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Fiscal Federalism

Fiscal federalism is an economic framework for understanding the relationship among federal, state, and local governments that focuses on the division of spending and taxing powers among these governments.

Fiscal federalism is primarily an economic, rather than political, theory of relationships among central and noncentral governments. One focus is the division of responsibilities among different types of governments. For example, the traditional theory of fiscal federalism argues that the central government should be responsible for macroeconomic policies but local governments should be primarily responsible for fire protection services. Another focus of fiscal federalism is the division of revenue-raising powers among various governments, often referred to as “tax assignment.” Here the traditional theory of fiscal federalism argues that taxes on highly mobile entities should be assigned to the central government, and taxes on less mobile entities to state or local governments. Finally, grants-in-aid become an important topic in fiscal federalism because of the potential mismatch between a government’s expenditure responsibilities and its tax capacity.

The traditional theory of fiscal federalism sets out principles regarding the proper division of spending responsibilities and taxing powers among types of governments. However, the term “fiscal federalism” is often used in a broader sense that includes a description of the actual division of spending and taxing powers.

Economists often use the term “fiscal federalism” to refer to one part of the field of public finance. Public finance is the economics of government spending and taxation, and when more than one type of government is involved economists apply the label of “fiscal federalism.”

There are some differences between fiscal federalism and political theories of federalism. Fiscal federalism applies to any country with both central and decentralized governments, as long as the decentralized governments have some control over spending and taxing policies. This control does not have to be substantial or constitutionally based. Thus fiscal federalism applies to many countries that political scientists would categorize as unitary rather than federal. When applied to the United States, fiscal federalism typically includes local governments in addition to the federal government and state governments. In the fiscal federalism framework, the fact that local government powers are not constitutionally independent is irrelevant.

Traditional fiscal federalism ignores politics, political institutions, and political power. Fiscal federalism must also be distinguished from a second economic theory of federalism, competitive federalism. Competitive federalism focuses on competition among governments, another subject area ignored in traditional fiscal federalism.

In recent years a new literature on fiscal federalism has emerged that considers the performance and evolution of federal systems, taking into account such issues as principal-agent problems, economics of information, and the theory of contracts (Oates 2005, Weingast 2009). Researchers refer to this evolving literature as a second generation theory of fiscal federalism and the traditional fiscal federalism as first generation fiscal federalism. This essay concentrates on first generation or traditional fiscal federalism, hereinafter referred to simply as fiscal federalism. Although the theory of fiscal federalism applies to many countries across the world, the tables below all describe the U.S. federal system, which is unique among federal countries, in part because of its tremendous diversity among the fifty states (Boadway and Shah 2009, Garcia-Milà, McGuire, and Oates 2017).

  • 4.1 Daphne A. Kenyon


Government expenditure responsibilities can be divided into stabilization, distribution, and allocation functions. Fiscal federalism provides general guidelines for dividing these responsibilities among federal, state, and local governments based on the nature of the expenditure function and the relative capabilities of the different types of governments.

The stabilization function entails efforts to impact unemployment and inflation levels and stimulate economic growth. Stabilization tools include fiscal and monetary policies. As no state or local government is big enough to affect the overall level of economic activity, experts agree for the most part that the stabilization function is best left to the federal government.

The distribution function concerns use of government’s powers of spending and taxation to redistribute income, in particular by providing assistance to poor households. Experts agree that this function is usually best left to the federal government. State or local efforts to redistribute income can be rendered ineffective because of the small geographic reach of these governments and their mobile populations. For example, efforts to redistribute income from high-income to low-income households could lead to a counterproductive out-migration of high-income households and in-migration of low-income households.

The allocation function concerns the production or provision of goods and services, such as national defense, university education, or garbage collection. Whether these functions should be provided by federal, state, or local governments depends upon a number of factors. First, the geographic reach of service benefits must be considered. As the benefits of national defense are national in scope, this service is best left to the federal government. In contrast, the impact of fire protection is local, and can often be best provided by local governments.

Economies of scale (per unit costs of production fall as the scale of production rises) and externalities or spillovers (whereby activities undertaken in one geographic area impact citizens in another area) are factors that tend to make government goods and services best provided by larger units of government such as the federal government or state governments.

TABLE 1. Percentage of Expenditures on Selected Functions by Type of Government, 2015

Sources : Budget of the U.S. Government FY2017 and U.S. Census.

Diversity in demand is the most important factor favoring local government provision of government goods and services. Local governments can best tailor services to fit the needs of their citizens. Decentralized provision of government services also facilitates a natural laboratory in which innovations tried and proved successful by one government can be adopted by an entire state or the federal government.

For the most part, the division of expenditure responsibilities in the U.S. federal system follows the pattern suggested in the traditional theory of fiscal federalism. Thus, the federal government provides national defense, state governments provide highways and university education, and local governments provide police and fire protection and K–12 schools.

However, there are some anomalies, such as the large nonfederal role in public welfare, largely a distribution function. In addition, there is some overlap of responsibilities, as in the provision of K–12 education in which state governments and the federal government have been playing an increasing role. Periodically, calls are made to change the division of expenditure responsibilities. Thus, Alice Rivlin (1992), a prominent economist and policy analyst, suggested the federal government eliminate most of its programs in education, housing, highways, social services, economic development, and job training, instead focusing on international issues and taking over full responsibility for health care financing, which it now shares with states in the Medicaid program.


Once expenditure responsibilities are divided among federal, state, and local governments, it is necessary to ensure that each government has the tools to fulfill its responsibilities. The ability to raise revenues via taxes will be considered first.

Experts have advised that certain types of taxes are most appropriate for central governments and others most appropriate for state and local governments. Taxes that are most appropriate for central governments are taxes on highly mobile factors, taxes used to redistribute income, taxes with unstable revenue patterns, and source-based taxes such as corporation income taxes. Taxes most appropriate for noncentral governments are taxes on immobile factors such as property, and residence-based taxes such as personal income and retail sales taxes.

TABLE 2. Percentage Reliance on Different Tax Sources by U.S. Federal, State, and Local Governments, 2015

Source : Budget of the U.S. Government FY2017 and U.S. Census.

As Table 2 illustrates, the use of taxes in the U.S. system of fiscal federalism closely follows the tax assignment prescription of the experts.

One exception is that state governments collect a significant portion of corporate income tax revenues. This appears to violate the prescription against state and local government reliance on source-based taxes with unstable revenues. Another exception is that state governments raise about one-fifth of death and gift taxes, which violates the principle that state governments should not levy taxes on a mobile base.


One reason for federal grants to state and local governments (and state grants to local governments) is that revenues of the subcentral governments may not be sufficient to meet their expenditure responsibilities. In other words, the federal government may provide grants to state and local governments when their tax capacities are insufficient. Block grants that do not affect the relative prices of government services can be the appropriate type of grant to respond to this problem.

In some circumstances, matching grants might be the appropriate type of grant. Consider state environmental programs that have positive spillover effects on other states. Without a federal matching grant, no state would have an incentive to take these beneficial spillovers into account when setting expenditure levels. With a matching grant, the federal government could set an appropriate matching rate so that states freely choose the correct level of environmental spending. For example, if 25 percent of the additional benefits of environmental spending by one state spilled over to other states, the federal government could set the federal match of the environmental grant at 25 percent.

Table 3 shows how federal grants to state and local governments have changed from 1960 to 2015. Whether measured as a percentage of total federal outlays, total state and local expenditures, or the national economy (GDP), federal grants to state and local governments grew from 1960 to 1980. The 1980's saw a decline in federal aid to state and local governments as a result of the Reagan administration’s policies intended to shrink the role of the federal government and increase the role of states. In the 1990's, largely because of the growth of the Medicaid program, an open-ended matching grant, federal grants to state and local governments began to grow again. From 2010 to 2015 federal grants to state and local governments fell in importance.

TABLE 3. Trends in Federal Grants to State and Local Governments Federal Grants as a Percentage of:

Source : Budgets of the U.S. Government, FY2017 and FY2018.

The composition of federal aid to state and local governments has also changed in important ways. The proportion of grants to places, such as grants for capital investment, has shrunk, and the proportion of grants to individuals has increased markedly. The most important grant to individuals is Medicaid, which has become the single largest federal grant to state and local governments.


The federal government affects state and local governments in many other ways. First, indirect forms of federal aid to state and local governments will be discussed.

The federal government provides indirect aid to state and local governments through two provisions of the federal tax code. Individuals can deduct individual income, sales, real estate, and personal property taxes if they itemize deductions on their federal income tax returns. Tax deductibility is considered a “tax expenditure” because it represents a departure from the standard tax base, and without this allowed deduction the existing federal tax code would raise more revenue. This provision of the federal tax code may make it easier for state and local governments to raise taxes and increase spending.

TABLE 4. Cost of Major Forms of Aid to State and Local Governments, 2016

Source : Department of the Treasury 2016 and Budget of the U.S. Government FY 2018.

A second form of indirect federal aid to state and local governments is the exemption from federal taxation of interest on state and local debt, which allows state and local governments to issue debt at lower interest rates than they would otherwise be able to.

Table 4 compares the cost of federal grants-in-aid to these two indirect forms of aid. Although federal grants to state and local governments account for over four-fifths of the total cost of federal aid to state and local governments, the cost to the federal government of indirect aid through the tax code is also significant.

The passage of the Tax Cuts and Jobs Act in December 2017, the first major overhaul of the federal tax code since 1986, is likely to significantly reduce the benefits of federal deductibility of state and local taxes and may also have a major impact on the municipal bond market and thus on the exclusion of interest on debt.

The federal government affects state and local governments in four other important ways. State personal and corporate income taxes are often linked to their federal counterparts. For example, some states that impose personal income taxes link their taxes to federal adjusted gross income (AGI). When the federal government changes provisions of the federal tax code that impact the value of AGI, this impacts state tax revenues unless states take explicit action to “decouple” from federal tax policy changes. Increases in federal AGI, as with the passage of the Tax Cuts and Jobs Act, will tend to increase state income tax revenues; decreases in federal AGI will tend to decrease state income tax revenues.

The federal government also imposes costs on state and local governments through regulatory requirements called mandates. One example is a direct federal order to implement a particular federal standard, such as the requirement that all public transportation systems be fully accessible to handicapped individuals. Problems with measuring the financial burden of federal mandates are considerable. The federal government also affects state and local governments through the Constitution , court interpretations of the Constitution, and federal law (other than mandates). These can all be considered “rules of the game.” For example, federal law relating to sales taxation makes it difficult for states to collect sales taxes from consumers making purchases via the Internet.

A final means by which the federal government affects state and local governments is through its management of fiscal and monetary policy. During periods of economic growth, state and local tax revenues tend to rise; during recessions, state and local government expenditure responsibilities tend to increase while revenues fall, straining state and local budgets.

Daphne A. Kenyon

Last updated: March 2018

SEE ALSO: Block Grants ; Decentralization ; Economic Development ; Education ; Externalities/Spillovers ; Health Care Policy ; Local Government ; Medicaid ; Reagan, Ronald ; Unfunded Mandates ; Welfare Policy

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Book cover

Local Public Finance and Economics pp 39–80 Cite as

Expenditure and Revenue Assignment: Principles

  • Harry Kitchen 4 ,
  • Melville McMillan 5 &
  • Anwar Shah 6  
  • First Online: 06 September 2019

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1 Citations

This chapter provides a conceptual overview of the principles of expenditure and revenue assignment to local governments. Local government is seen to be more aware of local preferences and conditions and more accountable to local residents than senior governments. Core and noncore responsibilities are distinguished (e.g., local streets versus schooling). Financing follows function. Financing follows the benefit criterion; that is, local residents pay for the local services from which they benefit—with user charges and local taxes although grants may be needed. Various (especially) noncore services involve interjurisdictional spillovers and/or redistributive considerations and so, if assigned to local governments require intergovernmental transfers to achieve efficiency and equity objectives. Financing alternatives and appropriate uses are reviewed.

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The vast number of references found in Bahl and Bird ( 2018 ) and Boadway and Shah ( 2009 ), two books providing comprehensive examinations of fiscal federalism and decentralization, illustrate the growth and extent of the literature. Earlier valuable contributions include those by Bahl and Linn ( 1992 ), Bird et al. ( 1995 ), Litvack et al. ( 1998 ), Manor ( 1999 ), McLure ( 1983 , 1999 ), OECD ( 1987 , 1997 , 1999 ), Owens and Norregaard ( 1991 ), Shah ( 1991 , 1994 ), and Ter-Minassian ( 1997 ).

A resulting additional argument for decentralization is that it enhances political participation. Greater responsiveness, accountability, and enhanced participation have long been seen as advantages of decentralization in the political literature. Other widely noted potential positive features of local government are greater transparency of government to local residents and, of course, greater autonomy. Shah ( 2014 ) advocates for movements toward FAIR (fair, accountable, incorruptible, and responsive) local governance and outlines a framework for evaluation. Blending these desirable characteristics with the economics of fiscal federalism has created a powerful case for decentralization and a more valuable tool for the analysis of decentralized government.

Besley and Coate ( 2003 ) have extended the theory underlying the conventional arguments for decentralization. Their more general model assumes cost sharing of centrally provided outputs under a nationally uniform tax system, allows for non-uniform central provision across localities, locally elected representation to the central government, cooperative and non-cooperative legislative decision-making, varying degrees of heterogeneity in local tastes, and varying interjurisdictional spillovers. Heterogeneity of tastes and the degree of spillovers are central to the centralization-decentralization choice with less heterogeneity and more spillover favoring centralization. However, the case for decentralization is surprisingly strong and prevails even when tastes are uniform and spillovers significant. Also see Ingram and Hong ( 2008 , 17–108).

Critical assessments of fiscal federalism and, particularly, decentralization have emerged—motivated in part by difficulties experienced within some countries. Oates ( 2005 ) characterized those as an emerging second-generation of fiscal federalism. He categorized the second-generation literature (notably in Oates 2008 ) as having two strands. The first strand applies a broader range of economic modeling (i.e., beyond the more conventional public finance) to the questions of fiscal federalism while the second strand evolved from public choice with a focus on political institutions. Both address problems with decentralization that have or might occur. A dominant concern is the problems that emerge with soft (rather than hard) budget constraints on decentralized governments. Essentially, the second-generation literature focuses on problems that can arise when there are flaws in the decentralization design. Surveys of the impacts of decentralization generate mixed results but do point to the importance of good design and implementation (e.g., see Bahl and Bird 2018 , Chapter 2). Also, there is some evidence that better-quality government enhances personal well-being (Helliwell and Huang 2008 ; Helliwell et al. 2018 ) and, though somewhat mixed and deserving of more detailed analysis, that decentralization can also increase well-being/life satisfaction (e.g., Bjornskov et al. 2008 ; Diaz-Serrano and Rodriguez-Pose 2012 ; Gao et al. 2014 ; Tomaney et al. 2011 ). Closely related is a literature on measuring the decentralization of government (e.g., Ivanyna and Shah 2014 ; Hooghe et al. 2010 , 2016 ; Hooghe and Marks 2016 ). The OECD provides valuable recent overviews of fiscal federalism and decentralization (e.g., OECD 2013 , 2016 , 2018 ).

It is important to recognize that borrowing is not a substitute for adequate funding. Debt must be repaid and debt-servicing costs met from the borrowing government’s revenues. Borrowing only facilitates financing long-term capital investments, particularly when they are large and irregular.

For example, see Wiesner ( 2003 ) for a discussion of the role of market-based decentralization in Latin America and Dollery and Wallis ( 2001 ) for a more general discussion of competition in the delivery of public services. Oates ( 1999 ) includes a discussion of market-preserving federalism.

See Tresch ( 2015 , Chapters 26 and 27) for a discussion of a redistributional role for local government.

For further discussion of the topics addressed in this section, see, for example, Dollery and Wallis ( 2001 , Ch 2), Fisher ( 1996 , Ch 6), and Oates ( 1972 ).

See a public finance text (e.g., Fisher 1996 ) for details of the ideal allocation of the cost of public goods. The basic idea is that each individual is charged a personal marginal cost equal to that person’s marginal benefit and the ideal level of output exists when, in the case of a pure public good, the sum of all individual marginal benefits equals the marginal cost of the output.

The problem of distinguishing between economics of sharing and economies of scale is that it is often difficult to distinguish between units of output when many individuals benefit from the same unit of output. For example, there could be economies of scale in the operation of an air pollution abatement system (e.g., cost per unit of particulate matter removed decline to some point) but the benefits of the improvement in air quality resulting from some additional abatement (change in output) could be enjoyed by many or few people (economies of sharing).

For insight into and a brief review of empirical economies of scale analyses, see Byrnes and Dollery ( 2002 ).

For discussion and empirical insights, see McMillan et al. ( 1981 ) and McMillan ( 1989 ).

For illustrations of the assignment of responsibilities among multi-tiered governments, see Table 4.1 of Chap. 4 and Shah ( 2006 , Chapter 1).

Even when services are purely local, citizens may prefer having an upper-level government to review certain activities (e.g., water quality, sewerage treatment, refuse disposal) to provide an informed and independent assessment of performance and especially of the less observable aspects.

See Dahlby ( 2001 ) for a “consensus view” of tax assignments. The shift of the payroll tax to the upper tier(s) of government has been prompted as well by its widespread utilization by senior governments to finance earmarked social benefit programs such as unemployment insurance and social security/pensions.

This treatment reflects the usual top-down perspective on tax assignment in that the matter is decided at the center. In some cases, however, tax assignment is a bottom-up decision where federating states decide upon what tax powers the new central authority should have. See Dahlby ( 2001 ).

In the interests of maintaining the advantages of an internal common market (i.e., free trade within the country) the only taxes, if any, on cross-border movements of goods and services should be national levies on foreign trade.

Bird ( 1999 ) argues that the international adoption of national value-added taxes and their revenue importance have contributed to this centralization.

A broader discussion of transfers—beyond the gap-closing role—appears in the latter part of this chapter.

Dahlby ( 2001 ) notes several problems with the “consensus” view. Those are (a) the need to link expenditure and tax decisions, (b) a need to consider expenditure assignment and grant systems, (c) neglect of distributional impacts of subnational government policies, (d) overlooking certain problems of joint occupancy of tax fields, (e) ignoring that some economic shocks calling for stabilization are region specific, and (f) putting little emphasis on administration and compliance costs of alternative tax assignment regimes.

It is important to remember that property taxes, and especially those taxing improvements as well as land, also may not match benefits exactly and, like a local personal income tax, involve some redistribution. On the other hand, a local personalincome tax may match better benefits and costs for a local service such as schooling.

Kitchen and Slack ( 1993 ) found that about 40 percent of municipal government (i.e., nonschooling) expenditure benefited nonresidential property.

Also see Bahl and Bird ( 2018 , pp. 208–211).

When prices for the services of local government enterprises are above the levels consistent with user charges (e.g., utility charges exceed full costs), the difference is effectively a special sales tax on those services.

For those reasons, Bird ( 1999 ) has recommended a more uniform local business value-added tax.

Besides the references cited below, the following provide valuable insights into intergovernmental transfers: Bird ( 2000 ), Bird and Smart ( 2002 ), Ebel and Yilmaz ( 2001 ), Martinez-Vazquez and Searle ( 2007 ), Shah ( 1999 , 2004 ), and Shah and Thompson ( 2004 ).

At the local government level, however, fiscal disadvantages may be offset in part through capitalization into property values.

Bird ( 1993 ) offers an additional rationale for conditional matching grants. Conditional matching funding can induce local governments to spend some of their own funds on the grantor’s priorities (e.g., achieving minimum standards or greater uniformity of local services) thus stretching the grantor’s budget. While a legitimate perspective, the basis for the mutual interest is in some shared or spillover benefits. Gramlich ( 1977 ) classifies conditional transfers aimed at such grantor policy objectives as also blending the advantages of centralized finance and decentralized supply as having a political-institutional justification. However, because those grants have an efficiency basis, they are distinguished here from the politically motivated grants below.

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Harry Kitchen

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Kitchen, H., McMillan, M., Shah, A. (2019). Expenditure and Revenue Assignment: Principles. In: Local Public Finance and Economics. Palgrave Macmillan, Cham.

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The revenue and expenditure assignments discussed in the preceding chapters normally give rise to vertical and horizontal imbalances within a nation’s intergovernmental finances. A vertical imbalance occurs when the own revenues and expenditures of various levels of government within a federation are unequal. A horizontal imbalance occurs when the own fiscal capacities of various subnational governments of the same level differ. These imbalances must be resolved through a variety of transfer and borrowing mechanisms in order to allow the various levels of government to perform their allotted tasks within a national policy framework.

There are two basic avenues of transferring resources from one level of government to another: sharing of revenues or a system of grants. Revenue sharing can take several forms: tax bases can be shared, or taxes can be pooled and then shared. Tax administration can be seen separately from tax assignments, and revenues collected at one level of government, typically but not exclusively at the central government level, could be assigned in part or entirely to other levels of governments.

A grants system could involve conditional or unconditional transfers. In turn, these transfers can be open ended, or subject to caps. Moreover, some conditional grants may require matching elements by recipient governments. Each alternative approach is examined in this chapter. The choice of transfer mechanism depends on the particular mix of objectives of the policymakers.

Subnational governments play an increasing role in providing infrastructure and lumpy capital outlays in some countries. Such investments may be financed by capital transfers, and/or net advances from the center which may itself borrow to fund such payments. In some cases, subnational governments may be given direct access to capital markets. Unless such markets are highly developed, and other conditions exist that permit market discipline to be maintained on such borrowing, rules may need to be developed to ensure that the scope of such borrowing is consistent with the overall objectives of national macroeconomic policy.

Vertical and Horizontal Imbalances

The existence of a vertical fiscal gap at different levels of government, arising out of own revenue and own expenditure assignments, provides a basic rationale for a system of transfers and borrowing arrangements. In addition, national governments may wish to ensure that citizens in different regions and localities have access to a certain modicum of publicly provided services. Differential subcentral capacities are said to constitute horizontal imbalances. Differential fiscal capacities leading to horizontal imbalances constitute another rationale for the system of transfers between different levels of government. These objectives give rise to different combinations of grants.

  • Vertical Balances

The vertical fiscal gap is generated by the expenditure and revenue assignments. However, individual policy choices also play a significant role in determining the resulting ex post vertical gap. If a lower level of government chooses to increase spending or not raise assigned taxes, the vertical gap would increase. Thus, if transfers were designed solely to close the vertical gap, there would be little incentive for the lower levels of government to raise own account revenues or restrict or manage expenditures efficiently. Unless there are objective criteria for the determination of transfers, “gap filling” to finance subnational deficits is likely to lead to macroeconomic difficulties as well as indeterminate “bargaining” between the center and lower levels.

Since vertical balances tend to favor the central government, the size of the transfers to subnational levels of government often may be a function of macroeconomic stabilization concerns.

Table 1 shows the vertical fiscal gap for different levels of government in a number of federal and unitary countries’ governments. Three measures are shown: the vertical fiscal balance as measured by the difference between the own account transactions at the central or all sub-central levels of government; the vertical current balance, which measures the balance on own account current transactions only; and a vertical capital balance, which shows the extent to which capital spending is financed from own resources and provides an initial insight into the “need to borrow” by different levels of government.

Vertical Current Balances 1

(Ratio of own source revenues to own source current expenditures)

1 The data show average ratios over selected periods for each country. The periods chosen are Australia, 1987-91; Austria, 1987-91; Brazil, 1982-91; Canada, 1985-89 (excluding 1987 for capital balance); Denmark, 1987-91; France, 1988-92; Germany, 1983-91; India, 1985-92; Netherlands, 1988-92; Spain, 1987-90; Sweden, 1988-92; United Kingdom, 1985-92; and United States, 1987-92.

  • Horizontal Imbalances

In practice, very few countries measure the horizontal imbalances, or fiscal capacities, of their regional governments in a systematic manner. The federations that undertake a comprehensive review of horizontal balances are Australia, Canada, and Germany. 1 An analysis of relative fiscal capacities of the different states in the United States was also prepared in the past, but is not used in determining transfers to states. 2 Among the unitary nations, Denmark and the United Kingdom evaluate the fiscal capacities of their local government authorities in determining grants.

The horizontal imbalances in fiscal capacity may be addressed by equalization transfers from the center (as in Australia, Canada, and Denmark), or between regions (as in Germany). While some countries do not use an explicit “equalization framework,” redistributional elements are often introduced into special purpose or conditional grants in order to achieve equity objectives, such as in Indonesia. However, in the absence of an overall framework for determining and evaluating grants, it is often difficult to ascertain whether conditionality of use, with numerous and diverse special purpose grants, is actually inequality decreasing or increasing (see Ahmad, 1997 ). Empirical evidence from countries as diverse as Australia, Argentina, Canada, and China suggests that there may be substantial differences across regions within the country in terms of revenue bases, as well as cost of provision of services, and that these may necessitate the use of a consistent framework for evaluating and determining grants.

  • Policy Options

Three different policy responses can be made to this link between vertical and horizontal balances:

Correct each imbalance by separate policy measures . The vertical imbalance at each level is resolved by tax-sharing or grant arrangements. Horizontal imbalances are then resolved by payments from regions with higher fiscal capacity to poorer regions. This is the approach used in Germany.

Implement an integrated system of equalization grants . The vertical and horizontal balances are dealt with simultaneously through a system of grants, including equalization payments and special purpose grants. This is the Australian and Canadian approach.

Correct only the vertical imbalance and ignore horizontal balances . As under the first option, vertical balances are resolved by tax sharing and grants, but no action is taken to correct horizontal imbalances. Capital and labor migration then responds, not only to earned income differentials, but also to the regional net fiscal benefits (net benefit received from government expenditure and of taxes paid). There may be, however, special purpose grants servicing central government objectives, which may also reduce horizontal imbalances at least in some functional areas. This is broadly the approach in the United States.

The Rationale for Transfer and Borrowing Mechanisms

If the sole concern of central and subnational governments is to fill the vertical fiscal gap created by imbalances in revenue and expenditure assignments, this could be achieved either by sharing revenue from the major taxes on a “derivation” basis (that is, shared in proportion to the revenue collected in each region), or by “gap-filling” unconditional grants. Both approaches may exacerbate horizontal imbalances, and the latter also generates undesirable incentives for recipient governments that could weaken macroeconomic controls.

In practice, both the central and subnational governments normally have diverse objectives to be met through a system of transfers, and these different objectives may need to be met through a combination of policy tools. Typical central government goals include the following:

Ensure that the overall fiscal stabilization objectives for the national economy are met.

Provide an acceptable degree of equity between individuals in different regions.

Encourage the efficient use of resources across the nation.

These goals and the associated policy responses are discussed below.

  • Stabilization

Aside from variations in its own account revenue, expenditure, and borrowing operations, the central government has two weapons at its disposal in this area: (1) varying the level of transfers and/or revenue shares to subnational governments, and (2) adjusting subnational borrowing, where the subnational governments have separate, but controlled access to the capital markets. 3 In some countries (for example, Canada), the latter option is not available to central governments. But, even in such cases, its relative size and influence may provide the central government with some leverage in persuading subnational governments to participate in coordinated stabilization efforts.

Since economic downturns often have a varying impact on different geographical areas within a nation, the central government may be expected to adjust both the level and geographical composition of its transfers to subnational governments in an anticyclical manner to assist the stabilization task. To the extent that the central government maintains an ongoing vertical current surplus with subnational governments, it can also draw on these resources to boost, or reduce, aggregate spending.

The term “equity” is often raised in the political debate on intergovernmental finances, especially in federations, and has a number of interpretations. First, there is the need to examine whether each region has the fiscal capacity to deliver an equivalent level of public services to its citizens. Second, there is a question as to which level of government should have primary responsibility for income redistribution.

  • Horizontal Equity Issues

Some federations (for example, Australia and Canada), but not all, have adopted extensive equalization arrangements. The arguments for such arrangements can be understood at both an intuitive and theoretical level. At the intuitive level, it can be argued that the creation of a national market place, or “economic space,” brings with it large benefits in terms of the production, distribution, and administrative scale economies, including common fiscal and monetary policies, common education, health, production and labor standards, and speedy communication and transport facilities. These benefits can be seen as being over and above those that would be available to any individual region, and a “fair” distribution of these benefits is often seen as the glue that bonds together the nation-state. 4

The public finance literature approaches equalization issues from a different viewpoint. The term “horizontal equalization” traditionally related to governments providing equal treatment of individuals who are equally well off. Application of this concept involved an examination of the so-called fiscal residuum (see above).

The concept of horizontal equalization was used by Buchanan (1950) to justify equalizing measures between regions. The problem can be summarized as follows. Even if a central government treats equals equally, while at the same time each regional government treats individuals within its boundaries equally, the overall impact of public policies within a federation is likely to violate the equal treatment of equals principle. The difficulty stems from that fact that even if two communities, one rich and one poor, have identical levels of public goods provision, the wealthier of the two communities will, ceteris paribus, be able to meet its revenue requirements with a lower level of tax rates. This follows because, for a given amount of revenue for each resident, lower tax rates are required in a community with the higher level of per capita income. Therefore, from the standpoint of the federal system, equals are not treated as equals.

The issue can be handled in two ways. First, it can be ignored. Some argue that such an overall equity goal “is not a prime goal in a federation.” Others consider that the horizontal equity goal is inconsistent with regional diversity, which is a virtue of federal systems. But Buchanan and others disagree. They call for measures to compensate for such inequality by geographically discriminating tax rates at the central government level, to equalize the total tax bill of individuals, or to make equalizing grants to communities.

These simple theoretical concepts have been the subject of considerable debate. One major criticism has been that the original models used by Buchanan assumed that the total spending of each government is distributed over the relevant citizens in proportion to an assumed (equal) sharing basis and the resulting money amount is taken as a measure of the total individual benefit. But this approach is probably only relevant in the context of universally provided welfare benefits. In the case of public goods, such as education services, it becomes merely a cost imputation exercise and cannot serve as a measure of the individual benefits received.

The equalization concept therefore involves many practical measurement difficulties, since particular individuals may choose not to avail themselves of a particular service or avoid payment of a tax or charge by refraining from the activity concerned. For these reasons, even if two regional governments applied the same revenue-raising and expenditure-provision policies, the fiscal residuum of two equally well off individuals would not necessarily be identical. This situation would continue to apply even if the term “individual” was redefined into some concept of family unit or household. The existence of companies and other organizations further complicates application of the principle. An attempt to tackle the application of the “equal treatment of individuals” would also raise a host of practical measurement difficulties, including measures to determine equality between citizens of different regions. All these factors may combine to make the strict “equal fiscal treatment of equals” a difficult objective in either a federation or a unitary state. However, in some countries, increasing interest is being accorded to direct provision of transfers to individuals, for example, through vouchers financed by the central government. These vouchers often allow public services to be provided by private sector contractors. Such contracting out has led to a reevaluation of the role of the state as a service provider, in many countries, without necessarily changing the nature of the public good.

Nevertheless, it can be argued that a central government can achieve an approximation of the equal treatment of equals objective through transfers to different subnational governments. The aim then is to provide each subnational government with the ability to make available a uniform set of public services at a comparable revenue effort.

Three different practical options might be considered:

The regional government’s capacity to provide regional services without having to impose higher taxes and charges than other regions (or regional budget capacity equalization).

Comparability of the regional government’s capacity to provide equally well-off individuals with equal fiscal residuals (or “individual-based” regional government capacity equalization).

Uniformity across regions in actual standards of service provision and in actual taxes and charges applied (termed performance-based regional government equalization).

Strictly speaking, the third choice might come closer to the desired theoretical objective. However, its achievement would require the central government not only to make the difficult judgments on relative fiscal needs of different regions, but also to impose detailed and binding conditions on the grants paid to regional governments to ensure that those chosen services and taxation norms are implemented. The second choice avoids the conditionality problem but also encounters major measurement problems.

Of the three objectives, the first method may be more acceptable to many democratically elected governments. While it still faces difficulties in quantifying judgments about publicly provided services and taxes, it avoids the subjective measurement of individual differences implicit in the second choice. The equalization of subnational fiscal capacities is likely to be consistent with the actual abilities of governments to achieve the desired objective of equal treatment of equals.

Each of these approaches has strong advocates, and individual preferences are colored by cultural and historical differences. In the United States, for example, there has been an emphasis on performance equalization, at least in respect of specific purpose transfers for public goods such as education. This was also the case in the former Soviet Union and other centrally planned economies, where absolute expenditure norms were used as a basis for regional allocation of funds. By contrast, Canada, Australia, Germany, Denmark, and a number of other countries have favored systems involving varying degrees of capacity equalization. Australia and Canada employ equalization grants from the center, which have the effect of helping to close the vertical gap, while at the same time at least partially correcting for the horizontal imbalances. 5 Another alternative approach involves transfers between subnational levels of government to close horizontal gaps, as employed in Germany.

It is important to recognize that the equalization approach does not necessarily imply full equalization of living standards (as, for example, measured by GDP per head), since private goods are not directly affected by such grant structures, and because subnational capital investment programs are generally managed separately. Even in respect of public programs, inequalities may remain, because different subnational governments may have different priorities. Some may choose to tax at a higher level and use the funds raised to provide a higher standard of public good, whereas others may have a preference for lower taxes and smaller governments.

  • Income Redistribution in a Regional Context

It is often argued that the role of redistributing incomes within a multilevel state should reside primarily with the central government. For some, this judgment reflects a view that common standards of redistribution ought to be applied, regardless of where people reside. A contrary view is that the degree of redistribution is essentially a question of taste and that preferences will differ between regions. Horizontal equalization of the type discussed above may provide each region with a capacity to provide some redistribution (which it may choose to use or not). However, there are clearly limits to such regional income distribution arrangements, since large differentials will tend to be thwarted by fiscally induced migration.

Nonetheless, the expenditure and taxation goals of subnational governments will frequently have redistributive consequences, even where the decisions are based on efficiency criteria. The extent to which subnational governments explicitly engage in redistribution across lower tiers depends on the availability of resources, as well as the need. In the United States, for example, within-state variations in incomes and service levels often exceed across-state variations. Thus, there is a role for state-level redistribution, while the federal government focuses on minimum standards. Moreover, the role of the federal government is being reconsidered, with greater autonomy allocated to the states.

As noted previously, theory suggests that, in the absence of externalities, expenditures should be matched to revenue sources, at the level of government at which the benefit is generated. Unfortunately, the adoption of simple guidelines is complicated by the existence of “externalities” in resource allocation, the so-called spillovers. The term spillover refers to instances where the benefits of a service provided by a subnational government spill beyond its own borders to benefit those not contributing to the cost of providing such services. Often-quoted examples are the cost of control of air or water pollution and the cost of educating students who relocate upon graduation to other regions. In each case, the total value of spending by a subnational government on the activities concerned should not necessarily be fully recouped from the residents of the region. In such circumstances, regional governments may consider only benefits to their own citizens and underprovide public services, hence yielding a case for supplementary central government grants for the given purpose.

  • “Flypaper Effect”

The so-called flypaper effect is an example of the difficulty of analyzing behavior in a multilevel government where the direct link between taxpayer or voter and the service provided is broken. The concept is based on empirical evidence that grants (or revenue shares) provided from one level of government to another tend to “stick” with the recipient government and be used for service provision, and will not be passed on to taxpayers in the form of lower taxes. As a result, the grant leads to a higher level of service provision than would be the case if the payment was made directly to individuals. To illustrate, take the following example. Region A receives a grant of $1,000,000, unrestricted and without matching requirements, which is used to increase expenditure by $800,000 and to provide tax reductions of $200,000. If the grant had been made directly to the individuals of region A, they may have voted to use only, say, $300,000 to increase services, but $700,000 to reduce taxes. The overprovision, or flypaper effect, is then $400,000. In the case of matching grants, the flypaper effect is measured by comparing the level of the public service if the matching rate were applied to the budget and that which would result if matching rates were applied to individual taxpayers. Empirical estimates suggest that the magnitude of the flypaper effect may be considerable in some countries. 6

  • Minimum Standards

In practice, many central governments wish to exert some influence over the minimum standards of service provided at subnational level, which affect both efficiency and equity objectives. These programs are advocated for a variety of reasons, such as:

The national interest, which is seen as being served by achieving some commonality of standards in particular functions (for example, primary school training or roads) mainly provided by subnational government.

Greater harmony between the programs of subnational governments.

The assurance of social objectives, such as a politically acceptable minimum living standard. This standard varies from country to country, covering programs such as Aid to Families with Dependent Children in the United States and access to public services, such as housing, in the United Kingdom and Australia.

Such transfers may have some spillover effect—such as implementation of national standards and/or performance guidelines that benefit business expansion. Furthermore, there may also be a desire to use such programs to promote a more equal treatment of the citizens of the country.

Of course, central government intervention is not the only possible response to spillovers, nor need it be the most efficient solution. One alternative, seemingly gaining attraction is for subnational governments to work together to operate regional services, such as railways, which yield benefits beyond their respective economic borders.

Conflicts and Complementarity in Objectives for Transfers

The various objectives outlined above for intergovernmental transfers may not be mutually consistent. Some of the issues that may arise are discussed below.

  • Stabilization and Equity

One example of conflicting objectives is that between the goals of stabilization and equity. This conflict can arise where revenue or expenditure actions taken by the central government to address stabilization concerns have a differential impact on the fiscal capacities of the subnational governments. For example, an income tax imposed by a central government may act to reduce the income and/or consumption tax bases available to subnational governments in a manner that differentially reduces their individual capacities to raise revenue. Similarly, expenditure cutbacks at the center may affect the expenditure needs of subnational governments in a differential manner.

  • Equity and Efficiency?

Conflicts may also arise between the efficiency and equity goals. Thus, the use of grants to relieve perceived efficiency problems (for example, conditional grants for education requiring the achievement of minimum standards within certain regions) may conflict with fiscal equity goals. This occurs because such grant arrangements ignore the overall fiscal capacity of a region. It is conceivable, therefore, that a region with a relatively high revenue-raising capacity may receive a relatively large education grant simply because it had chosen in the past to spend relatively less on education and, most probably, enjoy a commensurately lower level of taxation. It is possible to reconcile this potential conflict by designing the grants system within an overall equalization framework (see Appendix ).

There has been considerable debate about whether efforts to equalize through intergovernmental grants detract or add to the overall efficiency of the economy. There are two strands to this argument. The theoretical debate on this subject 7 centers on the possibility that, in the absence of equalizing transfers, residents in one region will move to another that exhibits higher net fiscal benefits, and whether this “fiscally induced” migration, in turn, creates economic efficiency costs making the nation as a whole worse off. 8

Boadway and Hobson (1993) provide an intuitive example within the Canadian context, 9 to demonstrate that a free migration equilibrium may be inefficient, when regions have different degrees of access to source-based taxes. This case is important in Canada where the provinces have unequal access to natural resources taxes. Moreover, while the free migration equilibrium will be efficient if residence-based benefits are levied to finance the public provision of private goods, the chances are that such outcomes will not be consistent with the redistributive goals of provincial governments, particularly where regions have to impose taxes on an ability to pay basis. Thus a proportional income tax imposed to finance publicly provided public goods will be redistributive when individuals are heterogeneous with respect to their ability to earn income, and the free migration equilibrium will be inefficient if average per capita incomes differ across regions. Within this model, therefore, efficiency requires that the average per capita income tax revenue be equalized across regions.

Within the model postulated, efficient free migration equilibrium would require either a rearrangement of tax assignments between levels of government to better align types of revenue sources with the types of expenditure to be financed by subnational governments or a system of intergovernmental equalization transfers.

The “efficiency arguments” for equalization are not universally accepted. For example, Swan and Garvey (1992) challenge the view that net fiscal benefits create migration equilibria. In mounting a case against equalization, and especially the original analysis of Buchanan (1950) , they suggest that a free migration equilibrium is efficient, since the migration process itself would lead to an equalization of incomes. Thus, all individuals would be equally treated from a public policy perspective.

Alternatives to equalization payments by central governments are also discussed in the literature. Cornes and Sandler (1986) draw on the theory of clubs to argue that regions could impose migration taxes on intending migrants. Myers (1990) also investigated the possibility that regions might undertake voluntary lump-sum transfers among themselves in order to deter migration. His results, which assume that migration is costless, suggest that a system of voluntary transfers would suffice and that no central government equalization transfers are required. Hercowitz and Pines (1991) continued this theme by examining the conditions under which a region will voluntarily transfer resources to another in the case where mobility is costly. They showed that, in this case, the interregional transfers will not be socially optimal and that central government transfers will still be required.

A number of empirical studies have also been undertaken in Canada to try to determine whether migrational efficiency distortions are potentially important. 10 These studies confirm that (1) differential net fiscal benefits do exist; (2) resource endowments are a significant contributing factor to these differential net fiscal benefits; (3) inefficient migration does occur in response to these net fiscal benefits; and (4) equalization slows inefficient migration. However, while these studies support the expected direction of change in the relevant variables, they do not provide much guidance on whether the magnitude of change is significant, or that the changes have had a major impact on national welfare.

Ultimately, the issue of whether equalization affects efficiency and growth depends on empirical investigation.

Transfer Options

The main transfer mechanisms used to tackle the various goals of government can be grouped into the following categories: (1) conditional transfers (or specific purpose payments) and (2) unconditional transfers.

Conditional transfers consist of matching grants, nonmatching grants for specific purposes, and block grants. Each of these may be implemented with or without redistribution criteria, which could be either open- or closed-ended.

Unconditional transfers consist of revenue-sharing arrangements, with or without redistribution criteria, and general purpose grants, which may be open-ended or subject to caps. In most countries, a combination of grant mechanisms will be used depending on the objectives of the central government.

  • General Choices

If grant mechanisms are employed, four levels of choice can be identified.

First, there is a basic choice as to whether the transfers should be made on a conditional or unconditional basis.

In many countries, the central government imposes conditions on some transfers on the use of the funds, and/or the performance achieved in the programs as a means of increasing central government influence over spending, which is primarily the responsibility of regional or local governments but which may also have an impact on matters of vital national concern (for example, air or water pollution control). Similarly, the central government may wish to leave the primary administrative responsibility for certain functions at the regional or local level, but seek to attain national minimum standards in these functions because of a national public concern (for example, on access to health or education programs). The extent of conditions imposed is likely to vary. At one extreme, the regional government may simply be reduced to acting as an agent of the central government. At the other extreme, the conditions may be limited to such matters as information supply, leaving the subnational government with ample scope for innovation and experimentation.

An unconditional grant will often yield a greater increase in utility in the recipient jurisdiction than will a conditional grant. This follows because unconditional grants simply increase community income without altering subnational government spending priorities, which themselves are dictated by local preferences.

The main justification for conditional grants over unconditional grants, therefore, must be that local decision making fails to produce the socially optimal outcome, as in the case of interjurisdictional spillovers discussed earlier. However, many developing countries have relatively weak expenditure management capabilities at the subnational level, and the proliferation of conditionality and performance criteria for special purpose grants is likely to generate confusion and pro forma fulfillment of the needed criteria. Thus, unless they possess the ability to monitor and manage the conditionality for grants, central governments would do better to simplify the design and conditionality of special purpose grants, and to supplement these by lump-sum transfers (which would be seen as own resources by recipient governments).

Second, within the category of conditional transfers, there is also a choice as to whether the central government should require subnational governments to undertake some matching of funding of programs by lower level governments.

Matching conditional grants generally alter local priorities to take account of the central government’s spending preferences. They are particularly effective where spillovers are thought to exist. There is extensive literature on this subject. Boadway and Hobson (1993) , for example, demonstrate that the optimal matching rate is the rate that will induce the recipient government to provide the socially optimal level of public service—that is, the level for which the marginal social cost is just equal to the marginal social benefit.

Another potential difficulty in administering matching arrangements is that different regions may be able to exert different leverage on the size of the overall grant, because of their different fiscal capacities. In order to limit the ability of any one region to influence the size of the grant, the amount of grant may be tied to total expenditure summed across all provinces. The grant is then tied to expenditures in all provinces, the cost to provincial taxpayers of an additional dollar of expenditure is $(1 − s / n ), where n denotes the number of regions. That is, the additional dollar of expenditure generates a transfer of $s from the central government but the transfer is spread over all regions, some what reducing the leverage of particular provinces as well as the disincentive to use resources effectively.

Third, there is a choice as to whether there is to be some redistribution in the transfer mechanism or whether the transfers will be simply made on an equal per capita basis to each member of the defined population in each region. While formal equalization is usually restricted only to general purpose transfer systems, some element of redistribution between geographic regions is often built into conditional grants (for example, for grants to poorer regions where education or health needs are greater). However, in the absence of an overall framework for evaluating grants, it is not obvious that separately formulated conditional grants (or revenue sharing) with redistributional factors will actually be inequality decreasing or redistributive in an aggregate sense.

Finally, within both conditional and unconditional transfer mechanisms, there is a choice of whether the grants should be open-ended or subject to some limit. Open-ended matching grants encourage local governments with an incentive to internalize identified spillovers and provide the required level of services. At the same time, stabilization considerations often lead central governments to regard such arrangements with some skepticism, and limits to grants are considered desirable on macroeconomic grounds.

  • Tax and Revenue Sharing

If revenue-sharing or tax-sharing approach is followed, the choices are normally reduced. For example, transfers of shares of major tax collections (such as VAT) are generally made without conditions since they are not related to specific expenditure functions. However, this need not always be the case. For example, excise taxes collected on fuel consumption are often earmarked for conditional transfers for specific road construction. Similarly, most tax-sharing arrangements do not require matching by subnational governments. Most are open-ended in nature, although stabilization policy requirements may induce central governments to impose floors and caps on the amounts transferred.

Generally, tax-sharing arrangements are made on a derivation basis, although formula-based distributions are to be found in many countries. As described above, it is not evident a priori that the overall effect of separately determined redistributive formulas will decrease overall inequality in the absence of a consistent framework for the evaluation of transfers.

Where different sharing ratios are established for different taxes, there may be an incentive for the administering authority to place more effort on taxes that provide greater benefits to its immediate level of government (see Chapter 5 on Tax Administration). India, China, and Russia have experienced such difficulties. There is thus a possibility for “strategic games” between different levels of government that might cloud the transparency of the tax system. 11

Alternatively, a separate “fund” or “pool” may be established, and resources may be distributed automatically on a “formula” basis. The disadvantage with such an arrangement is that the automatic sharing of all revenues could complicate a stabilization package, where it is generally assumed that lower levels would spend all additional resources. Thus, the federal government may have to make a larger own account fiscal adjustment than might otherwise be necessary.

The advantage in tax sharing is that lower levels of governments share in productivity gains leading to enhanced tax collections without having to petition the central government for additional resources (and ensuring that subnational governments have a vested interest in an efficiently functioning economy). This automaticity is not generally assured through a grant system. Moreover, those favoring the tax-sharing approach also often point to the added accountability in public decision making that may be expected to accrue, given that such resources are seen as own revenues of the recipient governments.

  • Equalization

Unconditional equalization programs are in use in many parts of the world. These may be based solely on differences in revenue (or tax) capacities across subnational levels of government, as in Canada. This approach implicitly assumes that there are no significant differences in cost in the provision of public services across provinces, or those that exist are taken care of by special purpose transfers (see Clark, 1997 ).

An alternative formulation is based on both the assessment of revenue capacities, as well as an explicit incorporation of expenditure needs (such as in Denmark and Australia). This more general formulation requires more data than the revenue-capacity only option (see Rye and Searle, 1997 ; and Craig, Chapter 8 ). It is important that the factors chosen for the estimation of expenditure needs be independent of the actions of individual provinces. If this criterion is ignored, then there is a danger that the process could be manipulated by recipient governments. In this case, the system could degenerate into a variant of gap filling (see Ahmad and Thomas, 1997 ). Note that even if an elaborate formulation of expenditure needs is adopted, the resulting equalization grant is still untied and the recipient governments could choose to spend it as they wish. For instance, a relatively low level of public services could be provided, with lower-than-standard tax rates, or higher-than-average services with a higher tax effort. This would not affect the amount of the equalization payment, which is lump sum. Provided that the recipient governments are able to vary tax rates and effort, a lumpsum transfer should result in greater accountability, as the policy choices by a spending government would be reflected in the resulting tax rates and burdens.

As with special purpose grants, a choice has to be made whether the equalization estimation should determine (1) the relative amounts going to different provinces; and in addition (2) the total amount to be made available for this purpose.

It is clear that the relative amounts going to each province should be determined by the equalization exercise. This could be based on transfers only to poorer provinces, organized by the central government, of transfers directly from richer to poorer provinces organized on a cooperative basis (as in Germany). Both variants have the advantage that the redistribution is clear and transparent. However, not all countries have the political cohesion that would permit a duplication of the voluntary transfers as in Germany. In addition, the visible redistribution may lead to strong opposition to transfers on the part of the better-off provinces (many of which also have unmet expenditure and investment requirements). Thus, equalization transfers going from the center to all provinces may have certain political advantages. This organizational choice will vary from country to country, depending on political economy realities.

The issue of the amount to be made available under equalization is important. Even in countries that conduct elaborate estimations for the basis of equalization, the amounts for this purpose may be less than that for special-purpose transfers (as in Australia). In some cases, the specification of the formula also determines the amount of the grant. And if this is more than can be justified given macroeconomic constraints, countries such as Canada have resorted to adjusting the formula or imposing caps (see Clark, 1997 ). The Australian formulation focuses on the determination of relativities for each state, which are then applied to the amounts to be transferred, determined exogenously by the government (see Chapter 8 ). This arrangement provides greater flexibility and objectivity to the estimation procedures.

Another decision that has to be taken relates to the extent to which special purpose grants are to be incorporated into the equalization process. On their own, numerous special purpose grants may be inequality increasing. Incorporation of such transfers within the equalization process provides a framework for such grants.

A description of a general grant determination process, based on both revenue capacities and expenditure needs, is presented in the Appendix. This draws largely on the Australian model.

  • Capital Grants

Many countries make extensive use of capital grant systems to finance public investment programs by subnational governments. This is especially the case in countries that do not have well-developed capital markets or where the weak financial position of subnational governments does not permit them to access such markets directly. While most of these grants are for specific purposes or projects, a question arises whether capital needs should be included in an equalization program. This may be of importance when some regions of a developing country lack the basic infrastructure (such as school buildings) necessary for the provision of key public services deemed to be relevant for the equalization exercise. In this context, it would be important to examine the methods of assessing needs, the appropriate mix of grants and advances, as well as the nature of payment arrangements.

As noted earlier, capital needs are normally excluded from equalization exercises because of the difficulties of measuring and assessing relative needs in different regions. Ideally, one might compile a list of projects and conduct cost-benefit analyses on each project. The projects might then be funded in descending order of merit, with a specific capital grant for each functional area, although there are considerable practical difficulties involved in implementing this theoretically appealing approach.

In particular, a difficult area is to decide on the extent to which project financing is to be based on a grant and the portion that should be financed through capital markets. Proxy and sometimes arbitrary measures must therefore be used to allocate funds. In some areas, such as roads and housing, some approximate stock measures may be derived that can serve as a crude basis for evaluation (but see earlier discussion of the varying possible approaches to equalization of capital needs).

These difficulties suggest that a prudent approach to formulating capital grants may argue for providing separate financing for large infrastructure projects (for example, regional airports) and some capital investments of a repetitive nature (for example, rural and district roads and low-income housing), but to leave other smaller enabling investments to be financed by block grants or the general purpose equalization grant (if the relevant activities had been considered in assessing the factors for such a grant).

It must be recognized that capital projects have a long life and that at least a portion of their benefits will be enjoyed by future generations. Moreover, for many large infrastructure projects user charges can be implemented to finance major portions of the total cost. Both these factors make equalization grants an inappropriate tool for financing such capital projects. Consideration should then be given to financing all or part of the projects by advances from the central government at market interest rates that at least cover the center’s own cost of borrowing.

In practice, central governments often employ a mix of special purpose grants and advances for large capital projects. The split of advances to grants must again be made on a pragmatic basis, reflecting judgments of the circumstances surrounding each type of expenditure.

  • Planning and Implementing Transfer Arrangements

The design and monitoring of intergovernment transfers is a complex task as it involves balancing many competing objectives across a wide range of activities. Some general principles emerge from country experiences:

(1) Stabilization concerns should predominate . The central government must preserve its capacity to manage the economy. Failure here may jeopardize other goals being pursued by the central and subnational governments.

(2) Developing a macroeconomic framework . Individual transfer arrangements should not be negotiated in a vacuum. Ideally, they should be considered in the context of jointly prepared medium-term rolling fiscal plans covering projections of the aggregate revenues and expenditures of all levels of government at least three years ahead.

(3) Arrangements should contain some flexibility . While the central government cannot avoid some degree of commitment of medium-term resources, it also needs room to vary overall levels of commitment. Open-ended commitments and variable grants or tax shares with floors or minimal guarantees need to be scrutinized carefully. Indexation arrangements—especially those that might be susceptible to actions by the grant recipient—also need to be handled with care. And while some medium-term funding indications may be unavoidable, a reasonably large component of the total grant should be left for final determination in the annual budget context. So-called sunset clauses should apply to ensure that programs are regularly reviewed.

(4) Objectives must be clearly spelled out and be capable of being monitored . The central and subnational governments must be particularly cautious of overlap and duplication in the provision of services. When central governments set conditions on the use of transfers they should have a good idea of how to monitor their objectives, what can be realistically achieved, and what sanctions can be applied in case of nonperformance. Matching requirements in many specific areas may simply undermine the capacity of the subnational government to manage crucial local services.

(5) Interrelationships need to be taken into account . While individual ministries will naturally focus on achieving specific objectives in any program, it is important that the ministry of finance monitor the overall impact of transfers. The consistency between conditional transfers and unconditional grants is important.

(6) Simplicity is important . The initial presumption should be that the expenditure needs can be met by the subnational own revenues, including shared taxes, and unconditional grants. The case for a special purpose grant should be clearly spelled out, with simple conditionality and reporting procedures.

(7) Examine alternatives . Not all services need to be provided by the state (at any level). In some cases, payments can be made to companies or persons via a voucher or some other mechanism to facilitate access to services such as education. Such measures may be particularly important where the national government seeks to encourage efficiency and diversity in the supply of services.

Concluding Remarks

Most countries need a combination of grants, ranging from special purpose grants, to correct for spillovers and other conditional grants to meet the policy objectives of the central government, to other conditional or unconditional grants, to meet vertical or horizontal imbalances. Each combination of grants will likely have different macroeconomic implications and could affect the incentives of recipient governments to raise their own revenues at the margin or to control own expenditures. A strong lesson from both the theoretical literature and the experiences of other countries (see Ahmad, 1997 ) is that the design of grants matters for macroeconomic stabilization, as well as efficiency and distributional objectives.

Gap-filling grants to meet the deficits of subnational governments are pernicious and should be avoided to the extent possible, to minimize the danger of fiscal irresponsibility.

Central governments will continue to rely on special purpose grants for a variety of reasons. However, the objectives should be stated clearly, and the conditionality defined in a manner that can be monitored and enforced. It is all too common to find the greatest reliance on special purpose transfers in countries that are unable to monitor effectively the usage of these transfers. Under these circumstances, such grants can induce inefficient resource use, as well as corrupt practices, because of the lack of accountability engendered. In addition, complex conditionality can lead to administrative paralysis at lower levels of government. Moreover, a multitude of special purpose grants bestowed by different agencies can lead to undesirable outcomes, such as an overall increase in horizontal imbalances. Thus, a simple design of special purpose grants, within a consistent overall framework, is to be strongly recommended.

Unconditional equalization grants, provided that these are lump sum and are not influenced by the actions of a recipient government, can be an effective vehicle for financing decentralized expenditures in a manner that encourages accountable resource use. Difficult choices need to be made in relation to the extent and formulation of such transfers, and these need to take into account data and institutional constraints that are to be found in particular contexts.

Appendix. Implementation of Equalization Grants Systems

Subnational governments differ in their fiscal capacities because some can raise more money from their available tax base than others and because the need for and the cost of providing certain services differs among regions.

A number of geographically large countries have felt a need to provide some intergovernment fiscal mechanisms to provide a degree of equity between regions over time. Specifically, full equalization would require that each region should have the capacity to provide the same standard of public services as the other regions, provided it makes the same effort to raise revenue from its own sources and conducts its affairs with an average level of operational efficiency.

If a country anticipated the introduction of a system of grants based on horizontal equalization, a decision would be needed as to the basis for equalization in the medium term: (1) whether to restrict the process to revenue capacities, or (2) whether to include both revenue capacities and expenditure needs.

If the decision is the former, then the revenue capacity equalization could be introduced fairly quickly in most countries. However, in large and diverse countries, there may be a preference to also allow for differences in expenditure needs, particularly if there are substantial differences in the cost of provision of such services and in access to such services.

Whatever is done and no matter how long full implementation might take, the long-term objective must be kept in mind at each stage of the system design, and it is therefore appropriate at the start to set the principles on which the system is to be based. Some considerations in designing the process and objectives of the system might be as follows:

Ensure that, as far as possible, the grants do not simply fill fiscal gaps in subnational government budgets. Thus, the recipients of grants should not be able to influence their grant share by their decisions—thereby preventing policy-induced disincentives.

Achieve an implementable system without imposing too great a burden on government in either the collection or processing of data.

Involve the subnational governments (especially at the state or provincial level) in the design of the system to achieve a degree of political consensus. This is likely to involve a gradual process in which sharp changes in provincial activity levels are avoided.

With the above considerations, a needs-based capacity equalization may have to be introduced in line with the development of databases and the choice of variables to be included in the exercise. The initial priority might be to introduce revenue equalization as soon as practicable but, since most countries have special purpose grants, these should be examined for inconsistencies with the equalization process and objectives—this too can be effected early on. It should be noted that an equalization process based on needs does not imply that the central government determines what lower levels of government must do. Rather, this should be seen as providing subnational levels of government with the capacity to provide a standard of services, and they may choose to do otherwise. The important aspect is that the equalization grant should be lump sum, thus ensuring that recipient governments have the incentive to use the resources wisely, and to manage their expenditures efficiently.

The steps needed to introduce the full revenue capacity and expenditure needs framework in an administratively manageable fashion are outlined below.

  • The First Step: The Scope of the Equalization Budget

Ultimately, the objective of an equalization system is to give provincial governments the capacity to provide equal levels of public services if they make equivalent tax efforts. This does not ensure equality in the actual provision of services to each person. An important first step in system design, however, must be to identify the range of public services that a provincial government should have the capacity to equalize.

The initial question would be whether to include both capital and recurrent expenditures and revenue sources within the range of functions to be considered. Typically the equalization process focuses on current expenditures. This however is less defensible in developing countries where the provision of current public services is constrained by the absence of appropriate infrastructure, such as school buildings.

On the other hand, there are major problems with measuring capital needs. Three approaches may be considered:

Flow equalization . This approach would just examine the capacity of each region to deliver a standard increment in own-financed capital stocks in any time period.

Stock equalization without memory of past accumulation . This approach would simply examine the capacity of a region to deliver a standard stock of own-financed capital in any time period without reference to past investment.

Stock equalization with memory of past accumulation . This approach would evaluate a region’s capacity to provide own-financed capital over the long-term, making each region bear the consequences of its own past actions.

Aside from the immense statistical difficulty of measuring regional capital stocks, each of the approaches has particular interpretation problems, which may prove insuperable. For example, poorer regions may object strongly to the first approach, on the grounds that the deficiency of the initial stock was due to insufficient transfers. The second approach could be opposed by states that had made a consistent effort to boost their capital stock, and may be penalized by this arrangement. The third approach may find more support among constantly good performers, but would not be favored by regions that had consistently ignored their capital needs.

Two parallel systems could be implemented:

A system of special purpose capital transfers enabling the central government to target specific infrastructure needs and projects.

An equalization system for untied transfers to assist in financing recurrent services. It may also be possible to include small capital investments within the equalization formulation on a needs-based approach, such as local public works and rural roads.

Of course, this approach would not necessarily mean that capital needs would be ignored in the equalization exercise. Capital needs may enter in various ways into the assessments. For example, regions may be assessed on their relative debt charges that would take at least some account of the accumulation in capital stock contributing to the present level of debt payments.

Once the range of recurrent services to be covered in the equalization exercise has been decided, this would be related to the own-revenue capacities of the provinces, along with the equalization transfers from the central government. The overall transfers would incorporate an estimated inflation adjustment, and only in very exceptional circumstances would there be ex post adjustments (for example, for major population shifts). The basic relationship is:

Cost of standardized recurrent services = provincial sources of recurrent revenue (at standardized levels) available to finance these functions + transfers from the central government (both untied and special purpose).

In an important way, therefore, the provincial capacity to link revenue sources to specific expenditure functions has an influence on the scope of the expenditure budget. If provincial revenues are very largely uncommitted, a matching of standardized revenue sources with standardized expenditure functions is impossible. Thus, if only one function is chosen to represent expenditure needs (such as education) and is related to total available own revenues, there would be a large standard budget surplus ( B i ), and a danger that the factors for education might misrepresent overall expenditure needs. It would thus be preferable for the standard budget to include as many relevant provincial services as possible. Methods of achieving this (with and without extensive data) are discussed below.

It is seldom possible to completely separate expenditure assignments among various levels of government, given that in each expenditure category there are responsibilities for policy, financing, and administration (see Chapter 2 ). In Australia, universities are constitutionally assigned to the states. However, all the financing comes from the commonwealth government, which provides funds for this purpose to the states. In policy terms, the universities are fairly independent. For equalization purposes, the universities are not treated as being a state expenditure function, even though the rest of the education sector is included. The definition of a “state-type public service” in the Australian standard budget covers items mainly administered by the states, even if such items are also provided by other levels of government, communities, or public sector enterprises.

In theory, the equalization objective should include all aspects of service provision regardless of the provider. It should not matter how the service provision is arranged or financed. The grants to the provinces can still be determined in such a way as to equalize capacity for them to ensure that, in total, there could be equal provision in each province.

It may be that, in at least some functions, the combined level of activity of the nonprovincial government sources can be assumed to satisfy the same proportion of the eligible group in all provinces. If this assumption holds, then the nonprovincial activity would not affect relativities if excluded from the standard budget and the assessment of disabilities.

If the level of activity of the subprovinces and enterprises is not assumed equal in all provinces, then there are two possible options for proceeding. Either the standard budget, or the expenditure assessment, can be adjusted.

The first option would require the inclusion of the following items in the standard budget:

The revenue or expenditure in the provincial government accounts.

The expenditure on the standard budget items included in sub-provincial and enterprise accounts.

The revenue received into subprovincial and enterprise accounts used to finance the standard budget expenditure items (this would normally be equal to expenditure but may be financed from higher levels of government).

The second option of adjusting expenditure assessment approaches is discussed below.

  • The Second Step: The Structure of the Standard Budget

This step involves the organization of items to be included in the standard budget in a manner that best assists the assessment process.

On the revenue side of the budget, it is probable that a small number of major sources of revenue should be assessed separately. For the others, the task involves distinguishing some common elements that might contribute to differences in revenue capacities and, where they exist, grouping the taxes into one category. For example, although taxes might differ on different types of gambling, it might be decided that income levels are the major source of capacity differences and that all gambling taxes might best be combined into one category.

Similarly, looking at the expenditure functions of government, it might be that some of the small functions such as the registration of births, deaths, and marriages; registration of motor vehicles; and other administrative services could be combined into one single category labeled, say, administrative services. The IMF’s Government Finance Statistics classifications provide a good guide to appropriate groupings.

Experience with equalization suggests that there is a tendency for separate categories to be developed in the early assessment stages, because they have attributes (especially availability of some specific data) that appear to lend themselves to separate analysis. On closer inspection, it is often found either that their weight in the total budget is so small as to make separate analysis unwarranted or that they would be better grouped with other items that have common underlying, revenue, demand, or cost influences.

  • The Third Step: Deriving Standardized Revenues

There are three options for determining the standardized revenue for any source of revenue to be included in the standard budget.

Undertake an “Active” Assessment

This involves the determination of the revenue base using objective data. This may be based on the actual revenue base being accessed by the provinces (such as payrolls) or some overall indicator of economic activity that can be used as an objective measure (such as state gross product on total consumption spending). An important consideration in this task is that the data used should not be simply a reflection of the actual revenues; rather, standard tax policies should be applied to an “independent” provincial tax base to reflect relative revenue capacities (for example, if there are a number of exemptions from the payroll tax base permitted by one province, then an attempt should be made to assess what the base would be if those exemptions had not been made). This difficulty points to the use, where possible, of nationally consistent databases.

Undertake an Equal Per Capita Assessment

This approach is best used when analysis suggests that there is no measurable difference in the per capita capacity of different provinces to raise revenue from a particular revenue source. For example, an equal per capita assessment may be appropriate if provinces collect a poll tax of $100 for each household and demographic data reveal that the number of persons in each household is broadly equivalent in all provinces. Any differences in amounts collected may then be seen to be essentially due to differences in the efficiency of tax administrations, or to policy differences such as particular exemptions granted to some households in some provinces. These differences would imply a need for the provinces concerned to address the efficiency or policy problems leading to lower collections, or make a case to the assessment authority that it suffered an unavoidable disability in the area concerned.

Undertake an Actual Per Capita Assessment

This approach could be taken when analysis suggests that there are few differences in the tax bases, tax rates, or efficiency of collection among provinces in a particular item. The actual collections could then be taken as a sufficiently accurate measure of underlying differences in tax capacity and, therefore, used as a measure of standardized revenue in the overall assessment. An example of successful use of this approach may be a tax item that is collected by the central government (such as VAT) and then shared with the province on a derivation (original source) basis. In that instance, it could be reasonably assumed that the policy and efficiency of the collection authority are broadly the same across all provinces.

There is a danger that the use of actual per capita assessments could be gap filling in that they discourage efficient tax collection practices. It is important, therefore, in any decision to use this approach, to ensure that no significant policy or efficiency differences exist. Revenue trends in any areas assessed by this method should be monitored closely to identify any attempts at grant-share manipulation and, if such action occurs, early steps will be necessary to vary the assessment approach.

  • The Fourth Step: Deriving Standardized Expenditures In this area, four alternative approaches are available:

The Factor Assessment Method

This method is used when there is sufficient confidence in an ability to identify provincial differences in the relative underlying demand and/or cost per unit of service provision. The process involves the identification of relevant disability factors and then quantifying their relative influence on the service in question. For example, in the area of primary education, the number of people in the age group of 5 years to 12 years might be seen as a relative measure of demand for the service, and differences in cost due to energy consumption to heat or cool schools might be seen as causing differences in the unit cost of providing education to a student. The Australian experience has been that demand influences are usually easier to quantify than cost influences, either because of the existence of better data or because of greater ease in getting agreement between recipient governments on their relative impact.

A further consideration is that demand factors are likely to be specific to individual expenditure categories in the standard budget—for example, different age or sex—and demographic influences are likely to apply to health and education services. However, cost factors tend to have a more common impact across functional expenditure categories. For example, Australian experience suggests that cost factors, such as variations caused by diseconomies of scale, variations in population density, and dispersion of the population, may have a broadly similar effect on many budget functions. In that context, studies of these broad cost factors, while time-consuming in themselves, may yield benefits for all aspects of distributional policy, including the allocations used in specific purpose grant programs.

Undertake an Assessment Based on a Current Distribution of Specific Purpose or Tied Grants

This approach may be appropriate where there are insufficient data to apply the factor assessment method but there is a specific purpose grant scheme in operation that contains a distribution system that the parties judge to be fair and appropriate (perhaps because of past studies of underlying demand and cost factors). This assessment process simply compares the individual province’s per capita share of the specific purpose payment with the national average per capita grant, and uses the relationship between the two as a measure of the global disability that should be applied to the function.

There are two benefits to this approach. First, it does not detrimentally influence the relations between the line ministry currently responsible for the specific purpose grant allocation and those charged with making the equalization grant (in some countries, an independent grants commission, and, in others, the ministry of finance). Second, it does not detrimentally influence the budget flexibility of the provinces by overriding the distribution of the specific purpose payment to which they have become accustomed, without an assessment having been made.

Undertake an Equal Per Capita Assessment—as with Revenue

The assumption is that provinces have no relative demand differences or variations in unit costs of providing services. Standardized expenditure for each province is thus equal to the standard level of expenditure.

Similar in principle to the revenue case mentioned above, the assumption here is that actual costs are an accurate measure of overall relative need. Actual expenditures can therefore be used as an accurate measure of standardized expenditure.

The problem of different contributions to total service provision being made by the nonprovincial suppliers could be overcome in the assessment process. This would avoid the possible difficulty of including subprovincial and enterprise financial transactions in the standard budget. If it was known, or could be estimated that nonprovincial supply of a service across the nation reaches, say, 20 percent of the total relevant population, this could be seen as a standard level of provision. Thus, a province in which more than 20 percent of the eligible population is being served by nonprovincial suppliers would have an advantage. It could be assessed as having a “nonprovincial supplier” factor of less than unity (that is, a relatively lower-than-standard disability). A province in which the nonprovincial suppliers were serving less than 20 percent of the eligible population would have a factor of more than 1.000 (that is, a relatively higher-than-standard disability).

Once such factors are applied, any change in the distribution of services between provincial and other suppliers would need to be closely monitored to ensure that provinces do not use policy decisions to change the balance in an attempt to influence their assessments of relative needs.

This approach may not be adequate for longer-term assessment if provinces are able to change policies in a manner that can affect the assessments. However, it may be acceptable in the short run if the inclusion of the financial activity of nonprovincial suppliers is judged to be too difficult to include in the standard budget.

A further aspect to this solution is that it is effectively excluded when equal per capita assessments are undertaken. This arises because the equal per capita assessments, if nonprovincial expenditure is excluded from the standard, assume an equal provision of nonprovincial supply. It may be that the equal per capita assessments need to be divided into two groups: those in which it is desired to assess a non-provincial supplier factor in which case that becomes the only factor; and those where a true equal per capita assessment remains.

A nonprovincial supplier allowance, however, is automatically included in actual per capita assessments. This will not present difficulties because any policy action by a province to reduce its expenditure at the expense of a nonprovincial supplier will automatically result in the province being assessed as having a reduced standardized expenditure.

A further consideration to the full equalization process in the environment of a developing country is the realization that some provinces—the ones where infrastructure is less developed—will receive grants to provide recurrent services that cannot be provided because of the absence of the necessary infrastructure. Unless an adjustment or other arrangements are made, these provinces will be able to either raise less than their standardized level of taxation, or provide above-standard services in areas unaffected by their poor infrastructure development. For example, even if there are no school buildings, the provinces would be given funds to employ teachers. These funds could not be spent on teachers, and may be used for other purposes or to reduce taxation as the province sees fit.

Under these conditions, the central government might encourage the provinces to use this part of their equalization grant for infrastructure development to ensure longer-term equalization. Such use of recurrent resources for capital purposes would, along with any funds received for capital investment, enable a province to achieve a standard level of service more rapidly.

However, the simple formulas used in the equalization exercises in Germany are not based on detailed region-by-region evaluations of fiscal capacity as in Australia and Canada.

See United States, Advisory Commission on Intergovernmental Fiscal Relations (1995) .

Such controls may spring from constitutional or legal restraints but often simply reflect a broader recognition by subnational governments of the need for such constraints.

Of course, the separate regional entities may still enjoy some of the benefits via some sort of confederation by participating in a free trade zone (for example, the European Union and the North American Free Trade Agreement), but those benefits may be less substantial than those of a full federation.

Even in Australia and Canada, it can be argued that the systems employed do not provide full equalization, since they cover only a selected portion of the overall state or provincial budgets.

Musgrave, Musgrave, and Bird (1984) .

See Buchanan and Goetz (1972) ; Flatters, Henderson, and Mieszkowski (1974) ; Boadway and Flatters (1982a and 1982b ); and Boadway and Hobson (1993) .

The equity case for equalization has often been criticized as setting up a disincentive for labor migration out of poorer regions. In the presence of net fiscal benefit differentials, however, such migrations may go too far—so-called fiscally induced migration—and result in an inefficient allocation of labor. To prevent this, full equalization of net fiscal benefits is called for.

The argument is based on a model that distinguishes, on the one hand, between publicly provided private goods (such as health, education, and welfare expenditures, which are assumed to vary proportionately with the population of the region) and pure public goods (where significant economies of scale may exist) and, on the other hand, between source-based taxes and resident-based benefit taxes. Efficiency requires that residence-based taxes should be used to finance the provision of publicly provided private goods, while pure public goods should be financed by source-based taxes.

Courchene (1984) , Winer and Gauthier (1982) , Norrie and Percy (1984) , Watson (1986) , and Economic Council of Canada (1982) .

Revenue sharing could be determined on a tax-by-tax basis or some pooling arrangement. Under the first choice, a portion x of specific tax (for example, VAT), may accrue to the central government, and the residual (100 − x ) to a subnational government in which the revenue was generated. A different share may be used for the enterprise income tax, and so on. Under the pool approach, all shared tax revenues (VAT, enterprise profits tax, and so on) are paid into one fund and then shared according to an established formula. If x percent of the pool is retained by the central government and the rest allocated on a derivation basis (that is, according to the region in which the revenue is generated), then this is equivalent to the x : (100 − x ) ratio applied to each shared tax.

Ahmad , Ehtisham , Jon Craig , and Dubravko Mihaljek , 1995 , “Implementing and Managing Grants—Institutional and Informational Requirements,” in Reforming China’s Public Finances , ed. by Ehtisham , Gao Qiang , and Vito Tanzi ( Washington : International Monetary Fund ).

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Within Same Series

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  • PART III Practice: Developing Countries
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  • VI: Special Topics
  • Chapter 4. Europe
  • 4 The Role of Fiscal and Monetary Policy in the Growth Process
  • 4 National Saving

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Cover Fiscal Federalism in Theory and Practice

Table of Contents

  • Front Matter
  • 2 Assigning Expenditure Responsibilities
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discuss tax assignment allocated to federal government

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Introduction to Government Budgets and Fiscal Policy

Chapter objectives.

In this chapter, you will learn about:

  • Government Spending
  • Federal Deficits and the National Debt
  • Using Fiscal Policy to Fight Recessions, Unemployment, and Inflation
  • Automatic Stabilizers
  • Practical Problems with Discretionary Fiscal Policy
  • The Question of a Balanced Budget

Bring It Home

No yellowstone park.

You had trekked all the way to see Yellowstone National Park in the beautiful month of October 2013, only to find it… closed. Closed! Why?

For two weeks in October 2013, the U.S. federal government shut down. Many federal services, like the national parks, closed and 800,000 federal employees were furloughed. Tourists were shocked and so was the rest of the world: Congress and the President could not agree on a budget. Inside the Capitol, Republicans and Democrats argued about spending priorities and whether to increase the national debt limit. Each year's budget, which is over $3 trillion of spending, must be approved by Congress and signed by the President. Two thirds of the budget are entitlements and other mandatory spending which occur without congressional or presidential action once the programs are established. Tied to the budget debate was the issue of increasing the debt ceiling—how high the U.S. government's national debt can be. The House of Representatives refused to sign on to the bills to fund the government unless they included provisions to stop or change the Affordable Health Care Act (more colloquially known as Obamacare). As the days progressed, the United States came very close to defaulting on its debt.

Why does the federal budget create such intense debates? What would happen if the United States actually defaulted on its debt? In this chapter, we will examine the federal budget, taxation, and fiscal policy. We will also look at the annual federal budget deficits and the national debt.

All levels of government—federal, state, and local—have budgets that show how much revenue the government expects to receive in taxes and other income and how the government plans to spend it. Budgets, however, can shift dramatically within a few years, as policy decisions and unexpected events disrupt earlier tax and spending plans.

In this chapter, we revisit fiscal policy , which we first covered in Welcome to Economics! Fiscal policy is one of two policy tools for fine tuning the economy (the other is monetary policy). While policymakers at the Federal Reserve make monetary policy, Congress and the President make fiscal policy.

The discussion of fiscal policy focuses on how federal government taxing and spending affects aggregate demand. All government spending and taxes affect the economy, but fiscal policy focuses strictly on federal government policies. We begin with an overview of U.S. government spending and taxes. We then discuss fiscal policy from a short-run perspective; that is, how government uses tax and spending policies to address recession, unemployment, and inflation; how periods of recession and growth affect government budgets; and the merits of balanced budget proposals.

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Abyssinia Law

Introduction to Fiscal Federalism and Division of Revenues under the Ethiopian Constitution

As a subfield of public economics, fiscal federalism is concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government". In other words, it is the study of how competencies (expenditure side) and fiscal instruments (revenue side) are allocated across different (vertical) layers of the administration.

It may be noted that the ideas of fiscal federalism are relevant for all kinds of government, unitary, federal and confederal. The concept of fiscal federalism is not to be associated with fiscal decentralization in officially declared federations only; it is applicable even to non-federal states (having no formal federal constitutional arrangement) in the sense that they encompass different levels of government which have de-facto decision making authority. This however does not mean that all forms of governments are 'fiscally' federal; it only means that 'fiscal federalism' is a set of principles that can be applied to all countries attempting 'fiscal decentralization'. In fact, fiscal federalism is a general normative framework for assignment of functions to the different levels of government and appropriate fiscal instruments for carrying out these functions. The questions arise: (a) How federal and non-federal countries are different with respect to 'fiscal federalism' or 'fiscal decentralization' and (b): How fiscal federalism and fiscal decentralization are related (similar or different)? While fiscal federalism constitutes a set of guiding principles, a guiding concept that helps in designing financial relations between the national and sub-national levels of the government, fiscal decentralization on the other hand is a process of applying such principles. Federal and non-federal countries differ in the manner in which such principles are applied. Application differs because unitary and federal governments differ in their political & legislative context and thus provide different opportunities for fiscal decentralization.

An original definition of fiscal federalism states that "fiscal federalism" concerns the division of public sector functions and finances among different tiers of government. In undertaking this division, Economics emphasizes the need to focus on the necessity for improving the performance of the public sector and the provision of their services by ensuring a proper alignment of responsibilities and fiscal instruments. While economic analysis, as encapsulated in the theory of fiscal federalism, seeks to guide this division by focusing on efficiency and welfare maximization in determining optimal jurisdictional authority, it needs to be recognized that the construction of optimal jurisdictional authority in practice goes beyond purely economic considerations. Political considerations, as well as historical events and exigencies, have in practice, played major roles in shaping the inter-governmental fiscal relations in most federations. 

Even in non-federal states, there has been a growing movement towards greater fiscal decentralization in recent years. Some analysts have attributed this to globalization and deepening democratization the world over on the one hand and increasing incomes on the other. Other specific reasons for increasing demand for decentralization are:

• Central governments increasingly are finding that it is impossible for them to meet all of the competing needs of their various constituencies, and are attempting to build local capacity by delegating responsibilities downward to their regional governments.

• Central governments are looking to local and regional governments to assist them on national economic development strategies.

• Regional and local political leaders are demanding more autonomy and want the taxation powers that go along with their expenditure responsibility.

Moreover, in recent years, decentralization has become a feature of reform agenda promoted and supported by the World Bank (as stated in the World Bank Report of 1997) and other multilateral institutions. The rationale for this has been in part that decentralization promotes accountability. It is not therefore surprising that by 1997, 62 of 75 developing nations had embarked on one form of decentralization or another.

Fiscal federalism in Ethiopia has been adopted within a unique political landscape of ethnic federalism. The TPLF-led government that replaced the Dergue has redrawn the political map of the country and adopted ethnic based federal structure of government. This experiment has been formalized in the 1994 Constitution. However, the constitutional provisions operate with political centralism that has remained to be the distinguishing feature of the current political system.

Fiscal federalism derives its nature and characteristics from constitutional provisions as well as the state of economic development, the pattern of income and resource distribution, and the institutional capacity of the system. The constitutional provisions define the framework within which decision-making would be exercised and establishes the vertical and horizontal structures that find meaning within the prevailing socio-economic environment of the system. The vertical structure defines the assignment of fiscal decision-making power between the federal and lower tiers of government. The horizontal structure outlines the nature of interaction across cross-sections of government levels. This aspect addresses how regional governments interact to each other especially when there are externalities and spillovers. The main economic rationale behind fiscal decentralization is improving efficiency of public resource utilization, creating enabling environment for private sector development and the growth of the national economy. The theory of fiscal federalism addresses three issues related to fiscal decision-making: assignment of responsibilities and functions between the federal government and the regional governments, the assignment of taxation power and the design of inter-governmental transfer (subsidy) of fiscal resources coupled with provisions about the borrowing windows to sub-national governments. These factors give rise to a third issue of the relative size of the public sector in the national economy. It is therefore the dynamics of these processes and public policy choices that ultimately shapes the performance of the fiscal sector and its impact on the national economy.

An important aspect of the exercise of fiscal federalism is the assignment of fiscal functions to the federal and the sub-national governments and the appropriate means of financing these responsibilities. The theory of fiscal federalism does not provide a clear-cut separation of fiscal responsibilities that would promote economic efficiency and resource distribution. The broad thrust of normative theory is that expenditure responsibilities in areas of macroeconomic stabilization and redistribution functions should remain within the domain of the federal government whereas allocation functions should be assigned to lower levels of government. The argument is based on the reasoning that lower levels of government have limited capacity and policy instruments to provide stabilization and redistribution functions. Due to the nature of the responsibilities, the federal government usually assumes macroeconomic stabilization and income redistribution functions and make sure that regional governments would not take measures that are not compatible with such functions. Moreover, there are functions such as national defense and foreign affairs that have national public good character and hence usually assigned to the central government.

Fiscal decentralization and the assignment of functions can generate economic efficiency of the public sector. If preferences are heterogeneous across jurisdictions, which is most likely the case, decentralized decision-making power as to the provision of local public goods and services improves efficiency by tailoring services to the preferences of the local population. The main argument is that local governments are closer to the local population and can identify their choice and preferences better than the central government. Accordingly, when the decision to provide a bundle of public goods is made by local officials and these officials are directly accountable to the local voters, there is an incentive for the local public officials to provide services that reflect the preferences of the local population. Moreover, as long as there is close relation between the benefits from public services and taxes on the local taxpayers, there is additional incentive to utilize resources efficiently and cost effectively. At least by implication, the theory recognizes the need for local authorities to exercise choice in the provision of public services that are of higher local demand instead of resorting to the unitary solution. The decentralization theorem suggests that, under such conditions, decentralization of fiscal decision-making can improve efficiency of the public sector and the welfare of the local population.

Once the allocation of expenditure responsibilities is conducted according to such broad principles, the fiscal system needs to address the issue of assigning taxing power that broadly identifies who should tax, where and what. The imposition of taxes, in the absence of lump-sum source of taxation, always involves a certain degree of economic inefficiency. In the context of fiscal federalism, the assignment process needs to identify the comparative efficiency and effectiveness of providing the fiscal instruments to the multi-tier decision-making centers so as to finance public functions and activities in the most efficient manner possible.

What kind of taxes should be assigned to the federal government and which should be assigned to the local governments? The theory and practice in the assignment of taxation power identifies the following main criteria in assignment process: taxes on mobile tax bases, redistributive taxes, taxes that could easily be exported to other jurisdictions, taxes on unevenly distributed tax bases, taxes that have large cyclical fluctuations, and taxes that involve considerable economies of scale in tax administration should be assigned to the national or federal government. There are efficiency and equity considerations behind such principle of tax assignment.

The assignment of taxing power between the federal and the regional governments and the provision for concurrent power to share establishes the basic link in which the behavior of one of the parties would influence the decision making power of the other and its effective tax base. There is a possibility for vertical tax externality that might require additional policy instruments to correct their effect on other levels of government. When there are clear cases in which vertical tax externalities are prevalent, the tension between the federal and the state governments would arise. This in turn would require mechanisms for the assignment of taxing power and revenue based on the nature and characteristics of the tax base.

The assignment of taxing power is a thorny issue in fiscal policy and its application is influenced by a number of considerations. First, despite the legislative assignment of taxes, the actual potency of the tax network depends on the nature and development of the national economy, the relative distribution of economic activities across jurisdictions, and the administrative efficiency of the taxation system. Second, the practice of fiscal federalism, especially when citizens across regions with diverse economic and demographic situations are treated unequally, gives rise to the violation of one of the core principles of horizontal fiscal equity. Moreover, fiscal decentralization might also potentially breach the principle of vertical fiscal equity by not treating taxpayers with different capacity to pay differently. Third, despite the monopoly of taxing power resides at the disposal of the government, the reach of the taxation network depends on the economic circumstances of the potential taxpayers.

The fiscal system of Ethiopia has historically been characterized by high centralization and concentration of fiscal decision-making power at the center. Moreover, the structure of the fiscal system shares important features with other underdeveloped economies in terms of reliance on indirect taxes, dependency on international trade taxes, and persistent fiscal deficits. The current fiscal system of Ethiopia features some departures from the previous systems and striking continuities in the structure and essential elements of fiscal performance of the economy. The main features of fiscal aggregates of Ethiopia suggest that either the government is not willing to fundamentally change its fiscal policy stance or the fiscal system is governed by the structural features of the economy that are not easily amenable to change in response to fiscal policy reforms. A closer examination of the main features of the fiscal system suggests that both factors play a role in the process. The nature and structure of the economy, the resulting tax bases, the excessive dependence on international trade taxes and external grants, and persistent deficits all contribute to the prevailing features of the fiscal sector as do the fiscal policy stance of the government.

For the period 1980/81-2001/02, the government on average extracted about 18 percent of GDP from the public and spent about 28 percent of GDP, of which recurrent spending took more than 19 percent and only 9 percent left for capital spending. This behavior of excessive spending left an average fiscal gap of about 10 percent. Foreigners provided about 3 percent as charity and lent about 4 percent of GDP and the rest was financed mainly from domestic banking system. A fiscal system that resorts to borrowing to cover about 36 percent of its spending appetite would sooner or later confront the consequence of its behavior. It is an important predictor of a looming crisis. This behavior of fiscal spending also affected the macroeconomic situation in which aggregate expenditure run in excess of domestic production. The country has become increasingly dependent on foreign aid and borrowing to finance its consumption and investment expenditure.

The fiscal system, nonetheless, witnessed important changes over time. Government revenue increased during the 1980s and reached a peak of 24.8 percent of GDP in 1988/89 before it declined drastically during the subsequent two years of political turmoil in the country. The fiscal regime was extremely coercive and led to distortions in resource allocation. The prohibitively high marginal tax rate had driven most activities underground and tax evasion and corruption were on the rise. Such a system was indeed unsustainable and the change in the political regime precipitates a collapse in the fiscal system. The decline in revenue was particularly severe from business profit taxes, export taxes and revenue from government investment income. The collection of government revenue collapsed from about a quarter of GDP to about 10.6 percent by 1991/92.

The transitional government introduced a number of fiscal and monetary policy reforms that had mixed implications on the revenue collection. The amendment in the tax codes, devaluation and gradual depreciation of the exchange rate, elimination of taxes on exports (except coffee duties), and the privatization process have had important implications on the amount and structure of government revenue. The average domestic revenue to GDP ratio has recovered gradually and for the period 1991/92 to 2001/02 the average reached about 17.2 percent with a gradual and yet increasing trend. The average tax revenue for the period was about 11.7 percent of GDP.

One typical feature of the tax structure is its narrow base. There is an increasing dependency on foreign trade, especially import, taxes in recent years. The devaluation of the currency and its subsequent depreciation over time somewhat expanded the domestic currency denominated tax base on imports. The tax revenue-to-GDP ratio for developing countries is about 18 percent and for African countries is about 20 percent. The ratio of tax revenue in GDP for advanced countries is significantly higher than developing countries, at about 38 percent, reflecting the state of economic development, the tax base and the efficiency of tax administration. This pattern could broadly be attributable to the structure and performance of the economy, the administration of the taxation system, and the design of the taxation system.

A longer view of the fiscal resource allocation behavior of the government, despite marginal changes in some aspects of the fiscal components, suggests that there has not been enduring and significant shift in policy over the past two or so decades. The current government in power, except some marginal changes, shares important characteristics and behavior in fiscal policy with its predecessor. The current regime spends about 26 percent of GDP and extracts from the public about 17 percent of GDP.

Foreigners still provide about 3 percent as grants and lend about 3.7 percent of GDP. The remainder of about 2.4 percent of GDP has been financed from domestic borrowing. The relative performance of the current fiscal regime shows some improvement and yet it still covers about 23 percent of its spending by borrowing. The result of such features of government revenue and expenditure has been the emergence of persistent fiscal deficits and the accumulation of public debt. Domestic government revenue apparently has been barely enough to cover recurrent government expenditure let alone to generate resources for financing capital expenditure. The level of deficit has increased so much so that in recent years it has been as much as the total tax revenue collection of the government. Such a stance of fiscal policy is unsustainable and the external grants, even if important to partially narrow the gap, would not and could not resolve the problem. The government has increased its appetite for borrowing from foreign sources to bridge the gap and when external borrowing does not satisfy it resorts quite easily to borrow from the domestic banking sector.

The fiscal performance of the country is reflections of a typical underdeveloped and agrarian based economy in which the majority of the population lives in chronic poverty and a government that devotes its effort to extraction of resources from the economy and failing to allocate these resources to priority areas and sectors of the economy. When this is coupled with a de facto fiscal centralization and stance of inefficient public resource allocation, it fails to address the priorities of the majority of the population and hence becomes increasingly unsustainable. However, both political imperatives and changes in the overall economic policy of the country opened the door for fiscal policy innovation.

As far as the current system of fiscal federalisms and division of revenues in Ethiopia goes, the FDRE Constitution provides that the Federal Government and the States all collect taxes and shall share revenue, taking the federal arrangement into account. By taking into consideration principles such as ownership of revenue, regional character of revenues sources, convenience for administration, population, and wealth distribution, sharing of revenue between the Federal Government and the State Governments serves the following purposes: enhancing the efficiency of the central and the regional governments so as to enable them to carry out their respective duties and responsibilities; helping the regional governments to develop their regions on their own initiatives; narrowing the existing gap in development and economic growth between the regions of the country; and encouraging common interest activities of the regions.

In sharing of revenues, taxes are grouped into three: central (that of the Federal Government), regional and joint. As far as collection of the revenues goes, the regional governments collect their own revenues whereas the Federal Government collects not only its own revenues but also the joint revenues, of course with a possibility of delegation whenever deemed necessary.

According to Article 96 of the FDRE Constitution the revenues of the Federal Government include customs duties, taxes and other charges levied on the importation and exportation of goods; income tax collected from employees of the Federal Government and international organizations; income, profit, sales and excise taxes collected from Federal Government owned enterprises; taxes collected from national lotteries and other games of chance; taxes collected from income generated through air, rail, and sea transport services; taxes collected from rent of houses and Federal Government owned properties; charges and fees on licenses issued and services rendered by the Federal Government; taxes on monopolies; and Federal stamp duties.

In a similar manner, Article 97 enumerates the revenue sources of the regional governments of the country as comprising of income taxes collected from employees of the States and of private enterprises; fees collected from land usufructuary rights; taxes collected from the income of private farmers and farmers incorporated in cooperative associations; profit and sales taxes collected from individual traders operating within state territories; taxes on income from water transportation within state territories; taxes collected from rent of houses and State Government owned properties; profit, sales, excise and income taxes collected from State owned enterprises; taxes on income, royalties, and land rentals from mining operations; charges and fees on licenses issued and services rendered by the State Governments; and royalties for use of forest resources.

Apart from these, there are certain revenue sources which are shared by the Federal and State governments. The joint revenues are listed in Article 98 of the FDRE Constitution as constituting profit, sales, excise and income taxes on enterprises jointly established by the Federal and State governments; profits of companies and dividends of shareholders; and income and royalties derived from large-scale mining operations and all petroleum and gas operations. For those powers of taxation which have not been explicitly stated in the provisions of the FDRE Constitution, such as value added tax, Article 99 clearly stipulates that the exercise of such powers is to be determined by a two-third majority vote in a joint session conducted by the House of Federation and the House of People’s Representatives, thus subjecting the exercise of this so-called “undesignated power” to strict requirements.

The exercise of the taxing powers of both the Federal and Regional governments has to take certain considerations into account. For one, both governments are required to ensure that any tax is related to the source of the revenue taxed and that it was determined per the proper procedures. Secondly, both governments are required to ensure that the relationship amongst themselves is not adversely affected by the tax and that the rate and amount of taxes are commensurate with the services that the taxes help deliver. Finally, both governments are prohibited from levying and collecting taxes on each other’s properties unless it is a profit-making enterprise.

The FDRE Constitution gives much power to the regional states. Collectively, the regional states are granted the status of a nation. They are given self-determination up to secession. Self-determination is broadly understood to mean as the use and development of one's language, culture, history and administrative structure. Beyond the "unrestricted right to administer itself", self-determination also includes proportional representation at federal organs. In order to resolve conflicting claims over representation, territory and resource, the constitution has created the House of Federation whose members are elected by State Councils. The ethnic groups are represented at this institute. This House is composed of "representatives of nations, nationalities and people" at least one for each of them, plus an additional member for nation or nationality for each one million of its population". Ethnical conflicts and boarder disputes are referred to the House of Federation. This body has the role of supreme interpretation of the constitution and resolving key question of the nationalities/ethnic groups.

The regional states have their respective autonomous governments set up. Accordingly, each regional government includes a State Council (the highest organ of state authority) and a State Administration (highest organ of executive power). The State Council is the highest political authority: it defines the region's policy and has all legislative, executive and judiciary powers regarding the region, except for those under the responsibility of the central government, such as defense, foreign affairs, economic policy etc. The State Council plans, approves, heads and controls economic and social development programs. It drafts, approves and manages the regional budget. The State Administration is the highest executive authority of regional government. It is elected by the State Council and includes 15 Executive Committee members. The State Administration enforces, as appropriate, the policies, proclamations, regulations, plans, guidelines and decisions of the central government and of the State Council. It manages, coordinates and supervises the activities of regional offices, zone administration offices and Weredas (district) offices. It drafts and submits economic and social projects to the State Council for approval, and manages the projects once they have been approved. It drafts the region's budget, submits it for approval to the State Council and manages the budget once approved.

At the broadest level, the general principle underlying the allocation of authority and legislative responsibility in federal systems has been that matters of common interest and concern to the country as a whole should be assigned to the federal government, and matters of a decidedly regional or local character should be assigned to the regional governments. In actual fact, however, there is a weak federal executive power whose relationship with the regional governments is not yet clearly coordinated. Constitutionally, the federal government is not effectively centralized through presidentialism. The president has a symbolic role. The federal executive power is vested in the Prime Minister and in the Council of Ministers which are politically accountable to the House of Peoples' Representatives in all the decisions it adopts. As enshrined in Article 77 of the Constitution, the Council of Ministers among others, ensures implementation of laws, and decisions adopted by the Federal Parliament, decided organizational structure of Ministries and other Federal Parliament, decided on organizational structures of Ministries and other organs of government responsible to it, coordinates the activities of organs of government, discusses and refers draft proclamations to the Lower House, and decides on the general socio-economic and political strategies the country should pursue.

State Councils of the regions are also responsible for appointment of the highest executives in charge of the various organs of State. The respective constitution of the various regional states stipulates that the State Councils are entrusted with the power of forming the Executive Committee, which is the highest state-level executive organ. State executive bodies are responsible for the execution of laws, policies and strategies falling within their jurisdiction. These include administering land and other natural resources in keeping with Federal laws, formulating and execution economic, social and development policies, strategies and plans of the state in question.

Consequently, health, security, and agricultural development and similar other matters seriously demand that the pertinent Federal and State executive organs work in close collaboration. There could be contexts where the common decisions of the two become vital to ensure maximum benefits in a particular area. But there is a weak exchange of information between the two levels. Under such circumstances, it is possible that the regional states can only issue and enforce their own laws not that of the federal government.

The most important factor which underlines the further autonomy of the regional states is the assigning of residual power. The Federal Constitution as stipulated in Article 52(1) states that "All powers not given expressly to the Federal Government alone, or concurrently to the Federal Government and States are reserved to the States". Accordingly, any residual power unspecified in the constitution is left for the States. It thus allocates residual authority to the constituent units. The significance of the residual power is that the regional states can exercise legislative power over matters not specified in the constitution.

The above three points suggest that the relationship between the federal government and the regional states is asymmetrical, even though they are in principle considered to be equal. Nonetheless, the financial and manpower resources of the regions are very limited. The revenue base of the regions is not that productive and expansive. Currently, they are dependent on federal fund, particularly for capital budget. They are not yet economically strong to claim that their laws supersede that of the federal law. According to the constitution, they are given all the power to develop their region.

As can be inferred from Sub-Article 7 of Article 62 of the FDRE Constitution, which enumerates the powers and functions of the House of Federation, there is a possibility by which the Federal Government may transfer revenue to the regional governments. Such a system of transfer payments or grants, by which a central government shares its revenues with lower levels of government, is an important aspect of the subject matter of ‘fiscal federalism’. The underlying rationale behind transfer of revenue is the existence of a fiscal gap at the sub-national level emanating from lack of locally generated own revenue to finance own expenditure; differences in the regions’ level of economic development and endowment with natural resources lead to the formation of a fiscal gap.

Federal governments use this power to enforce national rules and standards. Such transfers of revenues usually fall under three categories: conditional, unconditional and equalization grants. A conditional transfer from a federal body to a state, or other territory, involves a certain set of conditions. If the lower level of government is to receive this type of transfer, it must agree to the spending instructions of the federal government. The second type of grant, unconditional, is usually a cash or tax point transfer, with no spending instructions. Unconditional grants are usually general purpose grants aimed at addressing vertical imbalances. The third type of grant, equalization grant, is used to address horizontal imbalances between regional governments through the channeling of resources from the relatively wealthier regions to poorer ones; thereby equalizing the capacity of regional governments to provide a national standard level of goods and services.

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Allocating the Federal Tax Burden Among the States

Download Research Aid No. 3

Research Aid No. 3

Foreword For reasons set out in this study, Federal tax A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. collections by state as reported by the Internal Revenue Service do not reflect the distribution of the burden of these taxes. For example, tobacco taxes are largely collected in North Carolina , Kentucky and Virginia , but the burden of these taxes presumably falls on people in every state according to their consumption of tobacco. However, the burden of Federal taxes can be allocated among the states according to various economic series that reflect the distribution of the burden of particular taxes.

For many years Tax Foundation has annually published an allocation of the Federal tax burden by state. These allocations have been widely used by researchers, editors and others, particularly for comparing the total of Federal grants-in-aid to states with the allocated tax cost by state of these grant programs.

An example of this application is contained in Table 6. Other organizations have used allocation bases which differ in part from those used by Tax Foundation. The resulting differences in allocation estimates give rise to questions about the several methods and assumptions used in allocating the Federal tax burden by state. Moreover, the validity of these estimates for various purposes requires some analysis of the limitations of allocation estimates.

Methods of allocation are being improved as new statistical materials permit and as more of a consensus is reached on the conceptual and technical problems involved. It is not expected, however, that there will ever be complete unanimity in the selection of methods and bases for the allocation of the Federal tax burden by state.

This research aid discusses the uses and limitations of estimates of the Federal tax burden by state, explains some of the problems involved and the methods used in these allocations, and presents Tax Foundation’s allocation of the tax burden for 1957.

Tax Foundation, a non-profit organization, is engaged in research on government spending and taxation. Its purpose is to aid in the development of more efficient government at less cost to the taxpayer. It also serves as national information agency for organized taxpayer and research groups throughout the country.

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Where Your Federal Tax Dollars Go: Understanding the Impact of Income Taxes And What Taxes Pay for

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Where Do Your Federal Tax Dollars Go? Understanding Federal Income Tax Spending & What Taxes Pay For

Ralph Carnicer, CPA

January 4, 2024

Tax season often brings questions about where our hard-earned money is going. In this article, we'll dive into the intricacies of federal income tax and unravel the mysteries behind how your tax dollars are spent. Understanding tax allocation is crucial for every taxpayer. This knowledge not only helps in comprehending the government's spending but also aids in making informed decisions during elections and public debates. 

discuss tax assignment allocated to federal government

What is Federal Income Tax and Why Do We Pay It?

Federal income tax , a critical element of the U.S. taxation system, is collected by the federal government from individuals and businesses. This tax is based on taxpayers' income, including wages, salaries, and investment earnings. Its primary purpose is to fund government operations and public services, ranging from national defense to social programs. The amount of federal income tax an individual or business owes varies depending on their income level, deductions, and credits. This progressive tax system ensures that higher-income people pay a larger portion of their tax earnings. The collection and management of federal income taxes are overseen by the Internal Revenue Service (IRS), which ensures compliance with tax laws and collects taxes owed.

How Does the Federal Budget Utilize Our Taxes?

The federal budget, crafted annually by the government, reflects the nation's priorities in spending tax revenues. It allocates funds to various sectors, including defense, healthcare, education, and infrastructure. The largest portions often go towards mandatory spending, such as Social Security, Medicare, and Medicaid. Discretionary spending, another significant component, covers areas like military funding, educational programs, and scientific research. The budget also addresses interest payments on the national debt. It is a tool for economic policy, aiming to balance resource allocation between immediate needs and long-term investments. The process of creating and approving the federal budget involves both the President and Congress, reflecting the complexities of governance and fiscal policy.

Social Security: How Much of Our Taxes Support It?

Social Security , funded primarily through payroll taxes, is a vital part of the federal budget. It provides financial assistance to retirees, disabled individuals, and survivors of deceased workers. The program is designed as a social safety net to ensure a basic level of income for these groups. A significant portion of federal tax revenue, specifically from payroll taxes, is dedicated to this program. The Social Security Administration manages these funds, which are separate from the general federal budget. As the population ages, the proportion of tax revenue allocated to Social Security has been increasing, highlighting its importance in supporting an aging demographic.

Medicare Funding: A Critical Use of Tax Dollars

Medicare, a federal health insurance program for people aged 65 and older and for certain younger people with disabilities, is a major recipient of federal tax dollars. It is funded through a combination of payroll taxes , premiums paid by beneficiaries, and general tax revenue. Medicare provides vital healthcare coverage, including hospital care, physician services, and prescription drugs. The funding for Medicare is critical to ensuring that seniors and disabled individuals have access to affordable healthcare. As healthcare costs continue to rise, the portion of the federal budget allocated to Medicare has become increasingly significant, reflecting the importance of healthcare in public spending.

National Defense: Allocating Taxes for Safety and Security

National defense is one of the largest categories of federal spending, reflecting the government's commitment to national security and military readiness. Tax dollars allocated to defense cover a wide range of expenses, including personnel salaries, equipment, research and development, and operations. The Department of Defense manages these funds, ensuring that the military is prepared to respond to national security challenges. The allocation to national defense is often a subject of public debate, balancing the need for security with other national priorities. This spending category is crucial for maintaining the United States' position and responsibilities on the global stage.

Federal Spending: Where Else Does the Money Go?

Beyond the major sectors of Social Security, Medicare, and national defense, federal spending extends to various other areas. These include funding for scientific and medical research, which drives innovation and public health initiatives. Education spending supports public schools, higher education, and student loan programs. Infrastructure investments cover transportation, energy, and community development projects. Environmental protection, international aid, and housing assistance are also part of federal spending. This diverse allocation reflects the government's role in addressing a wide range of national needs and priorities.

The Role of Property Tax and Salary Deductions

Property taxes and salary deductions are integral components of the broader tax system. Property taxes, primarily levied by local governments, fund services like public schools, emergency services, and local infrastructure. Salary deductions include federal income tax and payroll taxes for Social Security and Medicare. These deductions reduce an individual's take-home pay but are essential for funding federal programs and services. Understanding these forms of taxation helps taxpayers recognize their contributions to both local and federal budgets and the services they receive in return.

Filing Your Taxes: Understanding the IRS Process

The process of filing taxes, overseen by the IRS, involves reporting income and calculating taxes owed. It can include claiming deductions and credits to reduce tax liability. The IRS provides guidelines and resources to assist in accurate tax filing. Tax professionals can offer expertise, particularly in complex tax situations. Timely and accurate filing is important to avoid penalties and ensure compliance with tax laws. Tax season is an opportunity for individuals and businesses to reconcile their tax responsibilities with their income and expenses for the previous year.

Taxpayer Rights and Responsibilities

Taxpayers have specific rights and responsibilities under the law. Rights include fair treatment by the IRS, privacy, and confidentiality regarding tax matters. Taxpayers are responsible for filing accurate and timely tax returns, paying any taxes owed, and keeping records. Understanding these rights and responsibilities is crucial for navigating the tax system effectively and avoiding legal issues. The IRS is committed to ensuring that taxpayers understand and can exercise their rights.

Planning for Future Tax Seasons: Tips and Strategies

Effective tax planning involves understanding potential deductions and credits, keeping accurate financial records, and staying informed about tax law changes. Utilizing tax-advantaged savings accounts, such as retirement accounts, can reduce taxable income. Seeking advice from tax professionals can be beneficial, especially for complex tax situations. Anticipating tax liabilities and planning throughout the year can prevent surprises during tax season and potentially reduce the amount of taxes owed. Staying organized and informed is key to a smooth and successful tax filing experience.

Key Takeaways: Understanding What Federal Taxes Pay For | Federal Spending

  • Federal Income Tax : In the 2023 fiscal year, individual income taxes are required to be paid by American taxpayers, including federal retirees and veterans.
  • Where Tax Dollars Go : Tax dollars are allocated to various sectors, such as social security and Medicare, which provide health coverage and are a safety net for low-income individuals and dependents.
  • Federal Spending in 2023 : A significant percent of the budget goes towards defense spending, social security, and Medicare, as well as scientific and medical research.
  • State and Local Taxes : Besides federal taxes, state tax and sales tax are collected by state governments and local governments, respectively, often used for goods and services like housing assistance.
  • Tax Rates and Forms : Tax rates vary each tax year, and different tax forms are used for personal income taxes and business taxes.
  • Tax Credits and Deductions : Tax credits like the Earned Income Tax Credit and child tax credit can lower the amount of taxes you pay.
  • Budget and Policy Priorities : The Center on Budget and Policy Priorities focuses on how federal tax dollars go towards various programs and services, including those for federal health and public safety.
  • Sales and Excise Taxes : Sales and excise taxes, collected by the state department of revenue, contribute to the state and local budgets.
  • Tax Bills and Paying Taxes : Understanding your tax bill is crucial for effectively managing the taxes you pay. In 2022, numerous changes to tax regulations affected how taxpayers pay in taxes.
  • Government Agencies and Programs : Federal and state governments provide various services and programs, including safety net programs like Medicaid and the Children's Health Insurance Program.
  • Tax Responsibilities : It’s time to file your taxes when the fiscal year ends, and being aware of your responsibilities, such as the proper submission of tax forms, is essential.
  • Scientific Research Funding : A portion of tax money is spent on scientific and medical research, highlighting the government's commitment to advancing health and safety.
  • Retiree Benefits : Federal tax dollars go towards benefits for federal retirees, ensuring they have support after their service.
  • Tax Planning for Future Years : Planning ahead for the next tax year can help American taxpayers effectively manage their individual income and understand where their taxes go, especially in terms of federal health programs like Medicare.

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