Fiscal Federallism

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Introduction:
Principles of Fiscal Federalism
a n wa r s h a h
A large and growing number of countries are re-examining the roles of var-
ious orders of government and their partnerships with the private sector
and civil society in order to improve their ability to serve their people more
effectively and efficiently. This rethinking has led to a resurgence of inter-
est in the principles and practices of fiscal federalism. Federal systems are
seen to provide safeguards against the threat of centralized exploitation as
well as decentralized opportunistic behaviour while bringing decision mak-
ers closer to the people. The principles of fiscal federalism are concerned
with the design of fiscal constitutions – that is, how taxing, spending, and
regulatory functions are allocated among governments and how intergov-
ernmental transfers are structured. These arrangements are of fundamen-
tal importance to the efficient and equitable provision of public services.
This chapter begins by reviewing basic concepts in federalism. This is
followed by a discussion of the conceptual underpinnings of federal fiscal
constitutions. The principles of fiscal federalism outlined in this chapter are
primarily based on economic premises; hence, they are limited in their ap-
plication to economic criteria. Some nations may well consider political, so-
ciological, and historical criteria of greater relevance in their circumstances.
A discussion of the conceptual basis of expenditure assignment is
followed by a review of the theory of tax assignment. Tax-base and reve-
nue-sharing concepts and transfer mechanisms are then introduced
briefly. A concluding section brings together the main themes of the
fiscal federalism literature.
basic concepts of federalism
Constitutional divisions of powers among various orders of government fall

into three categories: unitary, federal, and confederal.
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4 Anwar Shah
Unitary Government
A unitary country has a single or multi-tiered government in which effec-

tive control of all government functions rests with the central government.
A unitary form of government facilitates centralized decision making to
further national unity. It places a greater premium on uniformity and
equal access to public services than it does on diversity. An overwhelming
majority of countries (148 of 193 countries in 2006) have a unitary form
of government. The city-states of Singapore and Monaco are single-tiered
unitary governments. China, Egypt, France, Indonesia, Italy, Japan, Korea,
New Zealand, Norway, the Philippines, Portugal, Sweden, Turkey, and the
United Kingdom have multi-tiered governments based on unitary constitu-
tions. As a result, some unitary countries (e.g., China, Denmark, Norway,
and Sweden) are more fiscally decentralized than are some federal coun-
tries, such as Australia and India.
Federal Government
A federal form of government has a multi-order structure, with all orders

of government having some independent as well as shared decision-
making responsibilities. Federalism represents either a “coming together”
or a “holding together” of constituent geographic units to take advantage
of the greatness and smallness of nations in a flat (globalized) world in
which many nation-states are too large to address the small things in life
and too small to address large tasks.1 Subscribing to the “coming together”
view of federalism, Daniel J. Elazar pointed out and elaborated that the
word “federalism” has its roots in the Latin foedus, meaning “league,”
“treaty,” or “compact.”2 More recently, Robert Inman noted that “the word
‘federal’ has come to represent any form of government that brings to-
gether, in an alliance, constituent governments each of which recognizes
the legitimacy of an overarching central government to make decisions on
some matters once exclusively the responsibility of individual member
states.”3 “Coming together” has been the guiding framework for mature
federations such as the United States, Canada, and, more recently, the Eu-
ropean Union. The alternative “holding together” view of federalism, also
called “new federalism,” represents an attempt to decentralize responsibili-
ties to state-local orders of government with a view to overcoming regional
and local discontent with central policies. This view is the driving force be-
hind the current interest in principles of federalism in unitary countries
and in relatively newer federations such as Brazil and India and emerging
federations such as Iraq, Spain, and South Africa.
A federal form of government promotes decentralized decision making
and, therefore, is conducive to greater freedom of choice, diversity of
Introduction: Principles of Fiscal Federalism 5
preferences in public services, political participation, innovation, and

accountability.4 It is also better adapted to handle regional conflicts. Such
a system, however, is open to a great deal of duplication and confusion in
areas of shared rule and requires special institutional arrangements to
secure national unity, ensure regional equity, and preserve an internal
common market.
Federal countries broadly conform to one of two models: dual federalism
or cooperative federalism. Under dual federalism, the responsibilities of the
federal and state governments are separate and distinct. According to
William H. Riker, under such a system, “two levels of government rule the
same land and the people, (2) each level has at least one area of action in
which it is autonomous, and (3) there is some guarantee … of the auton-
omy of each government in its own sphere.”5 Under cooperative federal-
ism, the responsibilities of various orders are mostly interlinked. Under
both these models, fiscal tiers are organized so that the national and state
governments have independent authority in their areas of responsibility
and act as equal partners. National and state governments often assume
competitive, non-cooperative roles under such an arrangement. Dual fed-
eralism takes either the layer cake or coordinate-authority approach. Under
the layer-cake model, practised in Mexico, Malaysia, and Russia, there is a
hierarchical (unitary) type of relationship among the various orders of
government. The national government is at the apex, and it has the option
to deal with local governments either through state governments or more
directly. Local governments do not have any constitutional status: they are
simply extensions of state governments and derive their authority from
state governments. In the coordinate-authority model of dual federalism,
states enjoy significant autonomy from the federal government, and local
governments are simply handmaidens of the states and have little or no di-
rect relationship with the federal government. The working of the federa-
tions of Australia, Canada, India, Pakistan, and the United States resembles
the coordinate-authority model of dual federalism.
The cooperative federalism model has, in practice, taken three forms: in-
terdependent spheres, marble cake, and independent spheres. In the
interdependent spheres variety as practised in Germany and South Africa
(a unitary country with federal features), the federal government deter-
mines policy, and the state and local governments act as implementation
agents for federally determined policies. In view of federal domination of
policy making, in this model, state/provincial governments have a voice in
federal policy making through a second chamber (the upper house of the
Parliament). In Germany and South Africa, the second-order (state) gov-
ernments are represented in the upper house of the national parliament
(the Bundesrat and the Council of the Provinces, respectively). In the mar-
ble cake model of cooperative federalism, various orders of government
6 Anwar Shah
have overlapping and shared responsibilities, and all constituent govern-

ments are treated as equal partners in the federation. Belgium, with its
three territorial and four linguistic jurisdictions, has a strong affinity with
this approach. Finally, in a model of cooperative federalism with indepen-
dent spheres of government, all orders of government enjoy autonomous
and equal status and coordinate their policies horizontally and vertically.
Brazil is the only federation practising this form of federalism.
The competitive federalism model is a theoretical construct advanced by
the fiscal federalism literature and not yet practised anywhere in its pure
form. According to this construct, all orders of government should have
overlapping responsibilities, and they should compete both vertically and
horizontally to establish their clientele of services.6 Some analysts argue
that such a competitive framework would create leaner and more efficient
governments that would be more responsive and accountable to people.
Countries with a federal form of government vary considerably in terms of
federal influence on subnational governments. Such influence is very strong
in Australia, Germany, India, Malaysia, Mexico, and Pakistan; moderately
strong in Nigeria and the United States; and weak in Brazil, Canada, and
Switzerland. In the last group of countries, national control over subnational
expenditures is quite limited, and subnational governments have consider-
able authority to determine their own tax bases and tax rates. In centralized
federations, conditional grants by the federal government play a large role in
influencing the priorities of the state and local governments. In Australia, a
centralized federation, the federal government is constitutionally required
to follow regionally differentiated policies.
Federal countries also vary according to subnational influence on na-
tional policies. In some countries, there is a clear separation of national
and subnational institutions (“executive” or “interstate” federalism), and
the two orders interact through meetings of officials and ministers, as in
Australia and Canada. In Germany and South Africa, state/provincial gov-
ernments have a direct voice in national institutions (“interstate” federal-
ism). In the United States, regional and local coalitions play an important
role in the Congress. In some federal countries, constitutional provisions
require that all legislation recognize that ultimate power rests with the peo-
ple. For example, all legislation in Canada must conform to the Canadian
Charter of Rights. In Switzerland, a confederation by law but a federal
country in practice, major legislative changes require approval by refer-
endum. Such direct-democracy provisions indirectly reinforce the de-
centralized provisions of public services. In all federal countries, local
government influences on the federal and state governments remain unin-
stitutionalized and weak.
Asymmetric Federalism Countries with a federal form of governance do not

necessarily treat second orders of government in a uniform manner. They
often offer flexibility in accommodating the special needs or demands of

constituent units or impose a federal will in certain jurisdictions. This may
take the form of treating some members as less equal than others. For ex-
ample, Chechnya in Russia and Kashmir in India enjoy lesser autonomy
than do other oblasts and states. Or the federation may treat some mem-
bers as more equal than others by giving them wider powers, as is the case
with Sabah and Sarawak in Malaysia and Quebec in Canada. Some feder-
ations offer constituent units freedom of choice to be unequal or more
equal than others through opting-in or opting-out of federal arrange-
ments. Such options are part of the arrangements offered by Canada,
Spanish agreements, and the European Union’s treaty exceptions for the
United Kingdom and Denmark.7
Market Preserving Federalism Barry Weingast has advanced a theoretical con-

cept for comparative analyses of federal systems.8 Market-preserving federal-
ism is put forth as an ideal form of federal system in which (1) multiple
governments have clearly delineated responsibilities; (2) subnational gov-
ernments have primary authority over public goods and services for local au-
tonomy; (3) the federal government preserves the internal common market;
(4) all governments face the financial consequences of their decisions (hard
budget constraints); and (5) political authority is institutionalized.
Confederal Government
In a confederal system, the general government serves as the agent of the

member units, usually without independent taxing and spending powers.
The United States had a confederal system from 1781 to 1787. The United
Nations, the European Union, and the Commonwealth of Independent
States (cis), which now consists of 11 of the former republics of the Union
of Soviet Socialist Republics (ussr), approximate the confederal form of
government. A confederal system suits communities that are internally
homogeneous but, as a group, completely heterogeneous. The European
Union, however, over time has consistently moved to assume a federal role.
the genesis of fiscal federalism
Several accepted theories provide a strong rationale for decentralized

fiscal constitutions on the grounds of efficiency, accountability, manage-
ability, and autonomy.9
Home Rule
George Stigler identifies two principles of jurisdictional design:10 (1) a

representative government works best the closer it is to the people,
8 Anwar Shah
and (2) people should have the right to vote for the kind and amount
of public services they want.
These principles suggest that decision making should occur at the order
of government closest to the people consistent with the goals of alloca-
tional efficiency. Thus the optimal size of a jurisdiction would vary with
specific instances of economies of scale and benefit-cost spill-outs.
Fiscal Equivalency
A related idea on the design of jurisdictions has emerged from the public
choice literature. Mancur Olson argues that, if a political jurisdiction and
benefit area overlap, the free-rider problem is overcome and the marginal
benefit equals the marginal cost of production, thereby ensuring the opti-
mal provision of public services.11 Equating the political jurisdiction with
the benefit area is called the “principle of fiscal equivalency” and requires
a separate jurisdiction for each public service. Wallace Oates proposes a re-
lated idea, the so-called “correspondence principle.”12 According to this
principle, the jurisdiction determining the order of provision of each pub-
lic good should include precisely the set of individuals that consume it.
This generally requires a large number of overlapping jurisdictions.
The Decentralization Theorem
According to the “decentralization theorem” advanced by Oates, “each

public service should be provided by the jurisdiction having control over
the minimum geographic area that would internalize the benefits and
costs of such provision.”13 The practical implications of this theorem re-
quire a large number of overlapping jurisdictions. Bruno Frey and Reiner
Eichenberger have extended this idea to define the concept of functional,
overlapping, and competing jurisdictions (focj). They argue that jurisdic-
tions can be organized along functional lines while overlapping geographi-
cally and that individuals and communities could be free to choose among
competing jurisdictions. Revenues are raised from members in return for
delivery of services to them. The school communities of the Swiss canton of
Zurich and special districts in North America follow the focj concept.14
The Subsidiarity Principle
According to the subsidiarity principle advanced by the European

Union, taxing, spending, and regulatory functions should be exercised
by the lowest order of government (the government closest to the peo-
ple) unless a convincing case can be made for assigning these to higher
orders of government.
a l l o c at i o n o f r e s p o n s i b i l i t i e s
The “assignment problem,” or the allocation of expenditure, regulatory,

and tax functions to various orders of government, is the most fundamental
issue in a federation. The literature on fiscal federalism argues that finance
should follow function. In other words, assigning responsibilities for spend-
ing, including the exercise of regulatory functions, must precede the assign-
ment of responsibilities for taxation because tax assignment is generally
guided by the spending requirements of the different orders of government
and cannot be determined in advance. It may be desirable to decentralize
taxation at the same time as decentralizing spending, so that subnational
governments will not have to rely exclusively on grants from the national
government. If subnational governments are not responsible for raising at
least some level of their own revenues, they may have too little incentive to
provide local public services in a cost-effective way. If subnational govern-
ments are assigned more revenues than their spending requires, they may
have an incentive to reduce taxes or increase public-sector wages.
Principles of Expenditure Assignment
The fiscal federalism literature provides broad guidance in delineating ex-

penditure and regulatory responsibilities among member units in a feder-
ation. The basic principles enunciated by this literature are relevant even
for unitary states in which subnational governments are simply extensions
of higher-order governments. By following these principles, the central
government’s agents face just the right incentives for an efficient and equi-
table delivery of public services. These principles are discussed below, and,
where appropriate, qualifications for unitary governments are stated.
Efficient Provision of Public Services Public services are provided most effi-
ciently “by the jurisdiction having control over the minimum geographic
area that would internalize benefits and costs of such provision,” because:15
• Local governments understand the concerns of local residents.

• Local decision making is responsive to the people for whom the services
are intended, encouraging fiscal responsibility and efficiency, especially
if financing of services is also decentralized.
• Unnecessary layers of jurisdiction are eliminated.
• Interjurisdictional competition and innovation are enhanced.
A decentralized system ideally ensures an order and combination of

public services consistent with voters’ preferences, while providing incen-
tives for efficient provision of such services. Nevertheless, some degree of
10 Anwar Shah
central control or compensatory grants may be warranted in the provi-

sion of services when the following considerations apply:
• Spatial externalities. Spatial externalities arise when the benefits and costs
of public services are realized by non-residents. In the case of benefit
spill-outs, the jurisdiction providing the service does not consider the
proportion of benefits of a public service accruing to non-residents and
therefore underprovides such a service. The reverse result is obtained in
the case of cost spill-outs, where the public service could not be financed
by exporting taxes to other jurisdictions. There are also public services
whose benefits are considered national in scope, such as defence and
foreign affairs. As a corollary, these services would be best provided by
the federal government.
• Economies of scale. Certain services require areas larger than a local ju-
risdiction for cost-effective provision, for example, public transportation
and sewerage in metropolitan areas.
• Administrative and compliance costs. Centralized administration generally
leads to lower administrative costs associated with financing public services.
Fiscal Efficiency Decentralized decision making in a federation results in

differential net fiscal benefits (imputed benefits from public services mi-
nus tax burden) being realized by citizens depending on the fiscal capacity
of their place of residence. A richer jurisdiction can provide a higher level
of public services at a lower tax rate than can a poorer jurisdiction. It is ar-
gued that such differential net benefits (nfbs) would encourage people to
move to a resource-rich area, although appropriate economic opportuni-
ties may not exist there. Thus, resource allocation would be inefficient be-
cause people in their relocation decisions would compare gross income
(private income plus net fiscal benefits minus cost of moving) at new loca-
tions, whereas economic efficiency considerations warrant comparing pri-
vate income minus moving cost. It is argued that the national government
should have a role in correcting such a “fiscal inefficiency.”16
Regional (Horizontal) Equity Differential net fiscal benefits across jurisdic-

tions also lead to unequal treatment of citizens with identical private
incomes depending on their place of residence. This is because their after-
tax income inclusive of nfb would be different depending on their
residence. This calls for the national government to play a role in dealing
with these fiscal inequities.
The Redistributive Role of the Public Sector It is commonly argued that effec-
tive redistribution is possible only through national programs (i.e., progres-
sive income taxes and transfers to persons), suggesting that local jurisdictions
attempting to carry out redistributive policies are likely to drive out the rich.
While such arguments have merit, they leave a number of questions un-
answered. National governments often prefer to strengthen their own
power bases rather than to benefit citizens at large. In such situations, the
national government may not redistribute from the rich to the poor in a
symmetric fashion in the nation as a whole. Furthermore, views on stan-
dards for equity and methods to achieve such standards are likely to vary
across a nation, making subnational government involvement critical to
determining policies appropriate for each area. While the centre may as-
sume a dominant role in pursuit of vertical equity, the involvement of sub-
national governments in implementing specific programs can be tailored
to meet the circumstances of individual jurisdictions.17
Provision of Quasi-Private Goods Modern governments provide many ser-

vices that, by virtue of their technologies, are essentially private goods – for
example, health, education, and social insurance. Public provision of these
private services is justified on equity grounds. Given that benefits accrue
mainly to residents of separate jurisdictions, such services would be better
provided by subnational governments. The national government’s involve-
ment is nevertheless justified to ensure horizontal and minimum standards
of service in all jurisdictions. Except for minimum standards in environ-
mental protection – the absence of which would not adversely affect inter-
regional trade – such standards for most services encourage the free flow
of goods and services throughout the nation as a whole.
Preservation of the Internal Common Market Preservation of an internal com-

mon market remains an important area of concern to most nations un-
dertaking decentralization. Subnational governments, in their pursuit of
labour and capital, may indulge in beggar-thy-neighbor policies and, in
the process, erect barriers to goods and factor mobility. Thus, decentrali-
zation of government regulatory functions creates the potential for dis-
harmonious economic relations among subnational units. Accordingly,
the regulation of economic activity such as trade and investment is gen-
erally best left to national governments. It should be noted, however, that
national governments themselves may pursue policies detrimental to the
internal common market. Therefore, as suggested by Robin Boadway,
constitutional guarantees for the free domestic flow of goods and services
may be the best alternative to assigning regulatory responsibilities solely
to the national government.18
Economic Stabilization It is customary to argue that the federal govern-

ment should be responsible for stabilization policies because such policies
cannot be carried out effectively by local jurisdictions. Local pursuit of
such fiscal policies leads to much of the gains being lost to outside juris-
dictions. Monetary policy has little scope for being carried out by the local
12 Anwar Shah
governments. Guidelines for centralized fiscal policy have, however, only

limited relevance for a country with a decentralized constitution.
Decentralized fiscal policies have worked well in highly decentralized
federations such as Canada, Switzerland, and the United States, but the
concept of a decentralized monetary policy does not exist. The proposition
that monetary authority should be independent of any order of govern-
ment conflicts with a parliamentary system of government. In both Canada
and Switzerland, the monetary policy function is delegated by the federal
government to an independent central bank, while fiscal policy is a respon-
sibility shared by all orders of government. The federal governments in
these countries use their powers of the purse (transfers) and moral suasion
through joint meetings to induce a coordinated approach. The Swiss prac-
tice of allocating a portion of the profits of the central bank (seigniorage)
to cantons promotes a wider sense of ownership of the monetary authority
and could be a useful policy for other countries. An independent central
bank should have exclusive jurisdiction in monetary policy. The national
government should ensure fiscal policy flexibility by appropriately structur-
ing tax assignments and by coordinating fiscal policy through regular
meetings of officials of the national and subnational governments.
Monetary policy plays a critical role in ensuring a stable macroeconomic
environment for growth. Empirical evidence supports the view that an in-
dependent central bank with a singular focus on price stability is essential
for keeping inflation in check. Evidence on this practice confirms that
such independence is more likely granted in federal systems in view of the
presence of multiple orders of government with diverse and conflicting in-
terests. The politics of federalism dictates such an independence. There
are no such political imperatives in a unitary country unless there is an
unstable coalition in power. Thus, while monetary policy issues are mainly
governed by central bank behaviour, central bank governance is influ-
enced by the fiscal constitution of the country.
Federal fiscal constitutions appear to exert positive influence in this re-
gard. Fiscal policy coordination represents an important challenge for fed-
eral systems. In this context, fiscal rules and institutions provide a useful
framework for, but not necessarily a solution to, this challenge. Fiscal rules
binding on all orders can help sustain political commitment in countries
having coalitions or fragmented regimes in power. Coordinating institutions
help in the use of moral suasion to encourage a coordinated response.
The experiences of industrialized countries also show that, typically, uni-
laterally imposed federal controls and constraints on subnational govern-
ments do not work; instead, societal norms based on fiscal conservatism,
such as the Swiss referenda and political activism of the electorate, play im-
portant roles. Ultimately, capital markets and bond-rating agencies provide
more effective discipline on fiscal policy. In this context, it is important for
the national government not to backstop state and local debt and not to al-
low ownership of the banks by any order of government. Transparency of
the budgetary process and institutions, accountability to the electorate,
and general availability of comparative data encourage fiscal discipline.
Fiscal federalism poses significant challenges for macroeconomic man-
agement. These challenges require careful design of monetary and fiscal
institutions to overcome the adverse incentives associated with “common
property” resource-management problems or with rent-seeking behav-
iours. The experiences of federal countries indicate significant learning
and adaptation of fiscal systems to create incentives compatible with fair
play and to overcome incomplete contracts. This explains why decentral-
ized fiscal systems appear to do better than centralized fiscal systems on
most aspects of monetary and fiscal policy management and transparent
and accountable governance.19
Spending Power In a federation, there is always some degree of conflict

among the priorities established by the various orders of government. One
way to induce state and local governments to follow the priorities estab-
lished by the national government is for the latter to use its powers of the
purse, its so-called spending power. Matching transfers are often used to
influence state and local priorities. Both national and state governments
could legitimately pursue such policies; that is, state governments can also
pursue such policies with respect to their local government.
Besides having exclusive authority to carry out monetary policy and to
provide public services that are national in scope, the federal government
has a role in correcting the fiscal inefficiencies and regional inequities aris-
ing from the differential fiscal capacities of various jurisdictions. It also ex-
ercises a redistributive role through a tax and transfer system or through
the joint provision of such public services as education and health, which
are “transfers in kind.”20 The federal government may also provide com-
pensatory grants to cover the spillovers from provincial services.
Both the national and provincial governments could provide matching
transfers to influence state and local priorities to further their own objec-
tives. All other services are best provided by local governments, with the
national and provincial governments defining minimum standards. Table 1
presents a representative assignment of major public services based on the
theoretical considerations discussed above. It shows that a significant num-
ber of major services would be suitable for concurrent assignment to two or
more orders of government. For such services, in order to avoid duplication
and confusion and to ensure accountability to the electorate, it is important
to specify as clearly and as precisely as possible the roles of the various or-
ders of government. Such precise specification is critical for infrastructure
and social services in most developing countries.
14 Anwar Shah
Table 1
Representative assignment of expenditure responsibilities
Policy, Provision Production

standards, and and
Function and oversight administration distribution Comments
Interregional and U U N,P Benefits and costs

international con- international in scope
flicts resolution
Protection of U,N N N,P Has national and
fundamental rights global dimensions
External trade U U,N,S P Benefits and costs
international in scope
Telecommunications U, N P P Has national and
global dimensions
Financial U,N P P Has national and
transactions global dimensions
Environment U,N,S,L U,N,S,L N,S,L,P Externalities of global,
national, state, and local
scope
Foreign direct N,L L P Local infrastructure
investment critical
Defence N N N,P Benefits and costs
national in scope
Foreign affairs N N N Benefits and costs
national in scope
Monetary policy, U, icb icb icb, P Independence from all
currency, and orders essential; some
banking international role for
common discipline
Interstate Constitution, N P Constitutional safeguards
commerce N important for factors and
goods mobility
Immigration U,N N N U because of forced exit
Transfer payments N N N Redistribution
Criminal and civil law N,S N,S N,S Rule of law, a national
concern but states may
have special concerns
such as the French Civil
Law in Quebec
Industrial policy N N P Intended to prevent
“beggar thy neighbor”
policies
Table 1
Representative assignment of expenditure responsibilities (Continued)
Policy, Provision Production

standards, and and
Function and oversight administration distribution Comments
Regulation N,S,L N,S,L N,S,L,P N for Internal common

market, S,L for regional
and local concerns
Fiscal policy N N,S,L N,S,L,P Coordination possible
Natural resources N N,S,L N,S,L,P Promotes regional equity
and internal common
market
Education, health, N,S,L S,L S,L,P Transfers in kind
and social welfare
Highways N,S,L N,S,L S,L,P Benefits and costs vary
in scope
Parks and recreation N,S,L N,S,L N,S,L,P Benefits and costs vary
in scope
Police S, L S,L S,L Primarily local benefits
Water, sewer, refuse, L L L,P Primarily local benefits
and fire protection
Sources: Anwar Shah, The Reform of Intergovernmental Fiscal Relations in Developing and Emerging Market Economies
(Washington, dc: World Bank, 1994); Anwar Shah, “Fiscal Decentralization in Transition Economies and
Developing Countries,” in Federalism in a Changing World: Learning from Each Other, ed. R. Blindenbacher
and A. Koller, 432–60 (Montreal and Kingston: McGill-Queen’s University Press, 2003).
Note: U = supranational responsibility, icb = independent central bank, N = national government, S = state
or provincial government, L = local government, and P = nongovernmental sectors or civil society.
Roles and Responsibilities of Local Governments
The fiscal federalism approach treats local government as a subordinate

order in a multi-tiered system and outlines principles for defining the
roles and responsibilities of the orders of government. Hence, in most
federations, as in Canada and the United States (dual federalism), local
governments are extensions of the state governments. In a few isolated
instances, as in Brazil (cooperative federalism), they are equal partners with
the national and state governments. And, in an exceptional case, Switzer-
land, communes are the main source of sovereignty and have greater
constitutional significance than does the federal government. Thus, de-
pending on the constitutional and legal status of local governments, state
governments in federal countries assume varying degrees of oversight
16 Anwar Shah
with regard to the provision of local public services. That is why there is
an insignificant role for local governments in Australia but an expansive
role in Brazil and Switzerland.
The fiscal federalism literature, however, does provide a normative
framework for assigning responsibilities to local governments. The assign-
ment of public services to local governments or to metropolitan or re-
gional governments can be based on considerations such as economies of
scale, economies of scope (appropriate bundling of local public services to
improve efficiency through information and coordination economies, and
enhanced accountability through voter participation and cost recovery),
cost-benefit spillovers, proximity to beneficiaries, consumer preferences,
and budgetary choices about the composition of spending. The particular
order of government to which a service is assigned determines the public
or private production of the service in accordance with considerations of
efficiency and equity.
Large metropolitan areas with populations in excess of one million
could be considered for subdivision into a first tier of municipal govern-
ment of smaller size responsible for neighbourhood-type services and a
second tier of metropolitan-wide government responsible for area-wide
services. The first-tier governments could be directly elected, and elected
mayors of these governments could form the metropolitan council at the
second tier. Two-tier structures for metropolitan governance have been
practised in Melbourne, Australia; Vancouver, Canada; Allegheny County,
Pennsylvania, United States; and Stockholm, Sweden.
In mature federations, special-purpose agencies or bodies deliver a wide
range of metropolitan and regional public services, including education,
health, planning, recreation, and environmental protection. Such bodies
can include education and library boards; transit and police commissions;
and utilities providing water, gas, and electricity. These agencies deal with
public services whose delivery areas transcend political jurisdictions and
that are better financed by loans, user charges, and earmarked benefit
taxes, such as a supplementary mill rate on a property tax base to finance a
local school board. If kept to a minimum, such agencies help fully exploit
economies of scale in the delivery of services where political boundaries
are not consistent with service areas. A proliferation of these agencies
can undermine accountability and budgetary flexibility in the local arena.
Accountability and responsiveness to voters are weakened if members of
special-purpose bodies are appointed rather than elected. Budgetary flexi-
bility is diminished if a majority of local expenditures fall outside the
control of local councils.
Table 2 provides a subjective assessment of how various allocation criteria
favour local or metropolitan assignment and whether public or private pro-
duction is favoured for efficiency or equity. The criteria and the assessment
Table 2
Assignment of local public services to municipal and regional/metropolitan governments
Allocation criteria for public vs.

Allocation criteria for provision private production
Economies Economies Benefit-cost Political Consumer Economic evaluation

Public service of scale of scope spillout proximity sovereignty of sectoral choices Composite Efficiency Equity Composite
Fire fighting L L L L L M L P G P
Police protection L L L L L M L P G G
Refuse collection L L L L L M L P P P
Neighbourhood parks L L L L L M L P G G
Street maintenance L L L L L M L P P P
Traffic management L M L L L M L P P P
Local transit service L M L L L M L P P P
Local libraries L L L L L M L G G G
Primary education L L M M L M M P G P,G
Secondary education L L M M L M M P G P,G
Public transport M M M L,M M M M P,G G P,G
Water supply M M M L,M M M M P G P,G

Table 2
Assignment of local public services to municipal and regional/metropolitan governments (Continued)
Allocation criteria for public vs.

Allocation criteria for provision private production
Economies Economies Benefit-cost Political Consumer Economic evaluation

Public service of scale of scope spillout proximity sovereignty of sectoral choices Composite Efficiency Equity Composite
Sewage disposal M M M M M M M P,G P,G P,G
Refuse disposal M M M M M M M P P P
Public health M M M M M M M G G G
Hospitals M M M M M M M P,G G P,G
Electric power M M M M M M M P p P
Air and water pollution M M M M M M M G G G
Special police M M M M M M M G G G
Regional parks M M M L,M M M M G G G
Regional planning M M M L,M M M M G G G
Note: L = local government, M = regional/metropolitan government, and G = sector.

presented in this table are arbitrary; practical and institutional consider-

ations should be applied to this analysis, and the reader may well reach
different conclusions using the same criteria. Further, in recent years, global-
ization and the information revolution appear to place a premium on the
role of local government as facilitator of a broad network of service providers
in a local area to further local economic development goals and to improve
economic and social outcomes for local residents.21
Private-sector participation can also take a variety of forms, including
contracting through competitive biddings, franchise operations (local gov-
ernment acting as a regulatory agency), grants (usually for recreational
and cultural activities), vouchers (redeemable by local government with
private providers), volunteers (mostly in fire stations and hospitals), com-
munity self-help activities (for crime prevention), and private nonprofit
organizations (for social services). Thus, a mix of delivery systems is ap-
propriate for local public services, with local government acting as a pur-
chaser, regulator, or financier but not necessarily as a provider of local
public services. In most developing countries, the financial capacities of
local governments are quite limited. Fostering private-sector participation
in the delivery of local public services thus assumes greater significance.
Such participation enhances accountability and choice in the local public
sector. However, assigning responsibility for the provision of a service to a
specific order of government does not imply that government should be
directly engaged in its production. It may simply finance, purchase, or
regulate such a service. Limited empirical evidence suggests that public-
private competition and/or private production of some services promotes
efficiency and equity.
Principles of Tax Assignment
The division of revenue sources among federal and subnational govern-

ments constitutes the tax assignment problem. Once expenditure and reg-
ulatory assignments have been agreed on, tax assignment and the design
of transfers become critical elements in matching expenditure needs with
revenue means at various orders of government. Although tax assignment
can be undertaken independently of expenditure assignment – a common
practice in developing countries – the advantages of a centralized tax
administration and a decentralized provision of public services become
apparent when tax assignment reflects anticipated spending. Such ar-
rangements prevent an overdependence by state and local governments on
intergovernmental transfers, which can otherwise distort local spending
priorities. Where theoretical guidance on tax assignment is unclear, expen-
diture assignment can provide a powerful argument for assigning responsi-
bility to the government with the greatest need for more money. Efficiency
20 Anwar Shah
and equity arguments have to be tempered by administrative consider-

ations, and the exact assignment depends on informed judgment. We can,
however, outline the economic principles that come into play in deciding
which taxes to assign to what order of government.
Four general principles require consideration in assigning taxing powers
to various governments. First, the economic efficiency criterion dictates that
taxes on mobile factors and tradable goods that have a bearing on the effi-
ciency of the internal common market should be assigned to the national
government. Subnational assignment of taxes on mobile factors may facilitate
the use of socially wasteful beggar-thy-neighbour policies to attract resources
to own areas by regional and local governments. In a globalized world, even
the national assignment of taxes on mobile capital may not be very effective
in the presence of foreign tax havens and the difficulty of tracing and attrib-
uting incomes from virtual transactions to various physical spaces.
Second, national equity considerations warrant that progressive redistrib-
utive taxes should be assigned to the national government. This assign-
ment limits the possibility of regional and local governments’ following
perverse redistribution policies using both taxes and transfers to attract
high-income people and to repel low-income ones. Doing so, however,
leaves open the possibility of supplementary, flat-rate, local charges on
residence-based national income taxes.
Third, the administrative feasibility criterion (lowering compliance and
administration costs) suggests that taxes should be assigned to the jurisdic-
tion with the best ability to monitor relevant assessments. This criterion
minimizes administrative costs as well as the potential for tax evasion. For
example, property, land, and betterment taxes are good candidates for lo-
cal assignment because local governments are in a good position to assess
the market values of such assets.
Fourth, the fiscal need, or revenue adequacy, criterion suggests that, to ensure
accountability, revenue means (the ability to raise revenues from own
sources) should be matched as closely as possible to expenditure needs. The
literature also argues that long-lived assets should primarily be financed by
raising debt so as to ensure equitable burden-sharing across generations.22
Furthermore, such large and lumpy investments typically cannot be financed
by current revenues and reserves alone.
These four principles suggest that user charges are suitable for use by all
orders of government, but the case for decentralizing taxing powers is not
as compelling as is that for decentralizing public service delivery. This is be-
cause regional (province/state) and local taxation can introduce ineffi-
ciencies into the allocation of resources across the federation and cause
inequities among people in different jurisdictions. In addition, collection
and compliance costs can increase significantly. These problems are more
severe for some taxes than for others, so the selection of which taxes to
decentralize must be made with care, balancing the need to achieve and
sustain fiscal and political autonomy and accountability at regional and lo-
cal orders of government against the disadvantages of having a fragmented
tax system. The trade-off between increased accountability and increased
economic costs from decentralizing taxing responsibilities can be miti-
gated by fiscal arrangements that permit joint occupation and harmoniza-
tion of taxes to overcome fragmentation. In addition, fiscal equalization
transfers can reduce the fiscal inefficiencies and inequities that arise from
different fiscal capacities across regional and local governments.
Table 3 shows the assignment of major taxation instruments to various
orders of government based on the criteria discussed earlier. Box 1 pre-
sents guidance on local finances.
instruments of intergovernmental finance
Instruments of intergovernmental finance have an important bearing on

efficiency, equity, and accountability in federal systems.
Tax-Base and Revenue-Sharing Mechanisms
Tax-base and revenue-sharing mechanisms are customarily used to address

fiscal imbalances or mismatched revenue means and expenditure needs
arising from the constitutional assignment of taxes and expenditures to
different orders of government. Tax-base sharing means that two or more
orders of government levy rates on a common base. Tax-base determina-
tion usually rests with the national or state government, with the state and
local governments levying supplementary rates on the same base. Tax col-
lection is by one order of government, generally the national government
in market economies and the local government in centrally planned econ-
omies, with proceeds shared downward or upward depending on revenue
yields. Tax-base sharing is quite common in mature federations and almost
nonexistent in newer federations in developing countries.
A second method of addressing vertical fiscal imbalances is revenue
sharing, whereby one order of government has unconditional access to a
specified share of revenues collected by another order. Revenue-sharing
agreements typically specify how revenues are to be shared among the fed-
eral government and the state and local governments, with complex crite-
ria for allocation and for the eligibility and use of funds. Such limitations
run counter to the underlying rationale of unconditionality. Revenue-
sharing mechanisms are quite common in developing countries. They of-
ten address multiple objectives, such as bridging the fiscal gap, promoting
fiscal equalization and regional development, and stimulating tax efforts
by state and local governments.
22 Anwar Shah
Table 3
Representative assignment of taxing powers
Determination of
Collection and
Type of tax Base Rate administration Comments
Customs N N N,P International trade taxes

Corporate income N,U N,U N,U Mobile factor, stabilization tool
Resource taxes
Resource rent tax N N N Highly unequally distributed
(profits, income) tax bases
Royalties, fees, charges, S,L S,L S,L,P Benefit taxes/charges for
severance taxes; state-local services
Conservation charges S,L S,L S,L,P To preserve local environment
Personal income N N,S,L N Redistributive, mobile factor;
stabilization tool
Wealth taxes (taxes on N N,S N Redistributive
capital, wealth, Wealth
transfers, inheritances,
and bequests)
Payroll N,S N,S N,S Benefit charge, e.g., social
security coverage
Multistage sales taxes N N,S N,S Border tax adjustments possi-
(value-aided tax [vat]) ble under federal assignment;
potential stabilization tool
Single-stage sales taxes

(manufacturer, whole-
sale, retail)
Option A S S,L S,L Higher compliance cost
Option B N S N Harmonized, lower compli-
ance cost
“Sin” taxes
Excises on alcohol and N,S N,S N,S,P Health care a shared responsi-
tobacco bility
Betting, gambling S,L S,L S,L,P State and local responsibility
Lotteries S,L S,L S,L,P State and local responsibility
Race tracks S,L S,L S,L,P State and local responsibility
Table 3
Representative assignment of taxing powers (Continued)
Determination of
Collection and
Type of tax Base Rate administration Comments
Taxation of “bads”
Carbon N,U N,U N,U To combat global/national
pollution
BTU taxes N,S,L N,S,L N,S,L,P Pollution impact may be
national, regional, or local
Motor fuels N,S,L N,S,L N,S,L,P Tolls on federal/provincial/
local roads
Effluent charges N,S,L N,S,L N,S,L,P To deal with interstate, inter-

municipal or local taxes
Congestion tolls N,S,L N,S,L N,S,L,P Tolls on federal/provincial/
local roads
Parking fees L L L,P To control local congestion
Motor vehicles
Registration, transfer S S S State responsibility
taxes, and annual fees
Driver’s kitchen and fees S S S State responsibility
Business taxes S S S Benefit tax
Excises S,L S,L S,L Residence-based taxes
Property S L L Completely immobile factor,
benefit tax
Land S L L Completely immobile factor,
benefit tax
Frontage, betterment S,L L L Cost recovery
Poll N,S,L N,S,L N,S,L Payment for services
User charges N,S,L N,S,L N,S,L,P Payment for services received
Note: U = supranational agency, N = national/federal, S = state or province, L = municipal or local, and

P = private.
24 Anwar Shah
Box 1
Key considerations and tools for local government finances
key considerations
The overall objective of local governments is to maximize social outcomes for residents
and to provide an enabling environment for private-sector development through efficient
provision of public services. This requires that local financing should take into account
the following considerations:
• Local government should limit self-financing of redistributive services.
• Business should be taxed only for services to businesses and not for redistributive pur-
poses.
• Current period services should be financed out of current year operating revenues, and
future period services should be financed by future period taxes, user charges/fees,
and borrowing.
• Residential services should be financed by taxes and fees on residents.
• Business services should be financed on site/land value taxes and user charges. Profit,
output, sales, and moveable asset taxes may drive business out of the jurisdiction.
tools for local finance

• Local taxes for services with public goods characteristics – streets, roads, street lighting
• User charges for services with private goods characteristics – water, sewerage, solid waste
• Conditional, non-matching, output-based grants from national/state-order governments for

merit goods: education and health
• Conditional matching grants for spillovers in some services
• Unconditional grants for fiscal gap and equalization purposes
• Capital grants for infrastructure if fiscal capacity is low
• Capital market finance for infrastructure if fiscal capacity is high
• Development charges for financing growth with higher charges for developing land on
local government boundaries
• Public-private partnerships for infrastructure finance but keeping public ownership and
control of strategic assets
• Tax increment financing districts to deal with urban blight. For this purpose, the area
should be designated for redevelopment and annual property tax revenues frozen at
pre-vitalization levels. For a specified period, say fifteen to thirty-five years, all tax reve-
nues above base are used for redevelopment. Capacity improvements are undertaken
through municipal borrowing/bonds against expected tax increments.
Source: Robert P. Inman, “Financing Cities,” nber Working Paper 11203, National Bureau of Economic
Research, Cambridge, ma, 2005; and Anwar Shah, ed., Local Governance in Developing Countries (Washington,
dc: World Bank, 2006).
Intergovernmental Transfers
Intergovernmental transfers, or grants, can be broadly classified into two

categories: general-purpose (unconditional) and specific-purpose (condi-
tional or earmarked).
General-Purpose Transfers General-purpose transfers are provided as gen-

eral budget support, with no strings attached. These transfers are typically
mandated by law, but occasionally they may be ad hoc or discretionary.
Such transfers are intended to preserve local autonomy and to enhance in-
terjurisdictional equity. That is why Article 9 of the European Charter of
Local Self-Government advocates such transfers: “As far as possible, grants
to local authorities shall not be earmarked for the financing of specific
projects. The provision of grants shall not remove the basic freedom of lo-
cal authorities to exercise policy discretion within their own jurisdiction.”23
General-purpose transfers are termed block (also “bloc”) transfers when
they are used to provide broad support in a general area of subnational ex-
penditures (such as education), while allowing recipients discretion in al-
locating the funds among specific uses. Block grants are a vaguely defined
concept. They fall in the grey area between general-purpose and specific-
purpose transfers as they provide budget support with few strings attached
in a broad but specific area of subnational expenditures. The Community
Development Block Grant for poor municipalities in the United States is
one example.
General-purpose transfers simply augment the recipient’s resources. Be-
cause the grant can be spent on any combination of public goods or services
or can be used to provide tax relief to residents, general non-matching assis-
tance does not affect relative prices. Formula-based general-purpose trans-
fers are very common. The federal and state transfers to municipalities in
Brazil are examples of grants of this kind. Evidence suggests that such trans-
fers induce municipalities to underutilize their own tax bases.24
Specific-Purpose Transfers Specific-purpose, or conditional, transfers are in-

tended to provide incentives for governments to undertake specific pro-
grams or activities. These grants may be regular or mandatory in nature or
they may be discretionary or ad hoc.
Conditional transfers typically specify the type of expenditures that can
be financed (input-based conditionality). These may be capital expen-
ditures, operating expenditures, or both. Conditional transfers may also
require attainment of certain results in service delivery (output-based con-
ditionality). Input-based conditionality is often intrusive and unproductive,
whereas output-based conditionality can advance grantors’ objectives while
preserving local autonomy.
26 Anwar Shah
Conditional non-matching transfers provide a given level of funds with-

out local matching as long the funds are spent for a particular purpose.
Conditional non-matching grants are best suited for subsidizing activities
considered high priority by a national or state government but low priority
by local governments.
Conditional transfers may incorporate matching provisions, requiring
grant recipients to finance a specified percentage of expenditures using
their own resources. Matching requirements can be either open-ended
(meaning that the grantor matches whatever level of resources the recipient
provides) or closed-ended (meaning that the grantor matches recipient
funds only up to a pre-specified limit).
Matching requirements encourage greater scrutiny and local ownership
of grant-financed expenditures; closed-ended matching is helpful in ensur-
ing that the grantor has some control over the costs of the transfer pro-
gram. Matching requirements, however, represent a greater burden for a
recipient jurisdiction with limited fiscal capacity. In view of this, it may be
desirable to set matching rates in inverse proportion to the per capita fiscal
capacity of the jurisdiction in order to allow poorer jurisdictions to partici-
pate in grant-financed programs.
Conditional open-ended matching grants are the most suitable vehicles
through which to induce state and local governments to increase spending
on the assisted function. If the objective is simply to enhance the welfare of
local residents, general-purpose non-matching transfers are preferable as
they preserve local autonomy. To ensure accountability for results, condi-
tional non-matching output-based transfers are preferable to other types of
transfers. Output-based transfers respect local autonomy and budgetary
flexibility while providing incentives and accountability mechanisms to
improve service-delivery performance.
Designing Fiscal Transfers: Dividing the Spoils or Creating a Framework

for Accountable and Equitable Governance?
The design of fiscal transfers is critical to ensuring the efficiency and equity
of local service provision and the fiscal health of subnational govern-
ments.25 A few simple considerations can be helpful in designing these
transfers:
Guidelines for Grant Design
1 Clarity in grant objectives. Grant objectives should be specified clearly

and precisely.
2 Autonomy. Subnational governments should have complete indepen-
dence and flexibility in setting priorities. They should not be constrained
by the categorical structure of programs and uncertainty associated with

decision making by national officials. Tax-base sharing – allowing subna-
tional governments to introduce their own tax rates on national bases,
formula-based revenue sharing, or block grants – is consistent with
this objective.
3 Revenue adequacy. Subnational governments should have adequate reve-
nues to discharge designated responsibilities.
4 Responsiveness. The grant program should be flexible enough to accom-
modate unforeseen changes in the fiscal situation of the recipients.
5 Equity (fairness). Allocated funds should vary directly with fiscal-need
factors and inversely with the tax capacity of each jurisdiction.
6 Predictability. The grant mechanism should ensure predictability of sub-
national governments’ shares by publishing five-year projections of fund-
ing availability. The grant formula should specify ceilings and floors for
yearly fluctuations. Any major changes in the formula should be accom-
panied by hold harmless or grandfathering provisions.
7 Transparency. Both the formula and the allocations should be dissemi-
nated widely in order to achieve as broad a consensus as possible on the
objectives and operation of the program.
8 Efficiency. The grant design should be neutral with respect to subna-
tional governments’ choices of resource allocation to different sectors
or types of activity.
9 Simplicity. Grant allocation should be based on objective factors over
which individual units have little control. The formula should be easy
to understand so as not to reward grantsmanship.
10 Incentive. The design should provide incentives for sound fiscal man-
agement and should discourage inefficient practices. Specific transfers
should not be made to finance subnational government deficits.
11 Reach. All grant-financed programs create winners and losers. Consider-
ation must be given to identifying beneficiaries and those who will be
adversely affected in order to determine the overall usefulness and
sustainability of the program.
12 Safeguarding the grantor’s objectives. The grantor’s objectives are best safe-
guarded by having grant conditions specify the results to be achieved
(output-based grants) and by giving the recipient flexibility in the use
of funds.
13 Affordability. The grant program must recognize donors’ budget
constraints. This suggests that matching programs should be closed
ended.
14 Singular focus. Each grant program should focus on a single objective.
15 Accountability for results. The grantor must be accountable for the de-
sign and operation of the program. The recipient must be account-
able to the grantor and its citizens for financial integrity and results
28 Anwar Shah
(i.e., improvements in service delivery performance). Citizens’ voice

and exit options in grant design can help advance bottom-up account-
ability objectives.
Some of these criteria may be in conflict with others. Grantors may therefore
have to assign priorities to various factors in comparing design alternatives.26
As noted earlier, for enhancing government accountability to voters, it
is desirable to match revenue means (the ability to raise revenues from
own sources) as closely as possible with expenditure needs at all orders of
government. However, the national and state governments must be al-
lowed greater access to revenues than is needed to fulfill their own direct
service responsibilities. This is so that they are able to use their spending
power through fiscal transfers to fulfill national and regional efficiency
and equity objectives.
Six broad objectives for national fiscal transfers can be identified.
Each of these objectives may apply to varying degrees in different coun-
tries, and each calls for a specific design of fiscal transfers. Lack of atten-
tion in these designs to specific objectives leads to negative perceptions
of these grants.
Bridging Vertical Fiscal Gaps The terms vertical fiscal gap and vertical fiscal
imbalance have been mistakenly used interchangeably in recent literature
on fiscal decentralization. A vertical fiscal gap is defined as the revenue de-
ficiency arising from a mismatch between revenue means and expenditure
needs, typically of state and local orders of government. A national govern-
ment may have more revenues than warranted by its direct and indirect
spending responsibilities, while regional and local governments may have
less revenues than their expenditure responsibilities.
A vertical fiscal imbalance occurs when the vertical fiscal gap is not
adequately addressed by the reassignment of responsibilities or by fiscal
transfers and other means. Boadway argues that vertical fiscal imbalance
incorporates an ideal or optimum view of expenditures by different orders
of government and is therefore difficult to measure.27
A vertical fiscal gap may arise due to (1) inappropriate assignment of
responsibilities; (2) centralization of taxing powers; (3) pursuit of beggar-
thy-neighbour tax policies (wasteful tax competition) by subnational
governments; or (4) lack of tax room at the subnational orders due to
heavier tax burdens imposed by the national government. To deal with
the vertical fiscal gap, it is important to deal with its sources through a
combination of policies such as the reassignment of responsibilities, tax
decentralization or tax abatement by the centre, and tax-base sharing
(by allowing subnational governments to levy supplementary rates on a
national tax base). Only as a last resort should revenue sharing, or
unconditional formula-based transfers, all of which weaken accountability

to local taxpayers, be considered in order to deal with this gap.
Bridging the Fiscal Divide through Fiscal Equalization Transfers Fiscal equaliza-
tion transfers are advocated to deal with regional fiscal equity concerns.
These transfers are justified on political and economic considerations. Large
regional fiscal disparities can be politically divisive and may even create
threats of secession.28 This threat is quite real. Since 1975, about forty new
countries have been created by the break-up of existing political unions. Fis-
cal equalization transfers could forestall such threats and create a sense of
political participation, as is demonstrated by the impact of such transfers on
the separatist movement in Quebec, Canada.
Decentralized decision making results in differential net fiscal benefits
(imputed benefits from public spending minus tax burden) for citizens de-
pending on the fiscal capacities of their place of residence. This leads to
both fiscal inequity and fiscal inefficiency in resource allocation. Fiscal
inequity arises as citizens with identical incomes are treated differently
depending on their place of residence. Fiscal inefficiency in resource
allocation results from people in their relocation decisions comparing
gross income (private income plus net public-sector benefits minus cost of
moving) at new locations; economic efficiency considerations warrant
comparing private income minus moving costs, only without any regard to
public-sector benefits. A nation that values horizontal equity (the equal
treatment of all citizens nationwide) and fiscal efficiency needs to correct
the fiscal inequity and inefficiency that naturally arise in a decentralized
government. Grants from the national government to states and/or local
governments can eliminate these differences in net fiscal benefits if the
transfers depend on the tax capacity of each state relative to others and on
the relative need for and cost of providing public services. The more de-
centralized the tax system is, the greater the need for equalizing transfers.
The elimination of net fiscal benefits requires a comprehensive fiscal
equalization program that equalizes fiscal capacity (the ability to raise reve-
nues from own basis using national average tax rates) to a national average
standard, and it provides compensation for differential expenditure needs
and costs due to inherent cost disabilities rather than differences that
reflect different policies.
Fiscal equalization programs, especially if they are too generous, can
have some adverse unintended consequences for interjurisdictional factor
mobility and the economic well-being of disadvantaged regions. To the
extent such programs discourage factor mobility and dampen market ad-
justment mechanisms, they can create “transfer dependencies”; that is, in-
centives and magnitudes of transfers serve to counteract the natural forces
of adjustment or lead to decisions that are not in the economic interests of
30 Anwar Shah
fiscally disadvantaged regions. Transfer dependency symptoms include a

persistent interregional trade deficit, a regional unemployment rate persis-
tently higher than the national average, wages in the depressed regions
greater than productivity, and personal income in a depressed region
higher than its gdp. Such symptoms create a widow’s curse for the de-
pressed regions, whereby the generosity of fiscal transfers and regionally
differentiated expenditure policies retard natural adjustment processes
and prevent regional economic convergence. Some economists also argue
that, if public-sector tax burdens and service benefits are fully capitalized
in property values, then the case for fiscal equalization transfers is weaker
as residents in rich states pay more for private services and less for public
services (and vice versa in poorer states). According to this view, as argued
by Oates, fiscal equalization is a matter of political taste.29 This view has
gained currency in the federal government in the United States and helps
to explain why there is no federal fiscal equalization program there. In
contrast, local fiscal equalization drives most state assistance to local
governments in the United States, especially school finance.
Setting National Minimum Standards Setting national minimum standards

for regional and local services may be important for two reasons. First,
there is an advantage to the nation as a whole from such standards, which
contribute to the free flow of goods, services, labour, and capital; reduce
wasteful interjurisdictional expenditure competition; and improve the
gains from trade from the internal common market. Second, these stan-
dards serve national equity objectives. Many public services provided by the
subnational governments, such as education, health, and social welfare,
are redistributive in their intent, providing in-kind redistribution to
residents. In a federal system, state and/or local provision of such services
– while desirable for efficiency, preference matching, and accountability –
creates difficulty fulfilling federal equity objectives. Factor mobility and tax
competition create strong incentives for state and local governments to un-
derprovide such services and to restrict access to those most in need, such
as the poor and the old. Attempts to exclude those most in need are justi-
fied by their greater susceptibility to disease and potentially greater risks
for cost curtailment.
Such perverse incentives can be alleviated by conditional non-matching
grants, in which the conditions reflect national efficiency and equity con-
cerns and there is a financial penalty associated with failure to comply with
any of the conditions. Conditions are thus imposed not on the specific use
of grant funds but on attainment of standards in quality, access, and level
of services. Such output-based grants do not affect local government incen-
tives for cost efficiency, but they do encourage compliance with nationally
specified standards for access and level of services. Properly designed
conditional non-matching output-based transfers can create incentives for
innovative and competitive approaches to improved service delivery. Input-

based grants fail to create such an accountability environment.
In conclusion, while output-based (performance-oriented) grants are
best suited to the grantor’s objectives and are simpler to administer than
are traditional input-based conditional transfers, they are rarely practised.
The reasons have to do with the incentives faced by politicians and bureau-
crats. Such grants empower clients while weakening the sphere for oppor-
tunism and pork-barrel politics. The incentives they create strengthen the
accountability of political and bureaucratic elites to citizens and weaken
their ability to peddle influence and build bureaucratic empires. Their
focus on value for money exposes corruption, inefficiency, and waste. Not
surprisingly, this type of grant is blocked by potential losers.
Compensating for Benefit Spillovers Compensating for benefit spillovers is

the traditional argument for providing matching conditional grants. Re-
gional and local governments will not face the proper incentives to provide
the correct levels of services that yield spillover benefits to residents of
other jurisdictions. A system of open-ended matching grants based on
expenditures giving rise to spillovers will provide the incentive to increase
expenditures. Because the extent of the spillover is usually difficult to mea-
sure, the matching rate will be somewhat arbitrary.
Influencing Local Priorities In a federation, there is always some degree of

conflict among priorities established by various orders of government. One
way to induce state and local governments to follow priorities established
by the national or state government is for the national or state government
to use its spending power by providing matching transfers. The national
or state government can provide open-ended matching transfers with a
matching rate that varies inversely with the recipient’s fiscal capacity. The
use of ad hoc grants or open-ended matching transfers is inadvisable. Ad
hoc grants are unlikely to result in behavioural responses that are consis-
tent with the grantor’s objectives. Open-ended grants may create budget-
ary difficulties for the grantor.
Dealing with Infrastructure Deficiencies and Creating Macroeconomic Stability

in Depressed Regions Fiscal transfers can be used to serve national govern-
ment objectives in regional stabilization. Capital grants are appropriate for
this purpose, provided funds for future upkeep of facilities are available.
Capital grants are also justified to deal with infrastructure deficiencies in
poorer jurisdictions in order to strengthen the common economic union.
Capital grants are typically determined on a project-by-project basis. In-
donesia took a planning view of such grants in setting a national minimum
standard of access to primary school (within walking distance of the com-
munity served) for the nation as a whole. The national government
32 Anwar Shah
provided for school construction, while local governments provided land

for the schools. Experience with capital grants shows that they often cre-
ate facilities that are not maintained by subnational governments, which
either remain unconvinced of their utility or lack the means to provide
regular upkeep.
Special Issues in Transfers from States/Provinces to Local Governments
General-purpose transfers to local governments require special consider-

ations as local governments vary in population, size, area served, and type of
services offered. In view of this, it is advisable to classify local governments
by population size, municipality type, and urban/rural character, creating
separate formulas for each class of municipality. The national or state gov-
ernment could adopt a representative tax system-based fiscal capacity equal-
ization system and set minimum standards grants for each class and type of
municipality. Where the application of a representative tax system is not fea-
sible due to a lack of significant tax decentralization or poor local tax admin-
istration, a more pragmatic but less scientific approach to general-purpose
grants could be used. Some useful components in these grant formulas are
an equal per municipality component, an equal per capita component, a
service-area component, and a fiscal capacity component. Grant funds
should vary directly with the service area and inversely with fiscal capacity.30
South Africa has applied a variant of this approach in central-local transfers.
Having a formal, open, contestable, and deliberative process for munici-
pal incorporation, amalgamation, and annexation should be a prerequisite
for introducing an equal per municipality component in grant finance.
The lack of such a process can create a perverse incentive for the break-up
of existing jurisdictions so as to qualify for additional assistance, as is dem-
onstrated by the experience in Brazil.31
Lessons from International Practice in Intergovernmental Fiscal Transfers
Review of international practice yields a set of practices to avoid and a set of

practices to emulate. A number of important lessons also emerge (Table 4).
Negative Lessons: Types of Transfers to Avoid Policy makers should avoid de-
signing the following types of intergovernmental grants:
1 Grants with vaguely specified objectives.

2 General revenue-sharing programs with multiple factors that work at cross
purposes, undermine accountability, and do not advance fiscal efficiency
or fiscal equity objectives. Tax decentralization or tax-base sharing offer
better alternatives to a general revenue-sharing program because they en-
hance accountability while preserving subnational autonomy.
Table 4
Principles and better practices in grant design
Examples of Examples of
Grant objective Grant design better practices practices to avoid
Bridge fiscal gap Reassignment of Tax abatement and Deficit grants, wage
responsibilities, tax tax-base sharing grants (China), tax
abatement, tax-base (Canada) by tax sharing (China)
sharing
Reduce regional General non-matching Fiscal equalization with General revenue
fiscal disparities fiscal capacity explicit standard that sharing with multiple
equalization transfers determines total pool factors (Brazil
as well as allocation and India); fiscal
(Canada, Denmark, equalization with a fixed
and Germany) pool (Australia, China)
Compensate Open-ended matching Grant for teaching Closed-ended
for benefit transfers with matching hospitals (South Africa) matching grants
spillovers rate consistent with
spill-out of benefits
Set national Conditional non- Road maintenance Conditional transfers
minimum matching output-based and primary education with conditions on
standards block transfers with grants (Indonesia spending alone (most
conditions on before 2000) countries), pork barrel
standards of service transfers (usa e.g.,
Education transfers
and access $200 million earmark
(Brazil, Chile,
in 2006 for a “bridge to
Colombia),
nowhere” in Alaska),
Health transfers
ad hoc grants
(Brazil, Canada)
Conditional capital Capital grant for Capital grants with no
grants with matching school construction matching and no future
rate that varies inversely (Indonesia before upkeep requirements
with local fiscal capacity 2000), highway
construction matching
grants to states
(United States)
Influence local Open-ended matching Matching transfers Ad hoc grants
priorities in transfers (preferably for social assistance
areas of high with matching rate (Canada before 2004)
national but low varying inversely with
local priority fiscal capacity)
Provide Capital grants, Capital grants with Stabilization grants
stabilization provided maintenance matching rates that vary with no future upkeep
and overcome possible inversely with local requirements
infrastructure fiscal capacity
deficiencies
Source: Anwar Shah, “A Practioner’s Guide to Intergovernmental Fiscal Transfers,” in Intergovernmental Fiscal
Transfers, ed. Robin Boadway and Anwar Shah, 1–53 (Washington, dc: World Bank, 2007).
34 Anwar Shah
3 Grants to finance subnational deficits, which create incentives for run-

ning higher deficits in the future.
4 Unconditional grants that include incentives for fiscal effort. Improving
service delivery while lowering tax costs should be public-sector objectives.
5 Input- (or process-) based or ad hoc conditional grant programs, which
undermine local autonomy, flexibility, fiscal efficiency, and fiscal equity
objectives.
6 Capital grants without assurance of funds for future upkeep, which have
the potential to create white elephants.
7 Negotiated or discretionary grants in a federal system, which may create
dissention and disunity.
8 One-size-fits-all grants to local governments, which create huge inequities.
9 Grants that involve abrupt changes in the total pool and its allocation.
Positive Lessons: Principles to Adopt
Policy makers should strive to respect the following principles in designing

and implementing intergovernmental transfers:
1 Keep it simple. In the design of fiscal transfers, rough justice may be bet-
ter than full justice if it achieves wider acceptability and sustainability.
2 Focus on a single objective in a grant program and make the design con-
sistent with that objective. Setting multiple objectives in a single grant
program runs the risk of failing to achieve any of them.
3 Introduce ceilings linked with macro indicators and floors in order to
ensure stability and predictability in grant funds.
4 Introduce sunset clauses. It is desirable to have the grant program re-
viewed periodically – say, every five years – and renewed (if appropriate).
In the intervening years, in order to provide certainty in budgetary
programming for all governments, no changes should be made to the
grant program.
5 Equalize per capita fiscal capacity to a specified standard in order to
achieve fiscal equalization. Such a standard would determine the total
pool and allocations among recipient units. Calculations required for
fiscal capacity equalization using a representative tax system for major
tax bases are possible for most countries. In contrast, expenditure-need
equalization requires difficult and complex analysis, inviting much con-
troversy and debate; as desirable as it is, it may, therefore, not be worth
doing. In view of this practical difficulty, it would be best to deal with
fiscal-need equalization through output-based sectoral grants that also
enhance results-based accountability. A national consensus on the stan-
dard of equalization is critically important for the sustainability of any
equalization program. The equalization program must not be looked at
in isolation from the broader fiscal system, especially conditional trans-

fers. The equalization program must have a sunset clause and provision
for formal review and renewal. For local fiscal equalization, one size
does not fit all.
6 For specific-purpose grants, impose conditionality on outputs or stan-
dards of access and quality of services rather than on inputs and processes.
This allows grantors to achieve their objectives without undermining local
choices on how best to deliver such services. Most countries need to estab-
lish national minimum standards of basic services in order to strengthen
the internal common market and economic union.
7 Recognize the population size, class, area served, and the urban/rural
nature of services in making grants to local governments. Establish sepa-
rate formula allocations for each type of municipal or local government.
8 Establish hold harmless or grandfathering provisions that ensure that all
recipient governments receive at least what they received as general-
purpose transfers in the pre-reform period. Over time, as the economy
grows, such a provision would not delay the phase-in of the full package
of reforms.
9 Make sure that all stakeholders are heard and that an appropriate politi-
cal compact on equalization principles and the standard of equalization
is struck. Politics must be internalized in these institutional arrange-
ments. Arm’s-length institutions, such as independent grant commis-
sions, are not helpful as they do not allow for political input and
therefore tend to opt for complex and nontransparent solutions.
Moving from a public-sector governance culture of dividing the spoils

to an environment that enables responsive, responsible, equitable, and
accountable governance is critical. Doing so requires exploring all feasi-
ble tax decentralization options, instituting output-based operating and
capital fiscal transfers, establishing a formal fiscal equalization program
with an explicit standard of equalization, and ensuring responsible access
to borrowing.
Institutional Arrangements for Fiscal Relations
Who should be responsible for designing the system of federal-state-local

fiscal relations? There are various alternatives.32 The first and most com-
monly used practice involves the national government deciding on it
alone. The most obvious practice is to make the federal government solely
responsible, on the grounds that it is responsible for the national objec-
tives that are to be delivered through the fiscal arrangements. In many
countries, this is the norm, and one or more federal government agencies
assume exclusive responsibility for the design and allocation of fiscal
36 Anwar Shah
transfers. A potential problem with this approach is the natural tendency

of the federal government to be overly involved with state decision making
and not to allow the full benefits of decentralization to occur. This biases
the system towards a centralized outcome, despite the fact that the grants
are intended to facilitate decentralized decision making. To some extent,
this problem can be overcome by imposing constitutional restrictions on
the ability of the federal government to override state and local decisions.
In India, the Union government is solely responsible for Planning Com-
mission transfers and centrally sponsored schemes. These transfers have
strong input conditionality with the potential to undermine state and local
autonomy. The 1988 Brazilian Constitution provides strong safeguards
against federal intrusion by enshrining the transfers’ formula factors in the
Constitution. These safeguards represent an extreme step as they under-
mine the flexibility of fiscal arrangements to respond to changing eco-
nomic circumstances.
Alternatively, a separate body could be involved in the design and ongo-
ing reform and enforcement of fiscal arrangements. This could be an im-
partial body or a body made up of both federal and state representatives. It
could have true decision-making authority or be purely advisory. Whatever
body is responsible, in order to be effective it needs to be able to coordi-
nate decision making by the two orders of government. Three commonly
practised options are (1) an independent grants commission, (2) an inter-
governmental forum, or (3) an intergovernmental-cum-civil-society forum.
Some countries set up a quasi-independent body, such as a grants com-
mission, to design and reform the fiscal system. Such commissions can
have a permanent presence, as in Australia or South Africa, or they can be
brought into existence periodically to make recommendations for the next
five years, as in India. India has also instituted independent grants commis-
sions in the states as advisory bodies for state-local fiscal transfers. These
commissions have proven ineffective in some countries, largely because
many of their recommendations have been ignored by the government
and not implemented, as in South Africa. In other cases, the government
may have accepted and implemented the commission’s recommendations
but been ineffective in reforming the system due to self-imposed con-
straints, as in India. In some cases, these commissions become too rigorous
and academic in their approaches, contributing to the creation of an
overly complex system of intergovernmental transfers. This has been the
case with the Commonwealth Grants Commission in Australia.
A few countries use intergovernmental forums or executive federalism
or federal-provincial committees to negotiate the terms of the system, as
do Canada and Germany. In Germany, this system is enhanced by having
state governments (Länder) represented in the Bundesrat, the upper house
of the Parliament. This system allows for explicit political input from the
jurisdictions involved and attempts to develop a common consensus. Typi-
cally, such forums opt for simplicity in design so as to make the system
transparent and politically acceptable.
Finally, a variant of the above involves using an intergovernmental cum
legislative cum civil society committee with equal representation from all
constituent units, chaired by the federal government, to negotiate changes
in federal-provincial fiscal arrangements. The Finance Commission in
Pakistan is an example of this model, which is constituted periodically to
determine allocations for the next five years. Pakistan also follows the same
approach by having provincial finance commissions for designing and allo-
cating provincial-local fiscal transfers. An advantage of this approach is that
all stakeholders – donors, recipients, civil society, and experts – are repre-
sented on the commission. Such an approach keeps the system simple and
transparent. An important disadvantage of this approach is that, due to the
unanimity rule, such bodies may be permanently deadlocked, as has re-
cently been witnessed at the federal order in Pakistan.
selected issues in fiscal federalism
This section addresses three topical issues in fiscal federalism: regional

equity, horizontal competition, and corruption.
Federalism and Regional Equity
Regional inequalities represent an ever-present development challenge in

most countries, especially those with large geographic areas under their
jurisdiction. Globalization heightens these challenges as it places a pre-
mium on skills. With globalization, skills rather than the resource base of
regions determine their competitiveness. Skilled workers gain at the ex-
pense of unskilled ones. As typically rich regions also have better educated
and better skilled labour than do poor regions, the gulf between the
former and the latter widens. Large regional disparities represent serious
threats in federal countries as the inability of the government to deal with
such inequities creates a potential for disunity and, in extreme cases, for
disintegration. Although the policy challenges in reducing regional dis-
parities are large, federal flexibility in the choice of instruments is cur-
tailed by the division of powers in a federation. In contrast, central
governments in unitary states are relatively unconstrained in their choice
of policies and instruments.
Under these circumstances, there is a presumption in development eco-
nomics that a decentralized fiscal constitution leads to ever-widening
38 Anwar Shah
regional inequalities. However, empirical evidence refutes this presumption.

Raja Shankar and Anwar Shah show that regional development policies have
failed in almost all countries – federal and unitary alike – as regional con-
vergence is largely attributable to removing barriers to goods and factor
mobility and securing a common economic union, as demonstrated by the
successful experience of the United States in reducing regional income ine-
qualities.33 Federal countries do better in restraining regional inequalities
because widening regional disparities pose a greater political risk. In such
countries, inequalities beyond a threshold might lead to calls for separation
by both the richest and the poorest regions. While the poorest regions might
consider such inequalities a manifestation of regional injustice, the richest
regions might view a union with the poorest regions as, in the long run, pos-
sibly holding them back in their drive for prosperity.
Federalism and Horizontal Competition
Preserving interjurisdictional competition and decentralized decision mak-

ing are important for responsive and accountable governance in federal
countries. Beggar-thy-neighbour policies have the potential to undermine
these gains from decentralized decision making. Short of federal interven-
tion, a number of solutions are possible. Competing jurisdictions could
reach mutual agreements on the rules of the game and a coordination strat-
egy. There might be high coordination costs for reaching such agreement
and developing enforcement mechanisms. In the end, such agreements
could prove ineffective on issues with higher stakes for the competing juris-
dictions. Alternately, constitutional prohibitions against local impediments
to factor mobility may be helpful. But interpretations of these provisions by
the courts may not serve federalism well because they may unduly restrain
the powers of subnational governments.
There is no consensus as to the federal role in preserving horizontal
competition while overcoming some of the negative side effects associated
with this competition. Federal government oversight of horizontal compe-
tition may prove too obtrusive to respect local autonomy. However, a fed-
eral government role in using its spending power to secure a common
economic union appears promising.
This leads us to conclude that a partnership approach that facilitates an
economic union through free mobility of factors by ensuring common
minimum standards of public services and dismantling barriers to trade,
plus wider information and technological access, offers the best policy
alternative for regional integration and internal cohesion within federal
nations. The question is not how to compete or how to cooperate but,
rather, how to make sure that all parties compete but do not cheat.34
Federalism and Corruption
Power corrupts and absolute power corrupts absolutely. Federalism helps

to break the monopoly of power in the national order by bringing decision
making closer to people through localizing it. Localization strengthens
government accountability to citizens by involving them in monitoring gov-
ernment performance and demanding corrective actions. Localization, as
a means of making government responsive and accountable to people, can
help to reduce corruption and to improve service delivery. Efforts to im-
prove service delivery usually force the authorities to address corruption
and its causes. However, one must pay attention to the institutional envi-
ronment and the risk of local capture by elites. In the institutional environ-
ments typical of some developing countries – when, in a geographical area,
feudal and industrial interests dominate, institutions of participation and
accountability are weak or ineffective, and political interference in local af-
fairs is rampant – localization may increase opportunities for corruption.
This suggests a pecking order of anti-corruption policies and programs.
Thus the rule of law and citizen empowerment should be the first priority
in any reform. Localization in the absence of the rule of law may not be a
potent remedy for combating corruption.35
why fiscal federalism? some conclusions
Federal fiscal constitutions have been recommended for large and di-
verse countries because they create incentives for multiple orders of gov-
ernment to provide services to their citizens in a competitive, efficient,
equitable, and responsible manner. This is accomplished while respect-
ing diversity in local identities and preferences. Federal fiscal constitu-
tions pay special attention to regional economic and digital divides to
ensure a level playing field and to strengthen the economic union. A re-
view of comparative practices shows that federal countries do better than
unitary countries on all aspects of public governance – citizen participa-
tion, political freedom, political stability, rule of law, bureaucratic effi-
ciency, absence of corruption, human development, egalitarian income
distribution, and fiscal and economic management.36 This is because, as
elaborated in this chapter, federal fiscal constitutions pay a great deal of
attention to clarifying the roles, responsibilities, and accountabilities of
various orders of governments and designing fiscal institutions compati-
ble with responsive, responsible, and accountable results-based gover-
nance. The synthesis of the principles of fiscal federalism documented in
this chapter will, I hope, assist policy makers and practitioners in reform-
ing their fiscal systems.
40 Anwar Shah
notes
Author’s note: The author is grateful to John Kincaid for his helpful
comments.
1 Anwar Shah, “Fiscal Decentralization and Macroeconomic Management,” Interna-
tional Tax and Public Finance 13, 4 (2006): 437–62.
2 Daniel J. Elazar, “The Political Theory of Covenant: Biblical Origins and Modern
Developments,” Publius: The Journal of Federalism 10 (1980): 3–30.
3 Robert Inman, “Why Federalism?” unpublished paper, Wharton School, University
of Pennsylvania, Philadelphia, September 2006.
4 Not all federal countries are decentralized and not all unitary countries are
centralized. For example, Canada is highly decentralized, but Australia and
Germany are centralized federations, as is indicated by the share of subnational
expenditures in consolidated public expenditures. Nordic unitary countries are
more decentralized than are Australia and Germany.
5 William H. Riker, Federalism: Origin, Operation, Significance (Boston, ma: Little-
Brown, 1964), 11.
6 See Pierre Salmon, “Horizontal Competition among Governments,” in Handbook of
Fiscal Federalism, ed. Ehtisham Ahmad and Giorgio Brosio, 61–85 (Cheltenham,
uk: Edward Elgar, 2006); and Albert Breton, “Modeling Vertical Competition,”
in Handbook of Fiscal Federalism, ed. Ehtisham Ahmad and Giorgio Brosio, 86–105
(Cheltenham, uk: Edward Elgar, 2006). See also Daphne A. Kenyon and John
Kincaid, eds., Competition among States and Local Governments: Efficiency and Equity in
American Federalism (Washington, dc: Urban Institute Press, 1991).
7 See Ronald L. Watts, Comparing Federal Systems (Montreal and Kingston: McGill-
Queen’s University Press, 1999).
8 Barry Weingast, “Second Generation Fiscal Federalism: Implications for Decentral-
ized Democratic Governance and Economic Development,” discussion draft,
Hoover Institution, Stanford University, 2006, 6.
9 This refers to civic republics as termed by John Kincaid, “Municipal Perspectives in
Federalism,” unpublished paper, cited in Ann O. Bowman and Robert C. Kearney,
State and Local Government (Boston, ma: Houghton Mifflin Company, 1990).
10 George Stigler, “The Tenable Range of Functions of Local Government,” in The
Economics of Fiscal Federalism and Local Finance, ed. Wallace E. Oates, 3–9 (Cheltham,
uk: Edward Elgar, 1998).
11 Mancur Olson, “The Principle of Fiscal Equivalence: The Division of Responsibili-
ties among Different Levels of Government,” American Economic Review 59,
2 (1969): 479–87.
12 Wallace Oates, Fiscal Federalism (New York: Harcourt Brace Jovanovich, 1972).
13 Ibid., 55.
14 Bruno Frey and Reiner Eichenberger, The New Democratic Federalism for Europe:
Functional Overlapping and Competing Jurisdictions ( Cheltenham, uk: Edward Elgar,
1999).
15 Ibid., 55.
16 Robin Boadway and Anwar Shah, “Fiscal Federalism in Developing/Transition
Economies: Some Lessons from Industrialized Countries,” paper presented at the
National Tax Association Meetings, St. Paul, Minnesota, November 1994; National
Tax Journal, proceedings issue, April 1994, 64–71; Robin Boadway, Sandra Roberts,
and Anwar Shah, “The Reform of Fiscal Systems in Developing and Emerging
Market Economies: A Federalism Perspective,” Policy Research Working Paper
1259, World Bank, Washington, dc, 1994; Robin Boadway, Sandra Roberts, and
Anwar Shah, “Fiscal Federalism Dimension of Tax Reform in Developing
Countries.” in Fiscal Reform and Structural Change in Developing Countries, vol. 1,
ed. G. Perry, J. Whalley, and G. McMahon, 171–200 (London: Macmillan, 2000).
17 Robin Boadway, The Constitutional Division of Powers: An Economic Perspective (Ottawa:
Economic Council of Canada, 1992).
18 Ibid.
19 Anwar Shah, “Fiscal Decentralization and Macroeconomic Management,”
International Tax and Public Finance 13, 4 (2006): 437–62; and Anwar Shah,
“Corruption and Decentralized Public Governance,” in Handbook of Fiscal Federal-
ism, ed. Ehtisham Ahmad and Giorgio Brosio, 478–98 (Cheltenham, uk: Edward
Elgar, 2006).
20 Robin Boadway, The Constitutional Division of Powers: An Economic Perspective (Ottawa:
Economic Council of Canada, 1992).
21 See Anwar Shah with Sana Shah, “The New Vision of Local Governance and the
Evolving Roles of Local Governments.” In Local Governance in Developing Countries,
ed. Anwar Shah, 1–46 (Washington, dc: World Bank, 2006), 1–46.
22 Robert P. Inman, “Financing Cities,” nber Working Paper 11203, National Bureau
of Economic Research, Cambridge, ma, 2005.
23 Izabella Barati and Akos Szalai, “Fiscal Decentralization in Hungary” (Center for
Public Affairs Studies, Budapest University of Economic Sciences, 2000), p. 21.
24 Anwar Shah, “The New Fiscal Federalism in Brazil,” Discussion Paper 124, World
Bank, Washington, dc, 1991.
25 For a comprehensive treatment of the economic rationale for intergovernmental
fiscal transfers, see Robin Boadway and Anwar Shah, eds., Intergovernmental Fiscal
Transfers (Washington, dc: World Bank, 2007); and Anwar Shah, “A Practioner’s
Guide to Intergovernmental Fiscal Transfers,” in Intergovernmental Fiscal Transfers,
ed. Robin Boadway and Anwar Shah, 1–53 (Washington, dc: World Bank, 2007).
26 Anwar Shah, The Reform of Intergovernmental Fiscal Relations in Developing and Emerg-
ing Market Economies (Washington, dc: World Bank, 1994); Government of
Canada, Achieving a National Purpose: Putting Equalization Back on Track (Ottawa:
Department of Finance, 2006); Government of Canada, Restoring Fiscal Balance in
Canada (Ottawa: Department of Finance, 2006); and Anwar Shah, “A Prac-
tioner’s Guide to Intergovernmental Fiscal Transfers,” in Intergovernmental Fiscal
Transfers, ed. Robin Boadway and Anwar Shah, 1–53 (Washington, dc: World
Bank, 2007).
42 Anwar Shah
27 Robin Boadway, “The Vertical Fiscal Gap: Conceptions and Misconceptions,” paper
presented at Canadian Fiscal Arrangements: What Works, What Might Work Better,
Winnipeg, Manitoba, 16–17 May 2002.
28 Raja Shankar and Anwar Shah, “Bridging the Economic Divide within Nations: A
Scorecard on the Performance of Regional Development Policies in Reducing
Regional Income Disparities,” World Development 31, 8 (2003): 1421–41.
29 Wallace Oates, Fiscal Federalism (New York: Harcourt Brace Jovanovich, 1972). For a
more elaborate discussion of absence of fiscal equalization in the United States, see
Daphne A. Kenyon and John Kincaid, “Fiscal Federalism in the United States: The
Reluctance to Equalize Jurisdictions,” in Finanzverfassung im Spannungsfeld zwischen
Zentralstaat und Gliedstaaten, ed. Werner W. Pommerehne and George Ress, 34–56
(Baden-Baden: Nomos Verlagsgesellschaft, 1996).
30 On examples of state-local transfers from Australia, Brazil, and Canada, see Anwar
Shah, The Reform of Intergovernmental Fiscal Relations in Developing and Emerging Market
Economies (Washington, dc: World Bank, 1994).
31 Anwar Shah, The New Fiscal Federalism in Brazil (Washington, dc: world bank,
1991).
32 For an evaluation framework and comparative reflections on alternate institutional
arrangements, see Anwar Shah, “Institutional Arrangements for Intergovernmental
Fiscal Transfers and a Framework for Evaluation,” in Intergovernmental Fiscal Trans-
fers, ed. Robin Boadway and Anwar Shah, 293–317 (Washington, dc: World Bank,
2007).
33 Raja Shankar and Anwar Shah, “Bridging the Economic Divide within Nations:
A Scorecard on the Performance of Regional Development Policies in Reducing
Regional Income Disparities,” World Development 31, 8 (2003): 1421–41.
34 See Anwar Shah, “Interregional Competition and Federal Cooperation: To Com-
pete or to Cooperate – That Is Not the Question,” paper presented at the Interna-
tional Forum on Federalism in Mexico: Local and Global Challenges, held in
Veracruz, Mexico, 14–17 November 2001.
35 Anwar Shah, “Corruption and Decentralized Public Governance,” in Handbook of
Fiscal Federalism, ed. Ehtisham Ahmad and Giorgio Brosio, 478–98, (Cheltham, uk:
Edward Elgar, 2006).
36 Anwar Shah, “Balance, Accountability, and Responsiveness: Lessons about
Decentralizations,” Policy Research Working Paper Number 2021, World Bank,
Washington, dc, 1998; Anwar Shah, “Fiscal Decentralization and Macroeconomic
Management,” International Tax and Public Finance 13, 4 (2006): 437–62; and
Robert Inman, “Why Federalism?” unpublished paper, Wharton School, University
of Pennsylvania, Philadelphia, 2006.

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book Page 3 Tuesday, July 3, 2007 11:48 AM

basic concepts of federalism

Constitutional divisions of powers among various orders of government fall

A unitary country has a single or multi-tiered government in which effec-

A federal form of government has a multi-order structure, with all orders

Introduction: Principles of Fiscal Federalism 5

preferences in public services, political participation, innovation, and

have overlapping and shared responsibilities, and all constituent govern-

Asymmetric Federalism Countries with a federal form of governance do not

Introduction: Principles of Fiscal Federalism 7

often offer flexibility in accommodating the special needs or demands of

Market Preserving Federalism Barry Weingast has advanced a theoretical con-

In a confederal system, the general government serves as the agent of the

the genesis of fiscal federalism

Several accepted theories provide a strong rationale for decentralized

George Stigler identifies two principles of jurisdictional design:10 (1) a

The Decentralization Theorem

According to the “decentralization theorem” advanced by Oates, “each

The Subsidiarity Principle

According to the subsidiarity principle advanced by the European

Introduction: Principles of Fiscal Federalism 9

The “assignment problem,” or the allocation of expenditure, regulatory,

Principles of Expenditure Assignment

The fiscal federalism literature provides broad guidance in delineating ex-

• Local governments understand the concerns of local residents.

A decentralized system ideally ensures an order and combination of

central control or compensatory grants may be warranted in the provi-

Fiscal Efficiency Decentralized decision making in a federation results in

Regional (Horizontal) Equity Differential net fiscal benefits across jurisdic-

Introduction: Principles of Fiscal Federalism 11

Provision of Quasi-Private Goods Modern governments provide many ser-

Preservation of the Internal Common Market Preservation of an internal com-

Economic Stabilization It is customary to argue that the federal govern-

governments. Guidelines for centralized fiscal policy have, however, only

Introduction: Principles of Fiscal Federalism 13

Spending Power In a federation, there is always some degree of conflict

Policy, Provision Production

Interregional and U U N,P Benefits and costs

Introduction: Principles of Fiscal Federalism 15

Policy, Provision Production

Regulation N,S,L N,S,L N,S,L,P N for Internal common

Roles and Responsibilities of Local Governments

The fiscal federalism approach treats local government as a subordinate

Allocation criteria for public vs.

Economies Economies Benefit-cost Political Consumer Economic evaluation

Local transit service L M L L L M L P P P

Primary education L L M M L M M P G P,G

Secondary education L L M M L M M P G P,G

Public transport M M M L,M M M M P,G G P,G

Water supply M M M L,M M M M P G P,G

Allocation criteria for public vs.

Economies Economies Benefit-cost Political Consumer Economic evaluation

Sewage disposal M M M M M M M P,G P,G P,G

Hospitals M M M M M M M P,G G P,G

Air and water pollution M M M M M M M G G G

Regional parks M M M L,M M M M G G G

Regional planning M M M L,M M M M G G G

Note: L = local government, M = regional/metropolitan government, and G = sector.