-tax sharing is used in
Germany; fiscal need equalization grants are used in Australia, Russia, and
Spain (mostly historical expenditures). For most countries in our sample,
fiscal transfers reverse the fiscal position of the federal government from
surplus to deficit (see table 4).
Bridging the fiscal divide within nations
The fiscal divide within nations represents an important element of the
economic divide within nations. Such a divide is a matter of concern in all
the case study countries, with the important exception of the United
States. In Canada, such a divide is accentuated by provincial ownership of
natural resources and soaring oil and gas prices. Fiscal equalization programs,
with the objective of enabling constituent units to provide reasonably
comparable levels of public services at reasonably comparable levels of
taxation, are frequently advocated to overcome such a divide. Such programs
are expected to foster goods and factor mobility and help secure a
common economic union.
Among the case study countries, Australia, Canada, Germany, Malaysia,
Russia, Spain, and Switzerland attempt to address regional fiscal disparities
through a program of fiscal equalization. In the United States, there is no
federal program because factor mobility has served to bridge fiscal and
economic differences to a great extent, although such differences within
states remain a matter of policy concern. And, for that reason, state education
finance typically uses equalization principles. In Canada, such a program
is enshrined in the Canadian Constitution and is termed “the glue
that holds the federation together.” Such programs in the case study countries
are federally financed, with the exception of Germany and Switzerland.
In Germany, wealthy states make progressive contributions to the
equalization pool, and the poor states receive from this pool. In Switzerland,
the new equalization program, effective in 2008, has a mixed pool
of contributions from the federal government and wealthier cantons. In
Russia, equalization programs conducted by regions for local equalization
use the mixed approach.
All the case study countries with an equalization program have some focus
on fiscal-capacity equalization. Australia, in addition, has a comprehensive
approach to fiscal-need equalization. Spain equalizes fiscal need based on
historical expenditures, and both Russia and Malaysia consider partial equalization
of expenditure needs based on selected need indicators. The Canadian
and German equalization programs use an explicit fiscal-capacity
390 Anwar Shah
standard of equalization that determines both the total pool as well as allocations
across constituent units. Such a principled approach to equalization is
desirable as it results in greater transparency and objectivity in allocating
equalization payments. All other programs utilize a fixed pool but use allocation
formulae to determine allocation across units.
The equity and efficiency implications of equalization programs are a
source of continuing debate in most federal countries. In Australia, the
complexity introduced by expenditure-needs compensation is an important
source of discontent with the existing formula. In Canada, provincial
ownership of natural resources is a major source of provincial fiscal disparities,
and the treatment of natural-resource revenues in the equalization
program remains contentious. In Germany, the applications of overly progressive
equalization formulae result in a reversal of fortunes for some rich
jurisdictions. Some rich Länder in Germany have, in the past, taken this
matter to the Constitutional Court to limit their contributions to the equalization
pool. In Spain, the asymmetric treatment of autonomous communities
(charter regime) and the rest of the regions (common regime) for
equalization purposes is a continuing source of contention. In Brazil, India,
Malaysia, Nigeria, Russia, and South Africa, much controversy and debate
is generated by the equity and efficiency impacts of existing programs.
In Nigeria, arbitrary use of the Federation Account (resource revenue
pool) to retire federal debt and revenue-sharing formula components, especially
the 13 percent share for derivation component, are sources of
concern (especially for the Niger delta region).
Institutional Approaches to the Design
and Practice of Equalization Transfers
The case study countries use diverse approaches to institutional arrangements
for equalization transfers. These diverse arrangements have been designed
to suit the contexts of individual countries. In Spain, Switzerland,
Malaysia, Russia, and South Africa, the federal ministry of finance or treasury
is responsible for decisions on the total pool and allocation among constituent
units. In Brazil, the total pool is determined by the Constitution,
and the federal Senate determines the allocation for state and local governments.
In Australia, India, and Nigeria (semi-independent), independent
grant commissions are entrusted with making recommendations on the formula
for allocating such transfers, whereas the total pool is predetermined
by legislation. In Canada, intergovernmental forums make the initial determination.
These decisions are then endorsed and legislated by the federal
Parliament and implemented by the federal Ministry of Finance. In Germany,
a federal compact determines the allocation, which is legislated by
the federal government and implemented by the Ministry of Finance.
Comparative Conclusions 391
While, on an a priori basis, no one institutional arrangement is preferable
to another, experience has shown that independent grant commissions typically
opt for greater complexity in designing such transfers, leading to much
acrimony and debate. Leaving these decisions to the federal government
alone, however, makes such transfers vulnerable to the whims of the regime
in power. Intergovernmental forums offer a second-best alternative by having
all relevant stakeholders involved in the decisions on such transfers.
Setting national minimum standards through
output-based fiscal transfers
Setting national minimum standards in regional-local services serves both efficiency
(creating an internal common market) and equity (treating all citizens
equally regardless of their place of residence). Such standards can be
attained by conditional non-matching grants, in which the conditions reflect
national output-based efficiency and equity concerns and there is a financial
penalty associated with failure to comply with any of the conditions. Conditions
are thus imposed not on the specific use of grant funds but on the
attainment of standards in quality, access, and level of services. Such outputbased
grants do not affect state-local government incentives for cost efficiency,
but they do encourage compliance with nationally specified standards
for access, quality, and level of services. Properly designed conditional nonmatching
output-based transfers can create incentives for innovative and
competitive approaches to improved service delivery and results-based accountability
in the public sector. Input-based grants fail to create such an
accountability environment. Although output-based (performance-oriented)
grants are best suited to the grantor’s objectives and are simpler to administer
than are traditional input-based conditional transfers, they are rarely practised
in the sample federal countries. Prominent notable exceptions are education
and health finance in Brazil, Canada, and South Africa, and highway
finance in the United States. The reasons have to do with the incentives faced
by politicians and bureaucrats. Such grants empower clients while weakening
the sphere for opportunism and pork-barrel politics. The incentives they
create strengthen the accountability of political and bureaucratic elites to citizens
and weaken their ability to peddle influence and build bureaucratic empires.
Their focus on value for money exposes corruption, inefficiency, and
waste. Not surprisingly, this type of grant is opposed by potential losers.
In most of the case study countries, with a few notable exceptions, federal
conditional grants use input-based conditionality. Such conditionality
impairs state and local autonomy and is a source of conflict. Growing
use of such grants is a matter of state and local concern in Australia,
Germany, Spain, and Russia. Vertical fiscal gaps – differences between
the revenue share and expenditure share before fiscal transfers – are
392 Anwar Shah
very large for provinces in South Africa and states in Australia and India,
but these are eliminated by fiscal transfers.
In Brazil and Canada, and to a limited extent in South Africa, education
and health transfers focus on output and access-based conditionality. In
the Unites States, federal fiscal transfers to state and local governments,
with the important exception of highway grants, were in the past predominantly
input-based conditional grant programs, although since the 1990s,
an emphasis on shifting federal grants towards performance-based criteria
is slowly emerging.
5 lessons learned and concluding remarks
The following lessons emerge from these diverse experiences.
• Clarity in responsibilities but periodic joint review is key to the successful
working of the fiscal system. As Rudyard Kipling once said, there are 160
ways to design fiscal tiers, and every one of them is right. What matters is
that constitutional and legal systems and institutions must provide for
mechanisms to build societal consensus for new compacts in view of
changing circumstances and be amenable to timely adjustments to implement
such compacts.
• Asymmetric federalism arising from symmetric and uniform principles
leads to amicable and sustainable outcomes.
• Finance should follow function to strengthen responsiveness and accountability
to taxpayers.
• Fiscal rules accompanied by “gate keeper” intergovernmental committees
provide a useful framework for fiscal discipline and fiscal policy
coordination.
• To ensure fiscal discipline, all governments must be made to face the financial
consequences of their decisions.
• Securing a common economic union through unimpeded goods and
factor mobility and national minimum standards for social services and
infrastructure is the best guarantee for political and economic stability
and regional convergence in the long run.
• Institutional arrangements for managing intergovernmental conflicts
play an important role in the smooth working of a federal system.
• Properly designed intergovernmental transfers can strengthen resultsbased
accountability and also enhance competition for the supply of
public goods, fiscal harmonization, state and local government accountability,
and regional equity. Manna-from-heaven transfers or bilaterally
negotiated transfers can build transfer dependencies that cause the slow
economic strangulation of fiscally disadvantaged regions. All transfers
must be open for periodic reviews.
Comparative Conclusions 393
• Societal norms and consensus on the roles of the various orders of government
and limits to their authority are vital for the success of decentralized
decision making. In the absence of such norms and consensus,
direct central controls do not work, and intergovernmental gaming leads
to dysfunctional constitutions. Direct-democracy provisions can be helpful
in restraining governments.
• A clients’ charter with specified standards of services and feedback and
redress mechanisms can help strengthen government accountability
to citizens.
In conclusion, the federal countries examined in this volume have
shown a remarkable ability to adapt and to meet emerging challenges in
fiscal federalism. While the challenges they face may be very similar, the solutions
they discover and adopt are often unique and local. This represents
a remarkable attestation to the triumph of the spirit of federalism in its
never-ending quest for balance and excellence in responsive, responsible,
and accountable governance. The long march to attain new heights in inclusive
governance continues.
notes
1 The author is grateful to Professor John Kincaid for helpful comments.