Definition

Fiscal federalism is a subfield of public economics discussing which functions of the public sector and appropriate instruments to carry out these functions are best centralized and which should be allocated to decentralized levels of government (see, e.g., Kenyon and Kincaid 1991; Oates 1999).

Introduction

Roughly one half of the world’s population lives in systems of government where sovereignty is constitutionally divided between a central government and constituent political entities such as states or provinces, which in turn can also share their competences with local units such as cities or counties. Some countries, although not federations de jure, have devolved significant policy-making powers to local or regional levels of government (e.g., France or the United Kingdom). At the same time, the process of European integration is creating a federation sui generis. It can thus be studied how to best allocate functions of the public sector and policy instruments vertically to carry out these functions among the different levels of government.

Broadly speaking, the scholarship on fiscal federalism can be divided into a first and a second generation (Qian and Weingast 1997; Oates 2005). The earliest formulations of the first-generation theory of fiscal federalism (as in Musgrave 1959; Oates 1972) attributed to the central government two functions. One was the basic responsibility for macroeconomic stability. With highly open local economies, decentralized governments cannot affect local levels of employment and prices using the means of monetary policy. The other one was the assistance of the poor. Since individuals and businesses are mobile, redistribution should be done at higher levels of government to prevent net contributors from relocating to a jurisdiction with a lower tax burden. Second-generation economic theories of fiscal federalism expand earlier theories by adding components of political economy (public choice) and political science.

Consequently, this entry follows the historical development from first- (section “First-Generation Fiscal Federalism”) to second-generation federalism (section “Second-Generation Fiscal Federalism”). Section “Fiscal Federalism in the EU” specifically discusses federalism within the context of the European Union and gives two concrete examples: the case of migration and the European sovereign debt crisis. Finally, section “Conclusion” concludes.

First-Generation Fiscal Federalism

The public finance literature in the 1950s and 1960s came to an important finding, namely, that there should be a “separate governmental institution for every collective good with a unique boundary, so that there can be a match between those who receive the benefits of a collective good and those who pay for it” (Olson 1969, 483). First-generation fiscal federalism is thus primarily concerned with a fundamental trade-off: providing public goods and services through centralized policy-making is suboptimal because of the divergences in local tastes and conditions, while decentralization can lead to inefficiencies because local governments do not fully internalize interjurisdictional externalities.

The Tax Assignment Problem

The tax assignment problem, coined by McLure (1983), addresses the fundamental normative question which taxes are best suited at which level of government. It is assumed that people, goods, and resources can easily move between lower-level jurisdictions, while there is little or no mobility at the higher (e.g., national) level. At the starting point is the Tiebout (1956) model, in which mobile individuals can choose between bundles of taxes and public goods provided by a large number of local communities. Since people have different preferences regarding those bundles, they will move to the community that maximizes their personal utility. Through this mechanism, it is possible to provide public services at a decentralized level. Since the individual preferences are then matched with the local governments supplying exactly the public goods demanded, total welfare is increased. This proposition was formalized as the so-called decentralization theorem in Oates (1972). It follows that taxing mobile individuals through a decentralized system of government is impossible or causes distortions in resource allocation as individuals bear costs to avoid taxation. As the subsequent work of Oates and Schwab (1991) and Oates (1996) shows, thus mobile factors should be taxed with benefit levies. Non-benefit taxes, that is, those that usually have some redistributive effect, should be allocated to the central government. Nevertheless, many local jurisdictions still maintain local redistributive schemes.

The decentralization theorem also faced the question why a central government is inherently unable to produce the optimal outcome. The answer is twofold. First, there is an information problem: local governments are closer to their constituencies and thus have a better knowledge of their residents’ wishes and requirements, as well as of the costs involved in fulfilling them. Secondly, the idea that a central government fine-tunes its policies to the needs of local jurisdictions collides with the general principle of equal treatment at the national level, where a certain character of uniformity is expected from the central government.

Olson’s (1969) concept of fiscal equivalence, where local public goods were provided in such a way that the geographical scope of benefits coincided with the boundaries of the jurisdiction financing them, led to a practical problem: designing a federal system without any spillovers between jurisdictions could hardly exist (Oates 2005). Thus, with decentralized provision of local public goods, it is necessary that the central government provides subsidies to the local jurisdictions in order to internalize the benefits of positive externalities between the local governments. Another role for the central level government is less guided by efficiency concerns than it is by equity considerations: by redistribution from rich to poor jurisdictions, it can contribute to the cohesion of economically differently developed regions.

The early literature on the tax assignment problem already recognized the importance of hard budget constraints, that is, that jurisdictions cannot export parts of their tax burden onto other jurisdictions. Otherwise, local budgets would be inflated beyond efficient levels. Nevertheless, vertical transfers among entities in a federal state are common. While some countries have equalizing transfers from richer states or provinces to poorer ones (through the federal level), some other countries such as the United States know them primarily at the level of the states, that is, there are equalizing grants among local jurisdictions. Through such equalizing grants, spillover benefits can be internalized. There are also equity considerations for equalizing transfers, while the verdict is still out on their efficiency effects. It is not clear whether they promote economic growth in poorer regions or whether they inhibit the adjustments necessary for economic development. Furthermore, they play a role in ensuring a progressive tax system and correct the regressive effects of decentralized taxation.

The more recent literature on fiscal federalism has in further detail emphasized the importance of hard budget constraints (see below).

Economies of Scale

Providing public goods and services comes at a cost. If these costs have a fixed component (or more general have the feature of subadditivity), then decentralized provision means that these fixed costs have to be borne by each jurisdiction providing it and the total costs will be larger than if the central government incurred them. Thus, public goods and services with high fixed costs should rather be centralized, whereas goods and services with low fixed costs can be decentralized. This point can be applied not only to traditional public goods and services but also to law as a public good, which implies strong network externalities and may lead to path dependencies in the law provision (Heine and Kerber 2002).

Laboratory Federalism

Decentralized government can facilitate experimenting with new laws and regulations in order to assess their suitability. In a dissenting opinion to the US Supreme Court’s 1932 New State Ice Co. v. Liebmann ruling, Justice Louis Brandeis argued in favor of legal experimentation: “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country” (New State Ice Co. v. Liebmann, 285 U.S. 262 at 285). This idea has been taken up by theories of federalism. In this view, lower-level governments can experiment with new policies, which, if deemed successful, can later be implemented at the national level. Oates (1999) gives the examples of unemployment insurance and emissions trading. The recent decision of the Supreme Court on the unconstitutionality of any prohibition of same-sex marriages comes to mind as a more recent example of a case where experimentation at the state level led to subsequent complete adoption at the national level.

The diffusion of new policies does not necessarily have to be vertical, but can also be horizontal. A basic problem with such experimentation is that it is better not to be the first to implement a new policy, but to rather observe other jurisdictions innovate and then free ride on their learning experience. In other words, there is a positive information externality which potentially leads to too little experimentation (see, e.g., Rose-Ackerman 1980; Strumpf 2002). However, there are examples in which jurisdictions are very engaged in horizontal interjurisdictional competition, as the example of the US State Delaware showcases with regard to corporate law (Romano 1993).

Interjurisdictional Competition

With decentralization comes competition among lower-level governments. Through various policy instruments, such as tax rates but also, e.g., environmental regulation, they seek to attract capital investments.

It is still an open question under which conditions horizontal competition among governments is efficiency enhancing and when it is destructive. The models of Oates and Schwab (1988, 1991, 1996) liken interjurisdictional competition to perfect competition in the private sector. Local governments set efficient bundles of public goods and taxes in order to compete among each other for mobile capital. The result is a “race to the top.” For these results to hold, a series of assumptions has to hold, namely, that jurisdictions behave as price takers in capital markets, that public officials act in the interest of the common good and are not self-interested, and that all necessary regulatory instruments are available to them in order to carry out the desired policy.

Other models, but also the Oates and Schwab models if the abovementioned assumptions are not met, emphasize the possible outcome of a “race to the bottom,” in which competition is detrimental to total welfare. A typical example is the setting of environmental standards. If politicians are primarily concerned with attracting businesses and enlarging the local tax base, then they might set excessively lax environmental standards (Oates and Schwab 1988).

While mobility is an important factor in interjurisdictional competition, it has also been argued that the simple fact of observing policies in other jurisdictions – what has been called “yardstick competition” (Salmon 1987) – can be enough to exert pressure on politicians to implement similar ones. The presence of decentralized government influences decision-making and constrains the set of actions (e.g., the possible tax rates) even if local governments are not in a position strong enough to actively participate in the competition (Kenyon 1997).

Second-Generation Fiscal Federalism

While fiscal federalism is concerned with the optimal level of centralization or decentralization of state activity, it also provides a framework to explain and predict the constitutional arrangements found in practice. Second-generation fiscal federalism thus goes beyond the realm of public economics and draws its inspiration from public choice, information economics, the theory of the firm, organization theory, and contract theory (Oates 2005). It also profits from input from adjacent disciplines such as political science.

Market-Preserving Federalism

On a different level of analysis than the public economics approaches mentioned above, federalism can also be seen as an institution to preserve a market economy with well-defined property rights. In a strain of literature in the tradition of new institutional economics, federalism as a system can be designed as a mechanism limiting how far a country’s political class can encroach on its markets. In a seminal article, Weingast notes a “fundamental political dilemma of an economic system,” namely: “A government strong enough to protect property rights and enforce contracts is also strong enough to confiscate the wealth of its citizens” (Weingast 1995, 1). Property rights and the enforcement of contracts are thus only secure if the state is limited in its ability to confiscate wealth.

In subsequent articles, five conditions are established in order to create and to preserve market-preserving federalism. First, there “exists a hierarchy of governments with a delineated scope of authority (e.g., between the national and subnational governments) so that each government is autonomous in its own sphere of authority.” Secondly, “the subnational governments have primary authority over the economy within their jurisdictions.” Thirdly, “the national government has the authority to police the common market and to ensure the mobility of goods and factors across subgovernment jurisdictions.” Fourthly, “revenue sharing among governments is limited and borrowing by governments is constrained so that all governments face hard budget constraints.” Finally, “the allocation of authority and responsibility has an institutionalized degree of durability so that it cannot be altered by the national government either unilaterally or under the pressures from subnational governments.” While the first condition is inherent to federalism, the other four ensure its market-preserving character.

In a somewhat similar vein, Inman and Rubinfeld (1998) argue that federalism is next to rights enumerated in the constitution, and the separation of powers between branches of the central government is the third possible line of defense in protecting rights of citizens. The federal form, they argue, can also encourage participation, as individual votes are more likely to be pivotal in small jurisdictions and accessing as well as monitoring politicians is easier.

Self-Interested Agents in Political Processes

An important expansion on the initial literature on the economics of federalism is the insight that the public officials do not necessarily act in the interest of an elusive general interest, but can also act as self-interested actors. The same also applies to voters who also maximize objective functions in the context of political processes. With these assumptions, the principal-agent model becomes the main approach. The relationship between the principal and the agent is characterized by asymmetric information and imperfect monitoring, while the outcome has a stochastic component. The contract between the two thus has to be based on the observed outcome. With multiple levels of government and different societal actors, there are many possible interpretations of who the principal is and who the agent is. For instance, in what is referred to as “administrative federalism” (Inman 2003), the public officials of the local governments can be considered the agents of a central government, which has certain objectives. In other models of fiscal autonomy, the principal-agent conflict of interest is between the electorate and elected officials, and elections constitute incomplete contracts with unverifiable information. The conclusion from these models is usually that decentralization improves accountability and control (see, e.g., Seabright 1996; Tommasi and Weinschelbaum 2007).

Information Problems

The early literature on fiscal federalism already highlighted the information problem present in policy-making and understood it as an argument in favor of decentralization. Second-generation fiscal federalism elaborates a bit further on where this information comes from. At first, there is the question why the central government cannot, through various means, acquire detailed information on local needs. As Cremer et al. (1996) point out, such activities are costly, and obtaining such information is more important and valuable to local public officials than it is to those of the central government. This creates the fundamental problem that it is generally assumed that the central government has no significant issues collecting information on the needs regarding public goods and services provided at the national level. Additionally, the information problem creates the question how the central government is then able to set the Pigouvian subsidies to compensate local governments for positive interjurisdictional spillover effects. It can only do so if it has accurate information on the valuation of the spillovers at the local level. Nevertheless, it is argued (e.g., in Oates 2005) that an outcome with imperfect subsidies is still better than one where externalities are ignored altogether.

Functional, Overlapping, Competing Jurisdictions (FOCJ)

A proposal for a new kind of federalism lies in the concept of functional, overlapping, competing jurisdictions. Advocated in the late 1990s by Bruno Frey and Reiner Eichenberger (1999), the government is divided into organizations called FOCUS. The idea is that every such entity is functional, that is, it deals with a specific, delimited matter, such as education, public safety, or infrastructure. As a result, there are several, overlapping FOCJ covering certain individuals or regions. Individuals can then choose which FOCUS applies to them for which policy field. If the function is territorially bound, then a local entity (“commune”), such as a town, determines democratically which FOCUS it belongs to. There is thus competition between FOCJ. A FOCUS, once chosen, has the power to levy taxes. It is thus a jurisdiction.

The advantage of these FOCJ, so the argument, is that the concept combines four important aspects of the economic theory of federalism. First, fiscal equivalence can be achieved. Secondly, the boundaries are well defined so that new members of these clubs can be charged optimally, namely, at the marginal costs. Thirdly, the voting by foot mechanism is enabled through exit and entry. Finally, there is political competition through democratic processes and thus a “voice” mechanism.

Such a system that relies less on geographical units can be found in several federal settings around the world and in history. The United States knows the concept of “special districts,” Swiss local units can and do build functional and overlapping special communes, Germany knows “special purpose associations” (Zweckverbaende), and the European Union carries strong traits of FOCJ as well (e.g., the monetary union, the Schengen Area, and others).

Fiscal Federalism in the EU

There are two phenomena taking place at the same time in Europe. First, countries have devolved some competences from the central government to local or regional levels (e.g., the creation of régions in France and devolved governments in the United Kingdom), thus creating more decentralized policy-making. Secondly, there is, at the same time, the process of European integration, which gradually allocates competences to the European institutions. What might appear as contradictory at the first glance can very well be interpreted as a more nuanced approach to fiscal federalism.

The Principles of Conferral, Subsidiarity, and Proportionality

The structure of European federalism is laid out in the Treaty on European Union (TEU): “The limits of Union competences are governed by the principle of conferral. The use of Union competences is governed by the principles of subsidiarity and proportionality” (Art. 5(1) TEU). Under this principle, “the Union shall act only within the limits of the competences conferred upon it by the Member States in the Treaties to attain the objectives set out therein. Competences not conferred upon the Union in the Treaties remain with the Member States” (Art. 5(2) TEU).

In other words, the EU does not have the authority to appropriate competences to itself. This distinguishes it from other federations, where in some fields the national legislature has the so-called competence-competence (the power to assign competences) and can reassign competence between the federal and the sub-federal level through a regular law and not necessarily through a constitutional amendment. The EU’s competences are conferred through the TEU; thus, any change would require a treaty change, which is an intergovernmental procedure involving all 28 Member States and therefore lengthy and inert. This inertia also leads to a problem in the other direction: once the EU has a certain competence, it is very difficult to devolve policy responsibilities from the supranational back to the national level (Kirchner 1998).

Article 5(3) states: “under the principle of subsidiarity, in areas which do not fall within its exclusive competence, the Union shall act only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the Member States, either at central level or at regional and local level, but can rather, by reason of the scale or effects of the proposed action, be better achieved at Union level.…”

Finally, the principle of proportionality requires that “[…] the content and form of Union action shall not exceed what is necessary to achieve the objectives of the Treaties […].”

Current Challenges

Migration

In the European Union, migration is regulated at several levels of government. While the freedom of movement of EU citizens is a fundamental freedom well entrenched in EU law, admission of third-country nations (TCNs) is primarily left to the member states. The Schengen Area has a joint visa policy, and the Dublin system constitutes a joint framework for a decentralized system of examining applications for asylum.

The decentralized treatment of TCNs entails significant restrictions on their mobility within the EU. For instance, a recognized refugee is not allowed to relocate to a different EU Member State within the first 5 years of residence in the country that granted the refugee status. In this sense, the current migration regime challenges the common assumption in economic theories of federalism of complete mobility within a federation. Asylum seekers, who according to the Dublin system are required to request asylum in the EU member state that they first set foot in, might thus be stuck in a place that is not optimal from an allocative perspective (e.g., if their skills are more sought after in a different Member State).

The European Sovereign Debt Crisis

During the debt crisis that started in 2009, several Eurozone member states (Cyprus, Greece, Ireland, Spain, and Portugal) were unable to fulfill their obligations toward their creditors. They thus required assistance of the European Central Bank (ECB), the International Monetary Fund (IMF), and the European Financial Stability Facility (EFSF), a special purpose vehicle established by the EU member states in 2010, which was replaced by the European Stability Mechanism (ESM) in 2013.

In terms of fiscal federalism, the debt crisis showed that the hard budget constraint in the relationship between member states and the EU as a federal system of open economies could not be upheld. This does not necessarily mean that large-scale transfers among member states through the EU institutions are not economically justified. Furthermore, fiscal federalism theories in some instances do recognize the presence and necessity of interjurisdictional transfers.

Tax Harmonization

The European Union is currently discussing harmonizing taxes and tax bases within the Union. VAT harmonization has already taken place with the intention of creating a level playing field for firm operation across the EU. The currently principal legal source is Council Directive 2006/112/EC of 28 November 2006 on the common system of value-added tax. The EU harmonized not only VAT law but also limited the number of different VAT rates the Member States can set for various types of goods: there is a minimum 15 % “standard rate,” and countries can apply two reduced rates of at least 5 % on certain goods. The list of goods eligible for the reduced rates is set at the EU level. From a fiscal federalism point of view, it is debatable why the EU should regulate the VAT rates set by the Member States as it is not clear what the externalities in a nonregulated setting would be.

Another ongoing project is the establishment of a so-called Common Consolidated Corporate Tax Base (CCCTB). This proposal, which was developed by the European Commission, aims at formulating mandatory common rules on how to calculate the tax base and at allowing companies to report their tax results consolidated at the European level. The individual Member States would then still set the actual tax rate. From a federalism theory point of view, this measure seems to reduce the information problems present in intra-European trade while not limiting the ability of jurisdictions to set their own tax rates. However, one may conceive the CCCTB also as a first step toward the “cartelization” of tax policies of the Member States to the detriment of tax payers.

Conclusion

Taking the insights from economic theories of federalism seriously means to recognize that both centralizing and decentralizing ideologies are wrong. As Olsen pointed out, “there is a case for every type of institution from the international organization to the smallest local government” (Olson 1969, 483). Theories of fiscal federalism can contribute to assign specific competences to the appropriate level of government. Second-generation federalism added to this insight that the separation of powers across different vertical levels of government is per se a precondition to sustain a functioning market economy that honors property rights.