Published in R.D. Ebel and J.E. Petersen “The Oxford... Government Finance “, Oxford University Press, Oxford and New York,...

Published in R.D. Ebel and J.E. Petersen “The Oxford... Government Finance “, Oxford University Press, Oxford and New York,...

Published in R.D. Ebel and J.E. Petersen “The Oxford Handbook of State and Local
Government Finance “, Oxford University Press, Oxford and New York, 2012, pages
105-136
State and Local Governments: Why they Matter and How to
Finance Them*
by
Serdar Yilmaz**
François Vaillancourt **
and
Bernard Dafflon**
______________________
**Respectively senior economist, World Bank; Fellow, CIRANO,
Montréal; professor, Université de Fribourg
105
Introduction
Intergovernmental reforms have been at the center of public sector change in
countries across the globe. Indeed, the World Bank’s World Development
Report on Entering the 21st century asserts that two forces will influence
development policy in the first part of this century: globalization (the continuing
integration of countries) and localization (self-determination and the devolution
of power). 1 This force of “localization”, which in the international literature, is
also referred to as “decentralization” is that of the division of public-sector
functions among multiple types of government, central and subnational. Such
“decentralization” is occurring in unitary and federal states alike.
Established theories in economics and political science have articulated the
efficiency and accountability gains that could accrue from decentralization
reforms. The efficiency and accountability gains promised by a well-designed
intergovernmental system range from the internalization of spillover effects, 2
alleviation of information asymmetry and better accountability due to the
proximity of principals and agents 3 and the improvements in service delivery
and revenue policy that may result from the fiscal competition among local
governments. 4
This chapter begins with a generalized discussion of the “assignment” or
functional roles among different types of governments and then proceeds to
develop the theoretical case for decentralized governance. Recognizing that a
well-designed assignment of functions among different types of governments
will likely result is both vertical and horizontal fiscal imbalances, the paper
concludes with a conceptual examination of the critical role of
intergovernmental transfers in making intergovernmental finance “work”.
Distribution of Functions among Types of Governments
A seminal contribution to the theory of the intergovernmental assignment of
functions was provided by Richard Musgrave in his Theory of Public Finance
(1959) in which he identifies three functions of the public sector: (i)
macroeconomic stabilization; (ii) income redistribution; (iii) efficient allocation
of resources. At a very general level, the central (in the US, federal) government
should have basic responsibility for macroeconomic stabilization and income
redistribution functions. There are two tools in carrying out stabilization policy:
fiscal and monetary policy tools. The three usual pro-centralization arguments
for fiscal policy tools are that: 5 (i) local economies are small open economies
and, as such, there is little chance that stabilization efforts initiated at the local
level will bear fruit in this same local arena ; (ii) given that fact, local
government units could adopt a do little or nothing strategy, letting the other
local governments implement stabilization policies whose effects would spill
over in their favor; and, finally, (iii) limiting local deficits and debt may be
appropriate since financial markets do not function properly to create budget
106
discipline at that level of government. 6 With respect to this last point, there are
two perspectives amongst public finance experts, known respectively under the
terms of budget “discipline” versus “accountability.” The second tool, monetary
policy, is obviously one that can only be used by the central government Bank
(in the US, the Federal Reserve Bank). Thus stabilization is assigned to the
center.
Under Musgrave’s model, policies to adjust the inter-individual/household
distribution of a nation’s income and wealth—thus the distribution function—
also accrue to the center. This is because the full (assumed) mobility of both the
rich and the poor between subnational entities makes it impossible for one such
government to have more generous policies towards the poor than others if it has
to finance these policies itself, be it only at the margin. Either the poor will
move in, overloading the expenditure side and thus requiring higher taxes, or the
rich will move out, starving the revenue side or both will happen
simultaneously. A subnational government could have pro-rich policies to
encourage outmigration of the poor but this would be undesirable from an
overall allocative perspective. This would lead to segregation and thus to a
reduction in the externalities that emerge from mixing in a given territory
various groups. 7 However, there are costs associated with mobility. In small
countries (Belgium for example), differences in ethno-linguistic-religious
characteristics between subnational entities could reduce mobility from one
jurisdiction to another one. In large countries, distance and its associated costs
may be a barrier to mobility even if there are no differences in these
characteristics. Thus it is conceivable to have some income distribution at the
sub-national level.
This leaves the efficiency argument--i.e., allocation policy--as the traditional
raison d’être for the subnational role. This is not to say that an efficient
provision of public goods requires only subnational activity. Indeed, that is not
the case. Some social goods are such that the incidence of their benefits is
nationwide (i.e. national defense, certain aspects of public health, some court
systems), while others are geographically limited (i.e. street lighting, water
distribution, public safety, fire protection).
The recognition that the allocation function is an intergovernmental
responsibility applies not only to broad functions of services, but also, within
functions. Elementary education provides a good example. A nation as a whole
has a strong interest in a well educated population, as does the locality where the
service is provided. This fact, when combined with the spatial limitations of
benefit incidence, suggests that the responsibility for education can be broken
into several sub-functions: e.g., financing (primarily a local function, especially
with respect to capital expenditures); setting the curricula (a national “core”
curriculum supplemented by local options); teacher certification (the center may
wish to set minimum standards); staff hiring, firing, and salary determination
(local); and textbook selection (local).
The Allocation Function
107
In the “next seminal” contribution to the theory of intergovernmental finance,
Wallace Oates (1972) presented four criteria for assigning functional
responsibilities across types of governments:
i.
Economies of scale will vary across goods and services. Economies of
scale are significant in broadcasting, for example, where the unit cost
per viewer drops by half (absent the need for additional broadcasting
equipment) when the number of viewers of a given program doubles,
but negligible in the provision of individualized health services such as
surgical treatment. The existence of significant economies of scale
constitutes an argument for a regional (e.g., special purpose)
government to provide a particular good or service.
ii.
Heterogeneity of preferences and of circumstances also matters. Groups
living in different parts of a country may display strong heterogeneity of
preferences or may be faced with different environments in terms of
climate or topography. They may therefore prefer or may need different
amounts (more or less) of services, a different quality of service (for a
given amount), or a different language for delivering public services.
Decentralization is appropriate to address these needs if these groups are
separated by borders that match those of sub national governments.
iii.
The presence of externalities, negative or positive, has an impact. If
some of the activities of one government have important external effects
on the individuals or businesses located in other jurisdictions or on other
governments type, then these activities should be well coordinated
among the affected governments.
iv.
Emulation, also referred to as competition, which helps increase or
introduce best practices in government, requires at least two, and
probably more, units involved in a given activity. This is an argument
for decentralizing government activities.
In general, governments have three mechanisms to carry out their assigned
functions:
“functional” spending made through the budgetary process,
regulation of private activities, and tax expenditures. The most common one is
the functional budget–that is, the cost and accounting financial plan of the
government’s spending. 8 Regulations are both complements and substitutes to
budgetary spending. This typically involves mandating private agents to spend
on tasks that the government would otherwise carry out or requiring them to
modify their behavior, with or without a cost to them. For example, business
firms are often required to dispose of their “own” solid waste, with such
regulations accompanied by fines for noncompliance. The use of such regulation
to impose costs on households or firms cannot be justified on the basis that it
reduces budgetary government spending. Regulation can, however, be
appropriate if they are designed to “internalize” what are appropriately private
sector costs of production and/or privately-generated external costs to society as
a whole. 9 They are also appropriate if private provision is less expensive than
public provision due to low density for example; hence requiring septic tanks
can be a substitute for a sewer system in a given jurisdiction with both high and
low density parts. The distinction between national and local regulations is
relevant. Noise regulations are by nature mostly local while the regulation of
greenhouse gases is a national one in scope.
108
A third, and often much less transparent, way of spending is by the use of “tax
expenditures”—revenue losses resulting from tax provisions that grant special
tax relief designed to encourage certain kinds of taxpayer behavior and/or to aid
taxpayers in special circumstances. Tax expenditures may take one of several
forms, can be hard to measure, and are typically, particularly at the subnational
level, not given the periodic budget review required for good public financial
management. 10
Through these three mechanisms governments produce goods and services that
are not produced by the private sector in efficient amounts because of variety of
reasons.
The Case for the Provision of Local Public Goods
Different goods and services provided by the government have beneficiary areas
with different sizes. Certain publicly provided goods and services including
public goods, such as national defense and environmental protection, have a
beneficiary area defined by both national boundaries and treaties obligation and
explicit and implicit agreements. These kinds of goods and services are national
and sometimes international in terms of their beneficiary areas. Whereas other
publicly provided goods and services, such as street lighting and garbage
collection, have beneficiary areas limited to local jurisdictions. Some of these
publicly provided goods are called local public goods, being understood that
local is non national and thus can cover regional. 11
While the theoretical argument for public goods comes from Paul Samuelson, 12
he did not make a distinction between public goods with large catchment areas
such as defense and other public goods that are similar in outcomes (protection
from unwarranted use of force) but more local in nature such as policing. In his
seminal piece Charles Tiebout (1956) makes the distinction and examines the
difference between national and local public goods. He argues that citizens
having differing personal valuations on local public services and varying ability
to pay the attendant taxes, they will move from one jurisdiction to another until
they find the one which maximizes their personal utility.
Although conceptually the distinction between national and local public goods is
very intuitive, practically it is not always very clear. The question is: what kinds
of services are local public goods and what kind of services are national public
goods? A classical example is the difference between street lighting and national
defense. Street lighting is a local public good with a defined catchment area
whereas national defense is a national public good covering the whole territory
of a country and perhaps that of allies. However, one should note that broad
headings of public activities can be misleading. For example in health,
vaccination or food inspection activities have national impacts while the
provision of ambulance services has local impact.
The difference in size of beneficiary areas for national and local publicly
provided goods and services and regulations lends itself to decentralized
109
delivery of these goods and services. The economic case for decentralized
service delivery is based on the welfare gains from an improved allocation of
resources. Decentralization allows local governments to tailor the levels of
public services to the particular tastes and circumstances of their communities.
Local governments are closer to the people and they possess knowledge of local
preferences. Decentralized governments have their raison d’être in the provision
of goods and services whose consumption is limited to their own jurisdictions.
Since the efficient level of output (quantity and associated characteristics) of a
local public good is likely to vary across jurisdictions, decentralized provision of
services increases overall economic welfare. By tailoring local service delivery
to the particular preferences and circumstances of their population, local
government provision of local publicly provided goods and services increases
economic welfare above that which results from the more uniform levels of
national government service delivery. Furthermore, differential level of unit cost
of service delivery across jurisdictions provides overall welfare gains to an
economy.
Therefore, divergence in demand across jurisdiction and interjurisdictional cost
differentials are two important sources of welfare gains from decentralization:
1. Divergences in demand for local public goods and services
Figure 1 depicts the demand curves for local services of jurisdictions one (D 1 )
and two (D 2 ) per household. If we assume that local publicly provided goods
and services can be provided at a constant cost per unit of MC, the optimal
output levels are Q 1 in jurisdiction one and Q 2 in jurisdiction two—assuming
that there are no interjurisdictional spillover effects. If the central government
decides on the level of output and is unwilling to or unable, due to
legal/regulatory constraints, to provide anything but a uniform output, a uniform
level of output of Q C could be provided in all jurisdictions. 13 If the central
provision of Q C replaces the independent local provision Q 1 and Q 2 , then the
loss of social welfare from centralized provision would be the sum of triangles
ABC for residents of jurisdiction one and DCE for residents of jurisdiction
two. 14 A uniform centrally determined level of local public goods and services
will result in lower level of social welfare than decentralized service provision,
where each local government provides optimal level of local service in its
jurisdiction. This is the Decentralization Theorem. 15 The greater the divergence
between D 1 and D 2 —the population is more heterogeneous—the larger will be
the triangles ABC and DCE—the potential gains from decentralization will be
larger. And if either Q 1 or Q 2 were provided, then one triangle would shrink to
zero but the other would increase.
110
Figure 1
D1
$
DC
D2
D
E
C
A
MC
B
Q1
QC
Q2
Output
In a Tiebout equilibrium individuals locate in jurisdictions that satisfy their
demands for local public services, thus localities are perfectly homogenous in
terms of demand for local public goods and services. 16 In Tiebout’s model,
mobile households “vote with their feet”: they choose their jurisdiction to reside
according to the fiscal package (revenue and expenditure) best suited their
preferences. Decentralization is thus more important where the demand and
ensuing supply for local public goods has greater variation across local
governments. In places where the population is homogeneous with similar tastes
and preferences for local publicly provided goods and services, the potential
welfare gains from decentralization are smaller.
The impact of the mobility implicit in the Tiebout model can be illustrated with
the following example. There are three areas in one country that can become
three local jurisdictions, I, II and III which are susceptible of producing two
local public services, either S 1 or S 2 . There are 71 residents in the country who
are also beneficiaries and voters. With central provision, a majority vote gives
36 voices to S 2 ; the unsatisfied minority is 35. With devolution, residents/voters
in jurisdictions I and III choose to produce for local public provision S 1 ; while
S 2 is chosen in jurisdiction II. Without an exit alternative, there would be
altogether 25 unsatisfied residents. The “central” versus “devolved provision”
solutions correspond to that of Figure 1 that is D c and D 1 /D 2 . In the Tiebout
model, unsatisfied minorities could move to a preferred jurisdiction; in the
example minorities in I and III choose to move to jurisdiction II. In this solution,
no one is forced to accept the provision of an unwanted local service. Of course,
the cost of moving remains to be taken into consideration; also, jurisdictions I
and III providing the same service should consider possible economies of scale
in producing S1. 17
Jurisdiction
(wards with
Central
provision
Devolved provision
No mobility
Tiebout model Mobility
111
central provision, S 1
independent
entities when
devolved or
Tiebout
S2
I
10
8
II
5
16
III
20
12
majority
36
unsatisfied
35
Characteristics of
Central
outcome
command
Majority
choice
# in
minority
10-S 1
16-S 2
20-S 1
46
8
5
12
25
Specialization
respect of minorities
creativity, proximity
Choice
Vote by moving (with their feet)
Mobile population Final population
8 go to II
10 + 5=15
5 go to I
16+8+12=36
12 go to II
20
36 and 35
0
Specialization, respect of minorities, proximity, fiscal
competition
S1
S2
S1
Source: Authors.
2. Divergences in cost of local public goods and services
Cost differentials of service delivery across jurisdictions can also be a source of
welfare gains from fiscal decentralization. Figure 2 depicts a case where demand
curve, D C , is the same for local publicly provided services but the marginal cost
of local services differs between the two jurisdictions. MC 1 is the marginal cost
of local service delivery in jurisdiction one and MC 2 is the marginal cost of local
service delivery in jurisdiction two. In Figure 2 the Pareto efficient outcomes are
Q 1 and Q 2 . In this case, centralized provision of a uniform level of output at the
average marginal cost, Q C , results in welfare loss of triangle ABC in jurisdiction
one and triangle BED in jurisdiction two. The size of the welfare loss depends
on the distance between MC 1 and MC 2 .
The welfare gains from
decentralization will be greater if demand for local services is more price
responsive (less step demand curve).
Figure 2
$
DC
A
MC 1
C
MC C
B
E
D
MC 2
112
Q1
QC Q2
Output
Revenues
Once the assignment of service delivery responsibilities is decided, the next
question is to assign financing sources to local governments to carry out those
responsibilities. In an effective local government system, local governments
must have control over some of their revenues. Local governments that lack
independent sources of revenue can never truly enjoy fiscal autonomy, because
they may be—and probably are—under the financial thumb of the central
government. A rational assignment of revenue raising powers helps each level of
government control its fiscal destiny.
The important question is which revenue sources can and should be assigned to
which type of government. This is commonly referred to as the tax assignment
problem. 18 It is closely related to the assignment of expenditures, both because
of the importance, at least in principle, of benefit taxation and because of the
need for adequacy of revenues to finance local expenditures. An adequate
assignment of revenue raising powers permits choice in the level of public
spending by each type of government.
Each type of government should be assigned taxes that are related to the benefits
derived from its service delivery. Thus the proper assignment of taxes that are
related to benefits depends on the assignment of service delivery responsibilities.
In other words, to the extent possible local services should be financed by user
charges and fees. This is both fair and efficient in the sense of encouraging
responsible use of the nation's economic resources. 19 However, user charges,
fees, and taxes related to the benefits of public spending are likely to be
regressive. Therefore they are unlikely to reduce income inequality. 20 For both
equity and efficiency purposes, tax rates should reflect the costs and benefits of
public services. For example, taxes levied on motor vehicles and motor fuels are
benefit-related and receipts from these taxes can be used to construct and
maintain roads. Furthermore, such taxes can also be levied for the purpose of
reducing congestion and pollution—or both when the direct value of the service
provided to the user as well as social costs are factored in.
The notion of subsidiarity in taxation means a given tax should be assigned to
the lowest “level” of government that can implement it (or for which it can be
implemented) and for which it is not inappropriate. 21 Compliance with
subsidiarity principle is important to minimize the tendency toward vertical
imbalance. 22
The guiding principle in designing an intergovernmental fiscal system is that
subnational governments must have enough own revenues to finance the
services they provide. 23 Even if such subnational governments rely on grants
from a central government, if the grants are determined in an objective way and
are guaranteed by the constitution or by long-standing legislation they may be
113
considered to be own revenues at least in the short term, such as the agreed
period of a transfer formula. But these revenues are revenues that cannot be
increased or decreased by these subnational governments since they do not have
access to the base or rate so it is incomplete ownership as in the private
ownership of a protected historical property. On the other hand, if grants are
made at the sole discretion of the higher government, perhaps on an ad hoc,
arbitrary, and unpredictable basis, and even well into the fiscal year and subject
to renegotiation, subnational governments may be considered to have inadequate
level of revenues. In between these extremes, other arrangements include: tax
surcharges levied by one type of government (e.g., a local general purpose
government) but collected by another government (e.g., the state unit) as in the
case of revenue base sharing and tax-piggybacking. All of these arrangements
might be seen as own revenues if there is no substantial risk for revenues
accruing to the subnational governments.
If subnational governments are to be truly autonomous, they must be assigned
marginal sources of own revenues—that is to say they have some level of
control over their revenues. 24 If they can legislate 25 and implement their own
taxes and/or if they are allowed to impose surcharges on the taxes levied by the
central government at rates they choose, they can influence the amount of
revenues they receive at the margin—thus they control their revenues. Marginal
revenue raising powers allow residents of subnational jurisdictions to choose the
level of public services they want.
In assigning revenue raising powers to subnational governments it is important
to distinguish four aspects of revenue assignment: (a) which of government
determines tax policy choices, in other words, who makes policy decision on
taxes from which subnational governments receive revenues, (b) who defines the
tax bases, (c) who sets the tax rates, and (d) who administers the taxes.

Tax policy: The primary goal of taxation is to transfer resources from
one group to another one to achieve certain development objectives
without jeopardizing economic goals. Equity in taxation has both
horizontal and vertical components. Horizontal equity is present when
there is equal tax treatment of taxpayers who have equal capability to
pay taxes. Vertical equity concerns the proper relationship between the
relative tax burdens paid by individuals with different capacity to pay
taxes. There is no formula for setting the proper degree of progressivity
of taxation. It depends on factors such as the degree of inter individual
solidarity in a society or the degree of shirking by potential recipients of
transfers. But it is likely that, given the issues raised with respect to
income distribution above, subnational taxes will be less progressive
than national ones. In this context, which level of government decides
which taxes to be levied by which level of government is an important
aspect of the revenue assignment issue. However, subnational
governments clearly cannot be allowed total discretion in the choice of
the taxes they can levy. For example, they should not be allowed to levy
import duties on international trade or trade between subnational
jurisdictions or to impose taxes likely to be exported in large part.
114



Tax base: For efficiency purposes, it is important for subnational
governments to have some control over tax bases. But for shared taxes,
it is preferable for administrative and compliance reasons to have the
same base used by all tax levying jurisdictions. 26
Tax rate: For subnational governments setting the tax rates is clearly the
most important aspect of their fiscal sovereignty. Ability to set tax rates
allows subnational governments to choose the level of public services
while minimizing the compliance costs associated with collecting the
required revenues. A possible alternative would be that for equity
reason, the tax rate schedule would be set at the higher government
level, whereas lower level governments have the right to fix a tax
coefficient (sometimes within limits) in order to comply with their own
budget needs.
Tax revenue administration: In theory, revenue collection authority
should be devolved to the level of government that does it best. This
requires a trade-off between collection efforts, collection rates and
revenues and collection and enforcement costs. While central
governments may have low marginal collection costs, they may also
have low marginal collections since it is not their priority or that of their
tax collectors. The answer will thus depend on a thorough examination
of institutional arrangements. While some argue that in allocating
revenue administration function overall administrative and compliance
costs for the entire national and subnational system should be taken into
consideration (Mikesell 2002), this is not the sole consideration;
subnational autonomy may come with higher administrative/collection
costs.
These dimensions of revenue raising powers have important implications on
how revenues are linked to services provided. Some of the services that
subnational governments provide can be described as producing generalized
benefits, or benefits that cannot be closely related to taxes on the beneficiaries.
The general benefits of subnational government spending may be loosely related
to income or to private consumption. In these cases, unless there is some reason
to believe that benefits rise more or less rapidly than income or consumption,
relying on flat-rate taxes on income or consumption to finance such services
may be reasonable. If people do not work where they live (or if they do not
invest their savings where they live), an important tax policy choice is whether
production or consumption (income earned or income spent) is the better
measure of generalized benefits. If the benefits of public spending are more
closely related to production or the earning of income than to consumption or
the spending of income, origin-based taxes on value added and payroll taxes
levied where employment occurs would be superior to destination-based value
added taxes (VATs), retail sales taxes, and residence-based income taxes as
measures of benefits received.
Empirical evidence suggests that consumption (the spending of income) is
probably more closely related to the benefits of public spending than is
production (the earning of income). For example, education is usually provided
115
where people live, not where they work, and the same tends to be true for health
care and social aid. Therefore, for the purpose of taxing generalized benefits of
public services, residence-based income taxes are probably superior to
employment-based payroll taxes, and destination (consumption)-based sales
taxes are better than origin (production)-based ones. This may be difficult if
personal income taxation is not available to subnational governments. In that
case, payroll taxation levied in the region of employment but allocated on the
basis of the place of residence of workers (share of wage bill) may be a solution
most likely by the central government
A variety of approaches to assigning revenues to subnational governments differ
in the degree of fiscal autonomy they provide to subnational governments. In
certain countries, like Canada (provincial level), Switzerland (cantonal level),
and the United States (state level), independent subnational legislation and
administration, provides subnational governments with very high fiscal
autonomy. In these countries, subnational governments choose the taxes they
levy, define the tax bases, set the tax rates, and administer the taxes. 27 In fact, in
some cases, subnational jurisdictions enter into competition to attract businesses
and wealthy individuals to their localities.
Although tax competition 28 can protect citizens from the rapaciousness of
politicians and bureaucrats, excessive subnational latitude in the choice of tax
bases and in tax administration can create unacceptable complexity and
administrative burdens, as well as inequities and distortions in the allocation of
resources. In extreme cases, tax competition exposes public finance system to
inconsistency, duplication of effort, and excessive complexity of compliance and
administration. These problems can occur if different jurisdictions choose
radically different taxes (for example, if some levy retail sales taxes, but others
levy VATs as is the case in Canada), define their tax bases in different ways (as
in the case of state corporate income taxes and retail sales taxes in the United
States), or administer the same taxes in different ways. 29
In other countries, local government budgets are financed through surcharges or
piggyback taxes. For a surcharge, the surcharge rate is set locally but both the
main tax and the surcharge are collected by the government responsible for the
main tax. For a piggyback tax, the rate is set locally and the tax also collected
locally; it is piggybacking on an existing tax base. It is, thus, using information
already available to the taxpayer to compute a different tax. 30 Ideally, in these
countries, intergovernmental finance system is less prone to the problems that
occur when different subnational jurisdictions define the tax base in conflicting
ways, use different apportionment formulas, and administer the tax in different
ways. In a surcharge regime, although subnational governments don’t have the
ability to define the tax base and administer taxes, they have the power to set
surcharge rates–the most important attribute of fiscal sovereignty.
Subnational surcharges provide appropriate means with their own marginal
revenues in cases where revenue bases are scarce. However, an incentive
problem in subnational surcharge regimes is that the central or more generally
the tax collecting government collects a tax that it does not keep. Surcharges
116
should, of course, be limited to that portion of the tax base reasonably deemed to
arise in, or be attributed to, the taxing jurisdiction. In some cases the tax rate of
the central government is zero for a particular tax, in those situations the central
government simply administers the tax of subnational governments, thereby
ensuring uniformity and avoiding duplication of effort.
The third approach is tax sharing. Under tax sharing arrangements subnational
governments receive fixed fractions of revenues from particular national taxes
originating within their boundaries. In general the sharing rates are uniform
across jurisdictions, but there is always variation across taxes. This approach
restricts subnational governments’ fiscal autonomy. Although individual
subnational governments have autonomy over how to spend a given amount of
the shared revenue, they do not have the power to alter the amount of revenue
they receive. Therefore, they have limited control over the level public
spending. 31 In general, there is a formula to determine the deemed origin of tax
revenues. Thus the real loss of autonomy will also very much depends on
whether the formula is written in the constitution (as in Switzerland), in the
financial law or annually decided by parliament in the budget process.
Transfers
Intergovernmental transfers compose of a significant portion of subnational
governments' revenues in all countries and are therefore an essential component
of intergovernmental fiscal arrangements. Their design has important efficiency
and equity implications on local public service provision. In general,
intergovernmental transfers have three principal objectives: (i) to equalize
vertically (improve revenue adequacy); (ii) to equalize horizontally (interjurisdictional redistribution) (iii) to minimize inter-jurisdictional spillovers
(externalities). They may also be used to allow the federal government a
presence in policy areas where it has no direct role in te provision of publicly
provided goods and services given the constitutional division of powers. This is
the case for education in the USA (No child left behind) or health in Canada (
Canada health transfers) but with different degrees of condionalities.
Vertical fiscal imbalance is the disparity between revenue sources and
expenditure needs of subnational governments. A vertical imbalance occurs
when the expenditure responsibilities of subnational governments do not match
with their revenue raising powers. A horizontal imbalance occurs when own
fiscal capacities to carry out the same functions differ across subnational
governments. Horizontal imbalances across subnational governments arise from:
 Unequal distribution of revenue bases, natural resources, and wealth
across subnational governments,
 Variations in the socio-economic characteristics of population, and
 Differences in the geography and climate across jurisdictions that lead to
disparities in subnational economic opportunities or costs in the
provision of goods and services.
117
A third objective of intergovernmental transfers is to correct for
interjurisdictional spillovers. Some local government services’ benefits (or
costs) extend beyond the borders of the locality. For example, an outbreak of a
disease in one jurisdiction will have an impact on the overall health situation in
neighboring communities. Local governments may be unwilling to provide an
efficient level of certain services if they believe that people who reside outside
the locality will enjoy many of the resulting benefits. To ensure that local
governments provide a greater amount of those services, the central government
may transfer resources to them.
There are two general kinds of transfers; conditional and unconditional. In
conditional transfers, the transferring authority (central government) specifies
the purpose of use for these funds. The use of conditional transfer funds is
limited to a specific sector that is highly important to the transferring
government, such as education, health, housing, environmental. These types of
transfers are sometimes called specific purpose grants or categorical grants.
There are different applications of conditional transfers:
A. Open-Ended, Matching: For a unit of money given by the donor, the
recipient should spend some amount and there is no cap on the amount
of funds transferred to the recipient. Open-ended means as long as the
recipient provides co-financing; the central government will contribute
its share as well.
B. Close-Ended, Matching: Very similar arrangements but the transferring
authority puts a ceiling on the total amount to be transferred.
C. Non-matching: The recipient is not required to provide co-financing.
The donor gives a fixed sum of money with the stipulation that it be
spent on a specific publicly provided good or service.
In unconditional transfers the transferring authority places no restrictions on the
use of funds. In both conditional and unconditional transfer systems, one can
explicitly factor equalization into the transfer formula. The reasons for
introducing equalization are multiple since intra country inter region solidarity is
not explained only by economic arguments. Since no federal or decentralized
country is perfectly homogenous, the different levels of taxation by the
subnational governments (cantons, provinces, states collectively referred to as
SNGs) do not necessarily mirror differences in preferred local public services.
Local financial capacities depend on both the tax bases accessible to subnational
governments and the territorial distribution of those bases. Local needs vary
according to the particular preferences of the local residents; but they also
depend on geographic, demographic, and socio-economic factors. They are
further determined by constitutional or legal requirements as to the type and
nature (quantity, quality) mandatory public goods and services that SNGs must
provide.
Box 1 reviews the possible origins of fiscal disparities in the relevant
literature. 32 The logic behind this classification in five categories is twofold:
(i) "External" items that are outside the scope of local decision should be
compensated, at least partly, if they result in a significant spread in the relative
fiscal position of governmental units. We call them "disparities".
118
(ii) Those items that are within the scope of decision and the fiscal
management of SNGs should not be taken into consideration for equalization.
They belong to the sphere of local autonomy and responsibility. We call them
"differences".
Box 1: Five sources of fiscal differences across sub national governments and their appropriateness for
equalization
Appropriate for equalization - disparities
A
B
C
Differences in the territorial distribution of revenue bases (taxes, natural resource royalties…) or access to
them usually measured per head. This can result from differences in endowments (land, minerals…) location
(access to sea or trade routes…) or constitutional/legal constraints (some tax bases off limits).
Need differences in the number of units of standardized service required per capita owing to demographic
reasons (age structure, migrant / non migrant structure) and territorial (length of shoreline or border to be
patrolled).
Cost differences per unit of standardized public service that arise from factors such as: differences in the
quantity and composition of inputs that are necessary for producing the public service, differences in factor or
input prices, differences in physical characteristics (environmental factors) and presence or absence of
economies of scale in the service provision).
Not appropriate for equalization -differences
Differences in local preferences either for optional services, for quantities or quality above the minimum
standard level in the provision of services; or for autonomy that hinders the achievement of optimal size.
E Differentials that are attributable to strategic behavior on the part of the SNGs with respect to federal transfer
payments; local preferences between (non-benefit) taxes and user charges (benefit taxes), including the
choice – if any – among different forms of taxes
Source: adapted from Dafflon and Mischler, 2008: 215
D
Category A concerns resource equalization: revenue sources depend in part on
the geographic location of subnational governments in the national territory
(proximity of urban areas or economic centers or located at the periphery), on
the kind of economic activities, and on communication networks. Within an
open market economy, subnational governments cannot influence these
characteristics, thus they must be treated as exogenous variables.
Category B and C cover the two determinants of expenditure equalization. Both
items require more attention than differences in taxable capacity. Needs
disparities when measured using simple indicators should not be influenced by
subnational governments' decisions. But one must be careful as to the
interrelation between specific policies and outcomes; the possible origin of
needs disparities deserves careful consideration.
Well-measured cost disparities in input factors most often also fall outside the
SNGs' decision-making competence. But this requires using input prices from
the private sector for measurement purposes. Having examined what are
reasonable grounds for equalization, we turn in the next section to revenue
equalization that is equalization justified under category A of Box 1.
Revenue equalization
In this section and in the following one, we put forward both a graphical
depiction of revenue (expenditure) equalization and a discussion of issues that
119
cannot be included in such a graph. Figure 3 taken from Dafflon and
Vaillancourt (2003) addresses a first set of four issues.
The first issue is the level of the public revenues available to subnational
governments to both satisfy the needs of their population and to be shared in a
horizontal equalization scheme. The vertical axis records subnational revenue
divided by population (per capita). At point A on the vertical Y-axis, the
subnational government receives the average amount of public revenue per
resident for that type of jurisdiction in a given country, represented by the
standardized value 1.0. In this figure assume that all revenues available to satisfy
the needs of the population are also available for financing an equalization
scheme. But this may not be the case; for example, natural resource revenues
may be treated differently for each purpose.
The second issue is that equalization requires jurisdictions to be ranked
according to some indicator of contribution/entitlement to equalization; this is
addressed by the positioning of the various jurisdictions along the horizontal Xaxis. In Figure 3 this is revenue capacity since we are presenting revenue
equalization; in figure 4 it will be cost adjusted needs. The basic revenue
equalization rule is as follows: jurisdictions with higher-than-average revenue
capacity should receive less (pay more); jurisdictions with lower-than-average
capacity should receive more (pay less). In Figure 3, average capacity is given a
value of 100. For ease of exposition, the lower value for the “poorest”
jurisdiction is given a value of 30 and the highest a value of 150. In practice,
ranking SNGs is not easy. There are numerous indicators that can be used for
ranking purpose and good ad hoc reasons for each being deemed “best” by one
actor or another such as a public finance economist, 33 a macro economist, a
politician, the winning jurisdiction(s) or the losing jurisdiction(s).
120
Figure 3
A stylized representation of a revenue equalization scheme
Index of per capita public revenue of
subnational government before and after
horizontal (H) / vertical (V) equalization
G
1.15
1.10
E
1.00
A
0.85
B
0.55
C
0.40
D
K
90
30
poorest
Before H
equalization
F
After H
equalization
J
Perfect
equality
After H+V
equalization
100
poor
125
rich
Indicator of
per capita
financia l
capacity of
subnational
government
150
richest
Source: Dafflon and Vaillancourt, 2003: 401
Let us assume that these two issues have received an appropriate answer. The
third issue is the equalization formula. To understand this, let us compare the
“before” and “after” situations. With no equalization, and the possibility of
identifying exactly the origin of the tax revenues, “poor” jurisdictions would
certainly receive less than average per capita endowments, and “rich” ones
higher than average amounts, something like the line DEG (labeled “before
equalization public revenues”) in Figure 3. Any equalization formula would
have to give more to “poor” jurisdictions than they would receive following the
origin principle and “rich” jurisdictions would receive less, something along the
CEF line. The equalizing performance is represented by the distance between
lines DE and CE for beneficiary jurisdictions, and between EG and EF for the
jurisdictions supporting the financial cost of equalization. Thus, for example, for
the poorest jurisdiction with a revenue capacity of 30, equalization increases
public revenue per capita from 0.40 (at point D) to 0.55 (at point C), but for a
rich region with capacity of 125, equalization reduces public revenues available
to it from 1.15 to 1.10. Of course, a balanced solution with horizontal (H)
equalization requires that benefits (amounts received, represented by the surface
121
of triangle CDE) and payments (amounts contributed, represented by the surface
of triangle EFG) coincide. The importance of equalization depends on the
equalization formula, which gives the position of the slope CF around the central
point E.
The fourth issue is whether an equalization policy would introduce further limits
to the redistribution formula. In Figure 3, E represents an exactly neutral
position with regard to equalization: with an average financial capacity and
average per capita tax revenues, a jurisdiction at this point would neither pay
nor receive any equalizing amount. But the central point need not be at E. Other
equalization targets are possible, and often controversial. Two specific points
must be noted.
First, it can be debated whether jurisdictions with just below average financial
capacity should also benefit from equalization. One could argue on financial,
political and equity grounds that only jurisdictions below a certain level (e.g. an
indicator of capacity = 90) should qualify. Financial considerations could be one
argument: at 90, the triangle equivalent to CDE would be smaller, which means
smaller contributions by richer SNGs. But more crucial are political
considerations; at what value does fragmentation of the nation into poor and rich
jurisdictions endanger national coherence. Or, put differently how much poorer
is too poor?
A second related question is illustrated with the triangle BCK. The resources
available after applying the horizontal equalization formula are those
corresponding to line CE (above DE): the poorer a jurisdiction, the more it
receives. But the horizontal equalizing payments in the example can be argued
to be far from giving poor jurisdictions sufficient resources, increasing the
resources for the poorest SNG from (in our example) 40% to 55% of the national
average. Should they be increased? In the affirmative, what would be the
appropriate limit? The example in Figure 3 ensures that poor jurisdictions
receive equalizing payments so that their revenue endowment reaches at least
85% of the national average, along line BK. Since “rich” jurisdictions already
pay EFG to cover CDE (equal by construction), financial resources for paying
BCK come from a contribution from the center through a vertical equalization
scheme. 34 But is 85% a proper level? Fragmentation, equity and incentives must
be considered. But note that in Figure 3, beneficiary jurisdictions have no
incentive to take initiative for their development if they are satisfied with public
spending compatible with 85% of the national average per capita public
revenues, and if they have no preference for autonomous revenues rather than
transfers.
Not all the key issues of revenue equalization are captured in Figure 3. For
example, we do not discuss how equalization is financed. The questions are
which revenue (tax) source is to be shared and according to which decision
procedure? Several answers are possible, each with pros and cons; two are
discussed below with reference to vertical equalization but the questions are also
of relevance to horizontal equalization.
122


The amount is financed out of the general resources of the central
government and established in its annual budget. This is a very flexible
solution. But it has two main defects: (i) recipient governments are not
sure that they will receive a comparable amount (in real value) from one
year to another, which renders medium term planning and multi-annual
policies very difficult; (ii) annual budgetary debates are subject to ad
hoc political arrangements.
The exact calculation of the amount is explicitly stated in the
constitution or in a law, in the form of revenue sharing from at least one,
but preferably several or all, specific tax sources used at the central level
(the use of only one tax source for sharing purposes may result in the
central government either not collecting it as vigorously as it could since
its efforts in part reward sub-national governments or selecting the less
buoyant tax source). In this case, the political debate on equalization
takes place once when the constitution is amended or the law is passed
and not on an annual basis at the time the budget is discussed. And if the
tax sources are sufficiently diversified, such that they partly alleviate
macroeconomic cycles, it avoids important variations in the amounts
available. If they are not, it is possible to solve this potential cyclical
problem with the constitution of an equalization fund that can smooth
equalization payments over time.
Expenditure equalization
The focus of this section is on expenditure equalization, a combination of items
B and C in Box 1. Figure 4 presents a stylised expenditure equalization scheme.
The reader should note that contrary to figure 3, the recipients of equalization
are to the right of the pivot point and not to the left. As with figure 1, one must
answer four questions.
First, what are the equalizable expenditures carried out by SNGs? In this figure,
we assume that all expenditures are eligible for equalization. If we did not do
this, then the vertical Y -axis would be drawn only for eligible expenditures
which means that total SNG expenditures could be higher for some or all SNGs.
As in Figure 3, we present it in per capita terms. Second how should we rank
SNGs in terms for expenditure equalization?
To answer this question recall that as noted by Bird and Vaillancourt (2007)
average per capita expenditure differences in providing a public service reflect
two factors: need differences (Box 1, B above) and cost differences (Box 1, C).
 Need differences—differences in the number of units of standardized service
required per capita—usually arise owing to demographic reasons such as the
age structure of the population and different participation rates in social
programs by persons of different ages.
 Cost differences are differences in the cost per unit of a ‘standardized’ public
service. They may arise from climatic or geographic features, density or
distance factors, or differences in labor cost across regions. Costs should be
calculated using real (not nominal) private sector wages for equivalent inputs
and not on the basis of public sector wages which may reflect such political
123
35
Plausible factors related to needs differences are the share in the total population
of various age groups such as infants (post-natal care), elders (health care) and
school age children, the share of population with special needs, either temporary
i.e. new immigrants (language skills acquisition, integration into society) or not
e.g. aboriginal population. The relevance of many of these indicators depends on
the role SNG play in delivering public services. For instance, if it is the central
government or the private sector that provides health care, the share of infants or
elders in the population of SNGs may not be relevant in determining transfers.
Various factors determining cost differences have been proposed. Some are
natural ones that vary with geography such as climate (snowfall, heavy rain),
frequency of natural disasters (floods, earthquakes), topography (mountainous or
desert regions) and distance (remoteness from providers of inputs into public
services). Others are demographic such as population density/urbanization. The
difficulty is to estimate in monetary units the impact of such factors on costs. In
some cases, it may be not too difficult such as using private transportation costs
per km to estimate the impact of remoteness on the cost of schoolbooks being
delivered to a school. But if snow removal is done only by public maintenance
crews, then how does one distinguish between true differences in costs and the
relative strength of public sector unions in various SNGs, assuming that each
sets its own wages (not set centrally)?
We thus use a cost adjusted needs index on the X-axis of Figure 4. What does
this mean? Let us assume that we have two regions with identical revenue
capacity (same ranking on the vertical Y -axis of Figure 3), one (A) with a
proportion of 10% of older individuals in need of specific health services in its
population and the other (B) with 30%. In terms of needs, B has higher needs. If
the cost per % point of older population is 1 monetary unit, then B should
receive 20 more units of resources than A to be able to provide the required
services without having to levy more taxes than A. But if A is more
mountainous than B and the cost of getting the services to the older resident is
higher because of this say 1.5 per % point in A and still 1.0 in B, then the
difference in cost adjusted needs is only 15; (30x1)-(101.5)=15. Hence
adjusting for costs changes the relative position of these SNGs on the X-axis of
Figure 2; depending on original positions and the importance of cost
differentials, it could, invert the rankings.
The third issue is the equalization formula. To understand how it works, let us
compare the “before” and “after” situations. With no equalization “needier”
jurisdictions to the right of E spend less per capita than with equalization and
‘’un-needy’’ ones to the left of E more. Note that per capita expenditures in
Figure 4 are for the populations as a whole and not for the specific populations
(older, immigrants, school age etc.) that may be deemed to have specific needs.
Horizontal equalization in this context means than un-needy SNGs spend less
overall on their residents after equalization is implemented and implicitly spend
for residents of other jurisdictions. Needier jurisdictions can now spend to better
124
satisfy the needs of their residents without, given the assumption of equal
revenue capacity, having to levy higher taxes while before equalization they
spent less since we assumed no additional tax effort. Thus, for example, for the
neediest jurisdiction with a cost adjusted needs indicator of 150, equalization
increases expenditures per capita from 1.15 to 1.25, but for an un-needy region
with a needs indicator of 30, equalization with its diversion of revenues reduces
public expenditures it can finance from 0.7 to 0.5. As in Figure 3, a balanced
solution with horizontal (H) equalization requires that benefits and costs
coincide. The importance of equalization depends on the equalization formula,
which gives the positions of the lines around the central point E. It is
conceivable that the slopes of these two lines are not the same.
Figure 4
A stylised representation of an expenditure equalization scheme
SNG per capita
eligible expenditures
SNG expenditures
after equalization
1.25
SNG expenditures
before equalization
1.15
E
1.0
0.7
0.5
100
30 lowest
low
high
150 highest
Indicator of cost adjusted
needs
Source: authors adapted from Dafflon and Vaillancourt (2003)
The fourth issue is whether an equalization policy would introduce further limits
to the redistribution formula. In Figure 4, E represents an exactly neutral
position; a jurisdiction at this point would neither pay nor receive any equalizing
amount. But the central point need not be at E. Other equalization targets are
possible. It can be debated whether jurisdictions with just above average needs
should benefit from equalization; one could argue that this would be a
disincentive to become more productive or that measurement errors of needs are
125
upward biased and thus that a cushion of say 5% should be used. One could also
argue on financial, political and equity grounds that only jurisdictions above a
certain level (e.g. 110) should qualify.
We noted earlier in Box 1 and its discussion that while disparities are eligible for
equalization, differences (items D and E) should not be. We come back to this
now since it is relevant to expenditure equalization. Figure 5 illustrates the
difficulty of drawing the border between genuine disparities and local
preferences or management abilities that result in expenditure or cost
differences. The first scenario relates to the optimal size of SNGs and their
capacity to realize scale economies. The second scenario illustrates the difficulty
of distinguishing between higher production costs that arise from justifiable
factors and those that result from X-inefficiencies.
Scenario 1: Impossible economies of scale or reluctance to cooperate
The jurisdictions face the usual simplified U-shaped production function for a
local public good S. Start with the production function PF I for SNG1. Resident
beneficiaries pay for the service on a quid pro quo basis (for simplification: one
resident, one unit of local service S, one tax unit - no spillover). The efficient
solution is at E for a total of N optimal residents served. The E solution shows two
key results: the minimal average cost at AC 1 and the total local public
expenditure at the optimal level for PF I.
Consider SNG2: assume it has an identical production function PF I, but only N 2
residents. Average cost is AC 2. Why is this so? There are three plausible
answers (1) The number of beneficiaries is low because of socio-demographic
characteristics of the resident population in SNG2 (less school-aged children if S
is a primary school) (2) SNG2 is not in a position (for topographic reasons or
distance) to cooperate with neighbouring SNGs in order to increase the number
of beneficiaries towards N optimal . (3) SNG2 (for reasons of differences in
preferences or the desire to remain autonomous) is not willing to cooperate with
neighbouring SNGs? In this last case, it should also bear the fiscal consequences
of the decision and not receive equalization to make up for the difference which
is not due to equalizable disparities in cost.
Figure 5
expenditure
Production functions for a sub-national public
Average cost
Production Function II = PF II
(SNG3)
Production Function I = PF I (SNG1 and SNG2)
F B
0
E
126
Number of beneficiaries for service S
D
AC 2
AC 1
N2
SNG2
N optimal
SNG1
Source: Dafflon and Mischler, 2008: 218
Scenario 2: Genuine cost disparities versus X-inefficiencies
Now let’s look at a third local unit, SNG3 in Figure 5 with production function
PF II characterized by higher costs for the whole range of production. Even with
the optimal number of beneficiaries served, SNG3 cannot provide an equal level
of service S at the same tax price [N optimal D > N optimal E]. If the cost difference
AC 1 EDAC 2 is a genuine disparity, then the situation suggests some kind of
equalization so as to restore the fiscal balance. This would not only reduce the
average cost (tax price AC 2 ) of service S that residents in SNG3 face, but it
should also reduce fiscally induced migration, thereby enhancing efficiency. 36
But does PF II represent the real costs or does it hide any X-inefficiencies? How
can one interpret the difference ED in average costs if SNG1 and SNG3 serve
the same number of beneficiaries? 37 Can SNG3 do anything about the high
costs?
Figure 5 thus identifies three situations that need to be examined if expenditure
needs equalization is on the political agenda to be able to rank SNGs on the X axis. Cost adjusted needs can be determined in relative terms only if sources of
cost differentials are clearly traced and identified. This is not simple; it requires
information about the number of beneficiaries and the production function of
each public service selected for equalization for several SNGs in order to set the
standard cost function within a reasonably range. Such information is not always
available. 38 And are costs set by beneficiary or by a production determined
grouping of beneficiaries? For example, for primary school, is it average cost per
pupil that matters or average cost per class with different results if regulations
require a minimum and set a maximum number of pupils per class. And who
determines when mergers or at least cooperation between SNGs should be
required to lower average production costs; are mixed language or mixed
religious classes to be mandated either centrally or by SNGs that pay horizontal
equalization?
From this perspective, one can see that any policy of expenditure-based
equalization is a tremendous challenge. Since expenditure needs equalization is
complex should one conclude that one should renounce, as the Canadian Expert
Panel on Equalization recently proposed? 39 Or, should there be an attempt to try
to design expenditure needs equalization as best as possible with imperfect
knowledge, information and data? 40
127
Combined equalization
Can one combine the two types of equalization in one formula? Yes, but one
must be clear on the sequence to do this. Recall that equalization is about
providing similar levels of public services at similar levels of taxation. Hence to
combine both types of equalization, the following steps seem appropriate:
 First, establish the needs index and compute the expenditure equalization
entitlement, positive or negative of each SNG according to it;
 Second, correct the needs based index for cost differences and compute
anew the expenditure equalization entitlement, positive or negative of each
SNG according to it;
 Third, compute the revenue capacity index and compute the revenue
equalization entitlement, positive or negative of each SNG according to it;
 Fourth, combine the expenditure and revenue equalization entitlements
together to get total equalization
Horizontal versus Vertical Equalization
A last issue deserves attention, which is whether equalization is horizontal or
vertical. In Figure 3, surface CDE = EFG implies that equalization is horizontal,
between contributing and beneficiary SNG units; CBK, if it exits in total or
partially, is vertical. In Figure 4, a balanced solution (around E) with horizontal
equalization requires that benefits coincide: but the solution could be also to
grant equalization to the jurisdictions with cost adjusted needs higher than
average (100 points on the horizontal axis) without asking the jurisdictions with
cost adjusted needs lower than average to contribute; needs equalization would
then be vertical, centrally funded.
Horizontal equalization is typically a "Robin Hood"-type of equalization: highcapacity SNGs directly transfer public revenues to a fund serving low-capacity
SNGs. This is less conceivable for expenditure needs equalization. 41 This would
imply that SNGs with relatively low needs and costs of service provision accept
higher tax prices which allow subsidizing other SNGs with relatively high
expenditure needs. This would distort the relative local tax prices of public
services and result in allocative inefficiencies.
Two further arguments against horizontal expenditure equalization are: (1) for
those public services that are financed through user charges, if the “price" does
not reflect benefit, consumers will face false price signals; (2) when the
difference between SNG choices, X-inefficiencies and genuine disparities is not
clear, SNGs might indulge in strategic behaviour with the aim of placing
themselves in a more favourable equalizing position (in this case, higher costs
and more needs). Vertical needs equalization can be set on expenditure standards
that eliminate functions based on the benefit principle for their financing and
that ignore SNGs potential strategies but this adds to complexity. 42
Conclusion
This paper has shown that the decentralized provision of both public and private
goods and services, either through budgetary expenditures, tax expenditures or
regulation of economic behavior is often a solution that yields superior outcomes
128
than the centralized provision of these goods and services. What exactly should
be provided in a decentralized fashion needs to be defined precisely. One cannot
simply say education for example; one must distinguish between the various
inputs in education, ranging from school curriculum to school cleaning.
However, setting what goods and services should be provided in a decentralized
fashion is only half of the equation. One must then ensure that the decentralized
providers have the financial means of carrying out their mandate. This is done
not only through own revenues but in most if not all countries, through intergovernmental transfers. The appropriate own revenue depends on the type of
goods and services offered. The transfer scheme will reflect both vertical and
horizontal imbalances as well as the degree of solidarity between regions.
129
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Boadway R. and A. Shah (eds), op. cit. , 397-424.
Rossi S and B. Dafflon, 2002 : The theory of subnational balanced budget and
debt control; in Dafflon B. (ed): Local Public Finance in Europe: Balancing
the Budget and Controlling Debt, Edward Elgar, Cheltenham UK, Series:
Studies in Fiscal Federalism and State-Local Finance, pages 15-44.
Samuelson, Paul A. (1954). “The Pure Theory of Public Expenditure” Review of
Economics and Statistics, Vol. 36 (4): 387-389.
Ter-Minassian T. (ed), (1997), Fiscal Federalism in Theory and Practice,
International Monetary Fund, Washington.
Ter-Minassian, T. and J. Craig, (1997), "Control of Subnational Government
Borrowing", in Ter-Minassian (ed.), op. cit., International Monetary Fund,
Washington.
Tiebout, C. (1956). “A Pure Theory of Local Expenditures” Journal of
Political Economy, Vol. 64, pp. 416-424.
World Bank, Entering the 21st Century: World Development Report, 19992000. Oxford: World Bank and Oxford University Press, 2000, Chapter 1.
132
Endnotes:
1
World Bank (2000)
Oates (1972) and Mueller (1996)
3
Cremer et al. (1996); Raff and Wilson (1997) and Bucovetsky et al. (1998)
4
Tiebout (1956)
5
Rossi and Dafflon 2002: 20–25.
6
Ter-Minassian and Craig, 1997:162; Dafflon and Tóth, 2009: 337.
7
These can occur in the schooling environment for example.
8
The related technical issues of “off” vs. “on” budgeting and extra-budgetary accounts is
not discussed here. For discussion see Wong with Gooptu and Martinez-Vazquez
(2002).
9
Whenever one economic actor (a firm or individual) undertakes an action that has a
(net) added value or cost to another economic actor, there is an externality. If these
values (positive externalities) are not paid for by the recipient or net costs (negative
externalities) are not paid for by the first actor, the result is inefficient resource
allocation.
10
Gravelle (2005) identifies four variants: (i) exclusions, exemptions, and deductions,
which reduce taxable income; (ii) preferential rates, which apply lower rates to part of all
of a taxpayer’s income; (iii) credits subtracted from taxes and ordinarily computed, and
(v) deferrals of tax, which result from delayed recognition of income for from allowing
in the current year deductions what are properly attributable to a future year.
11
Governments also provide private goods. Indeed, in many countries, the provision of
private goods dwarfs that of public goods in the budget. Education services, most of
health services and some income insurance/support scheme are joint “private-public”
goods: private because the service is delivered to individual and, as such, it consumption
is rival and price exclusion is possible; public because the service provides externalities
which are of collective nature (education is a key factor in social and cultural
homogeneity, labor capacity and mobility, health and the exercise of democracy) The
distinction between national and local applies to such private goods. The provision of
education is more a local good while the provision of a pension scheme is more national.
12
Samuelson defined public goods (or “collective consumption goods” as he calls) as:
“…[goods] which all enjoy in common in the sense that each individual’s consumption
of such a good leads to no subtractions from any other individual’s consumption of that
good...” (Samuelson 1954: 387).
13
We assume that the output will be a compromise between the two desired levels, a
reasonable outcome in a democratic system .
14
For Qc, group D1 would be ready to pay B, but has to pay much more in C; and for a
price equal to C, group D2 would rather obtain quantity Q2 but has to satisfy itself with
Qc only. Note that the two jurisdictions could enter into a cooperative agreement,
producing more in total that in the independent solution at a lower cost for each of them
(Buchanan, 1968).
15
Oates (1972).
16
Tiebout 1956.
17
If they are neighbors, amalgamation could be on the agenda since the residents’
preferences are now identical at least for this public service.
18
Musgrave (1983) asks, “Who Should Tax, Where, and What?” The tax assignment
problem is part of a larger set of questions that can be referred to as the revenue
assignment problem. The latter includes the design of intergovernmental grants and the
framework for borrowing by subnational governments.
2
133
19
Where strict compliance with benefit finance is infeasible because of the difficulty or
undesirability of exclusion from the benefits of public spending, the principle is,
nonetheless, instructive.
20
This statement is incomplete if the benefits of public spending, as well as tax burdens,
are considered. Taxes related closely to marginal benefits may finance expenditures that
involve substantial inframarginal benefits. These inframarginal benefits may be of
special value to low-income families. Obvious examples include the provision of safe
drinking water. Many consumers would probably consider themselves better off if they
had access to safe water, even if they had to pay for it. The problem is often access, not
cost.
21
Subsidiarity in taxation was introduced to the European Union with the Maastricht
Treaty amendments to the Treaty of Rome (Article 3B). The Commission of the
European Communities (1991, p. 7) explained that subsidiarity requires that “Member
States should remain free to determine their tax arrangements, except where these would
lead to major distortions.”
22
Vertical imbalance may exist because subnational governments have difficulty
implementing many taxes, but higher levels of government can implement almost any
tax that a lower level of government can implement.
23
If a subnational government legislates and collects its own taxes, protected by
meaningful constitutional safeguards of its right to do so, it clearly has a source of own
revenues.
24
Even if subnational governments have own revenues, they may be unable to influence
the amount of revenue they receive. This is true, for example, if the central government
shares revenues from certain taxes with subnational governments. In such a case, these
are own revenues but not marginal revenues of subnational governments.
25
An important prerequisite for the exercise of subnational fiscal autonomy is the ability
to choose statutory tax rates. An issue here is why statutory and not effective tax rates.
Effective tax rates would vary if subnational governments could alter deductions,
exemptions, and so on, but this would mean changing the base and not the rates. This
would increase the complexity of the system and the compliance costs of firms operating
in multiple jurisdictions.
26
In the case of Canada for example, provinces that use the harmonized sales tax (HST),
a VAT collected by the federal government for both it and the province at a jointly
agreed rate (5% Federal and a provincial rate) are allowed a maximum 5% variation in
their base from the federal government base.
27
Subnational constitutions or laws may limit any of these, but self-imposed restrictions
in the constitutions of subnational governments differ from restrictions imposed from
above by law or as part of a national constitution. In the case of Switzerland, for
example, the definition of the income tax base and tax deductions is federal and applies
to the twenty-six cantons. The cantons can choose their own tax rate schedule and the
amount of deduction (but cannot add one to the federal list). The communes (local
government units) can only decide the tax coefficient for balancing their budget in a true
piggyback tax system.
28
Note first that “tax competition” is distinct from the Tiebout model: in Tiebout, it is
the best alternative “basket of local public services – taxes” that determines the
localization of economic agents: it is “fiscal competition” through benchmarking and
mobility. In tax competition, it is assumed that the basket of public local public services
is almost identical so that only taxes may be considered. Brennan and Buchanan (1983)
provide a strong argument for tax competition (see also McLure 1986). This is only part
of the story, although an important part. Because those who enjoy public goods cannot
be excluded from enjoying the benefits, they have little incentive to reveal their
preferences for such goods. There is thus a tendency to underprovide public goods that
134
tax competition might aggravate (see Gordon 1983 for a theoretical analysis of the
inefficiencies that can result from decentralization, including tax competition). Benefit
taxation helps to combat this source of market failure (Wildasin 1986). Tax competition
makes it difficult for subnational governments to tax mobile factors—capital and highly
educated or skilled labor—and therefore to engage in progressive taxation.
29
Inequities and economic distortions can also occur if the tax systems of various
subnational governments do not mesh, resulting in gaps or overlaps in taxation. Within
limits, these problems—which differ in importance from tax to tax—can and should be
tolerated in the interest of gaining the benefits of fiscal decentralization. Serious
complexities, inequities, and distortions can be achieved without greatly compromising
the fiscal autonomy of subnational governments through intergovernmental compacts
among subnational governments or the imposition of uniform ground rules by a higher
level of government, for example, rules governing the definition and division of the
corporate income tax base.
30
In a sense US states using federal AGI as their PIT tax base do this.
31
Although all subnational governments, acting as a group, can attempt to influence
their share of revenues from these taxes, no subnational government, acting unilaterally,
can hope to do so.
32
For a commented review of the literature on this, see Dafflon, 2007, 363-366.
33
In recent years, public finance economists have proposed that SNGs' financial capacity
would be better measured with RTS methods (for Representative Tax System). RTS
measures the per capita tax potential of SNGs and not the actual tax yield. RTS
methodological steps are: 1) determine which taxes have to be included in the
calculation (structural versus irregular tax yield, buoyant or not, all taxes or a selection,
and so on); 2) if the capacity is computed on the potential tax yield and not the tax base,
which are the referred "standard" tax rates or tax rates schedules; 3) with several tax
sources, decide which weight should be given to each of them (the standard method is
that weights are proportional to the respective potential tax yield); 4) decide if the
calculation is made on an annual basis or an average of several (three, more?) years.
Another aspect of the debate is whether SNGs' financial capacity should be measured
with macroeconomic data, such as regional GDP per capita or RTS. But the discussion is
rather semantic: with small open economies, regional GDP appears to be a rather broad
evaluation; at the local level, this calculation does not exist. RTS avoid this trap.
34
Which may well be paid for by residents of SNGs already contributing to horizontal
equalization if central and SNG tax capacity are correlated.
35
Courchene, 1998; Rechovsky, 2007: 400-409.
36
Bird and Vaillancourt, 2007: 262.
37
Take the example of primary education. Suppose SNG1 and SNG3 buy the same
number of books for the same number of pupils. Does SNG3 overspend on fancier
books, try harder to keep up with new pedagogical trends, or teach a different language
group and thus face higher unit costs for otherwise identical books? Yet if one refers to
the logic behind Box 1, further questions arise. Is SNG3's choice to follow a new
pedagogical path an item of laboratory federalism, a decision taken in coordination with
other SNGs (in this case, equalization is acceptable), or is it an own decision following
the specific tastes of the constituency (no equalization)? If language is different, is the
higher government concerned with the protection of minorities (equalization is
acceptable) or are language differences not an issue (no equalization)? Not only is it
difficult to isolate variables that affect costs from variables that indicate differences in
public good preferences, but the answers (to laboratory federalism and preoccupation
with minorities protection in the example) – and therefore the justification of
expenditure needs equalization – belong to the realm of politics.
38
Dafflon and Mischler, 2007: 183-185.
135
39
Boothe and Vaillancourt, 2007: 48.
Boex and Martinez-Vazquez, 2007: 291.
41
Dafflon, 2007: 370-371.
42
Dafflon and Mischler, 2008: 235.
40
136