Chapter 1 Introduction: "European" Fiscal Federalism
1.1 Federalism and Decentralization
1.2 Fiscal federalism: a European approach
1.3 Decentralization: an essay of typology
1.4 Local public goods (LPG)
1.4.1 Definition
1.4.2 Divisibility and LPG
1.4.3 Spill-over effects
1.4.4 Congestion Effects
1.4.5 Economies of scale
1.5 Analysis of traditional theories
1.5.1 Arguments in favour of centralization
1.5.2 Arguments in favour of decentralization
1.6 The role of institutional constraints
1.7 What have economists to say about federalism and decentralization?
References
Bird, Dafflon, Jeanrenaud, Kirchgässner, 2003, Assignment of responsibilities and Fiscal Federalism,
in Blindenbacher R. and Koller A. (eds), Federalism in a Changing World - Learning from Each Other, McGill-Queen University
Press, Montréal, pages 351-372
Council of Europe, 1985 and 1998, The European Charter of Local Self-Government and Explanatory
Report, Strasbourg, Council of Europe Printing
Oates, 1999, An Essay of Fiscal Federalism , Journal of Economic Literature, Vol. XXXVII, Issue 3, pp. 1120-1149.
Oates, 2005, Toward a Second-Generation Theory of Fiscal Federalism, International Tax and Public Finance,
12, pages 349-373
1.1 Federalism and Decentralization
Figure 0-1
Oates' continuum in government system
Unitary system
Federal system
Rather centralised
Confederal system
Rather decentralized
Anarchy
Figure 1-2
The two dimensions of government system
decentralized
Switzerland
term
Spain
France
term
In budgetary
in constitutional
unitary
centralized
federal
Germany
Figure 1-3
Lijphart's classification
decentralised
•
•
Switzerland
Spain
• Germany
•
Portugal
centralised
unitary
federal
1.2 Fiscal federalism: a European approach
Figure 1-4
Relational web in a decentralised government system
federal/central
1
2
1.1
1.2
Median
Voter
Citizens
Residents
3
1.3
… Regions
(Cantons)
1.4
… local
government
1.3 Decentralization: an essay of typology
Table 1-5
Two types of (de)centralization
types of (de)centralization
Objectives
top-down
bottom-up
= become local
= remain local
• Displacement of the budget constraint towards the local
tiers (displacement of outlays rather than devolution of
competencies)
• Increasing national welfare (better adjustment " offer to
• Increase the innovation potential at the local level
• maintain a large diversity of mix "local public goods and
services – local financing (taxes or user charges)
• "voting with the feet" argument
the demand") in maintaining minimum standards for the
provision of decentralised public policies (merit goods)
• increase the allocative efficiency (better coincidence in the provision of public services to local preferences)
• guarantee of a better governance (Olson's equivalence principle between the circles of deciders, beneficiaries and payers;
budget responsibility, accountability)
Performance
Fulfilment of the objectives decided by the centre
evaluation
Modality
protection of local jurisdictions against too much centralization
respect of local choices for public services
• deconcentration
• local autonomy
• delegation
• subsidiarity
• devolution
• decentralized (horizontal) cooperation
• horizontal et vertical competition
• (political) benchmarking
Dominant model • Dominant vertical relations between the centre and the
• conflict central/local (if society is heterogeneous, local
regions, the centre and the communes, respectively the
decisions are different from those which would result from
regions and the communes.
a central choice)
• Dominant preferences of the centre;
• dominant local autonomy
• principal-agent model where the centre is the
• subsidiarity
principal and the regions the agents.
• Information asymmetry in favour of the centre
• horizontal / vertical co-operation and competition
• dominant preference of local residents
Table 1-6
Public finance according to the form of government
" decentralized public finances"
Government
Federal centralized (Germany)
system
Unitary decentralised (Spain)
"fiscal federalism"
Federal decentralized (Switzerland)
Unitary centralized (France)
Constitution
• institutions are organised in a formal "constitution"
• the (historical) territorial map exists before the Constitution,
(number of government layers, territorial design,
which is designed ex post. The Constitution takes as they are
Institutional
competencies, finances, rule for the assignment of
the territorial limits of the constituent states.
organisation of
resources and transfers) )
the State
• the constitution fixes the design of subnational
governments (SNG)and fixes the rules for
intergovernmental relations
• powers and competencies which are not explicitly given
to SNG are de facto in the power of the centre
• national preferences are dominant
• The Constitution reflects a voluntary association of sovereign
member states (a Confederation) and fixes the
intergovernmental cooperation rules.
• Competencies belong de facto to the local and regional
government units. The Constitution (federal, respectively
cantonal) must explicitly mention which competencies are
transferred bottom-up and assigned to the higher tier. The
same for revenue sources (taxation)
• the Constitution = set of rules + consensus requiring a
double majority of the voters and the member states for the
re-assignment of functions and resources
Types of inter-
• importance of specific conditional grants
governmental
transfers
• budget autonomy and accountability : limited number and
amount of specific conditional grants
• equalization transfers with the objective of reducing
• equalization transfers aimed at reducing fiscal disparities
disparities in local budget (reducing individual inequality
between member states, but no objectives of interpersonal
caused by disparities in the local provision of public
redistribution
services and local taxation )
Model for inter-
• « principal– agent » model
governmental
• in unitary centralized nation, the principal defines the
relations
• negotiation model
competencies and finance of SNG in view of the central
interest
• information asymmetry and moral hazard
Case studies
• federal centralized (Venezuela, Austria, India)
• semi-federal States or unitary decentralized (Spain,
Nederland, Sweden)
• unitary centralized State (France, United-Kingdom)
• mix federalism (Germany, USA)
• « dialogue/diplomacy » between provinces and the central
government in Canada
• Switzerland: cooperation between the federal state and the
cantons; horizontal cooperation between the cantons;
concordats; Ministerial (Functional) Conferences of the
Cantons; consultation, initiative, referenda
What is decentralization?
• deconcentration
The central State keeps all and every competencies for specific functions, but decides that these functions should be provided
and the regional or local level by administrative agencies of the centre (line ministry)
• delegation
SNGs and LGs are agents of the centre for the provision of public services at the standard levels fixed by the centre
- can SNGs and LGs provide more that the standards?
- Which government has to finance the provision of local public service "at the standard level"?
• devolution
Competencies are given to SNGs and LGs. They have competency, responsibility and accountability for the provision of these
public services and have to finance them.
Categories of federalism: another set of definitions
9 Dual federalism is characterized by the clear separation of competencies between government layers: if a competency is assigned to a
government layer, its authority is exercised without sharing. Dual federalism is seldom implemented.
9 Cooperative federalism
is characterized with more interdependency between government layers. Decisions are not taken without
consultation between territorial stakeholders decentralized jurisdictions, a process that can be long and complex. Vertical fragmentation of
competencies also implies that each government layer contributes to the public policy for implementation.
9 Competitive federalism
is characterised
with competition between subnational government units (regional or local). SNG units offer
attractive basket of public services and attempt to lower as much as possible the tax price of this basket. Connected idioms: fiscal competition,
(tax competition, tax race to the bottom.
9 Executive federalism: in this form of federalism, the federal government maintins its full responsibility and power to define certain specific
functions, but transfer the implementation and the delivery of services to SNG units. It is a "principal – agent" relation in which the federal
government (the principal) fixes the objectives and the rules of the games and edict the standards which have to be respected in the provision
of local public service. The SNG units (the agents) have to provide the service and, in many cases also to fund the service.
•
The same categories exist between regional and local government layers.
1.4 Local public goods (LPG)
1.4.1
Definition
∑ ni=1 B1i
market good
B1 =
collective good
S1 = S1a = S1b = S1c = S1d = ...= S1n
local public service S
S 1i = S 1 N - α
with α = the parameter of divisibility
if
α=0
N-0 = 1, and therefore S1 × 1 = S1 Samuelson's pure collective good
α=1
N-1 = 1/N and therefore Si1 = S1 × 1/N = S1/N = a pure market good, distributed between the N consumers,
each for 1/N of the total offer,
0 < α <1
a collective good that is more (towards 1 = local) or less (towards 0 = central) divisible,
1<α
rationing of the service (limit of capacity in the production function).
Bonuses and problems that emerge with "local" collective goods and services
Individual preferences for local
public goods and services
If political decision-making is decentralized among subnational units, and assuming heterogeneous
preferences for public goods, each local government can tailor its tax and service package to the
preferences of like-minded individual residents and thus minimizes coercion.
Economies of scale
If in the provision of local public services there are economies of scale that extend beyond the
jurisdictional limits, it makes sense to have larger service precincts
Spillovers or geographical
externalities
A potential difficulty with subcentral provision is that subcentral authorities may ignore any external
benefits (spillovers) to non-residents and so underprovide their services.
Congestion costs
Non-residents who move to the production place in order to benefit from non-exclusive services might
create congestion costs. For economic optimality, access should be restricted to residents only
Information and decision costs
Even if it were possible to create separate authorities to serve each group that jointly consumes a
particular local public good, there are strong reasons for not doing so because of the individual costs to
participate in too many decision-making processes. Information and participation costs have to be taken
into account: there can be some major gains in reducing the levels and number of governments which
would have the responsibility for providing many subcentral services.
Fiscal competition
Competition among jurisdictions would allow for a variety of taxes and public goods menus. Individuals
would reveal their preference for one combination by moving into the jurisdiction that provides them
with the maximal net benefit.
1.5 Analysis of traditional theories
The TOM model of fiscal federalism
TIEBOUT
1956
A Pure Theory of Local Expenditures
OLSON
1969
The principle of Fiscal Equivalence: the division of responsibilities among different levels of government
OATES
1972
Fiscal Federalism
MUSGRAVE
1961
Approaches to a fiscal theory of political federalism
1.5.1
Arguments for centralization
Macroeconomic and stabilization policies
•
Inflation
•
Failure of a local anti-cyclical public policy: small economies are opened
•
Free Rider behaviour
•
Local public debt limitation
•
Inflation
It is generally accepted that a central agency (the central bank, not even the central government) must control the supply of money. If not,
decentralized government would print money to make up for their deficit and this would create inflation.
•
Failure of a local anti-cyclical public policy: small economies are opened
Stabilisation policy via the local budget is not possible because the local economy is largely open. Multiplier effects of local additional
expenditures for stabilisation purpose would largely flow over the local border: both regions and local governments are in the position of a
"small" open economy (Balassone and Franco, 1999).
- There is little if no chance that additional public investment, however important but only local, would alone boost a depressed economy.
- Local entrepreneurial capacity can be insufficient to respond to public tenders – which in any case have to be opened, nationally or
internationally, according to their amount.
- Revenues generated through those additional activities (wages, raw material, equipment and so on) will neither necessarily fall into local
hands, entrepreneurs, traders or resident workers, nor be spent within the local borders.
•
Free Rider behaviour
Why then should a local government borrow to finance additional investment when its benefit will spill over? It could as well wait and adopt a
free rider position, letting other jurisdictions implement macroeconomic policies and waiting for the benefits to spill in.
Now, jurisdictions are not stupid; they will rapidly learn and in turn implement strategic behaviours.
This is a typical non cooperative situation which requires an external hand to get out of this prisoner's dilemma.
The theory asserts that the "external" hand must be "central".
•
Local public debt limitation
This is a controversial argument when LGUs have access to own revenue sources together with the right of the decentralized jurisdictions to
borrow: without rules limiting deficits and borrowing at the decentralized level, fiscal myopia will push SNGs to indulge in deficit spending and
too high level of indebtedness. Uncontrolled access to capital markets and mismanagement of the budgets by regional and local government
could jeopardise the efforts, if any, to stabilise the economy. For this reason, so the textbook argument runs, central government ought to have
some monitoring or control power. This argument also raises the question of "budget responsibility" assumed be a LGU versus "budget
discipline" imposed from above.
In addition, global limits, such as the Maastricht criteria, raise the problem of how the deficit /debt limits are distributed between government
layers.
The double argument for central regulation is:
(i) to avoid bailout situations and
(ii) that primary reliance on market discipline does not function properly in the capital market.
Redistributive Branch
•
Mobility
The ability of decentralized jurisdiction to support redistribution from high-income to low-income groups is limited by the very nature and extent
of the local tax bases, and the mobility of the poor, the rich and business activities across local boundaries.
Sharp redistribution by a given jurisdiction in isolation will attract the poor from neighbouring places and, at the same time, repel mobile
individual or corporate taxpayers in higher tax brackets to more clement skies. The consequence is the shrinkage of the tax base and a selfdefeating redistributive policy – a consequence that is worsened through tax competition.
•
Federal Welfare Programmes
But even in the quasi absence of mobility, there could be good arguments for centralized social (redistributive) policies: it may simply be that
the electorate favours federal welfare programs – such as social security* – for reasons of equal access, actuarial efficiency and costs, social
national cohesion or possible disparities (risk selection), that would result if such insurances were left to the initiative and finance of
decentralized units.
* in Switzerland: social security for the aged, disabled, widow, + unemployment insurance for unemployed + illness and accident insurances at
the norm (AVS, AI, APG, AMat, AFA, AFam, AMal belong to the category of federal merit goods).
Arguments for decentralization
•
The Preference- matching argument
If political decision-making is decentralized among subnational units, and assuming heterogeneous preferences for collective services and goods,
each local government can tailor its tax and service package to the preferences of like-minded individual residents and thus minimizes coercion.
centralisation
jurisdiction
decentralisation
Tiebout's model
S1
S2
choice
minority
choice
I
10
8
S1
8
S1
8 go to II
10 + 5
II
5
16
S2
5
S2
5 move to I
16+8+12
III
20
12
S1
12
S1
12 move to II
20
36
46
majority
Not satisfied
vote with the feet
46 + 25
35
25
Merit good
0
Specialisation
Specialisation, respect of minorities, proximity,
Respect of minorities
Conservatism
Innovation
Fiscal competition
Proximity
•
Accountability
Politicians can not divert rents for their own benefit; lobbying is more difficult.
•
Proximity
The voice argument: residents can address their complaints, remarks and suggestions directly to the elected
•
Innovation
The "learning by doing" argument: LGUs are small "laboratories" where new ways of delivering local public services can be experimented without
too high a cost in case of failure.
Mimicking is possible in case of success.
•
Budget and fiscal Responsibility
The 1969 Olson's equivalence principle: the basic idea is that there should be coincidence between the three circles of those who decide local
public goods, those who capture the benefits and the payers. Coincidence corresponds to local accountability which requires that the tax
consequences of locally decided expenditures, the benefits of which are assumed to accrue only for local residents, should be passed on to the
local payers through either taxation or user charges.
•
Protection of minorities
Decentralisation allows a better protection of minorities. The three layers of government accept vertical cooperation: if the local layer refuses or
ignores the "legitimate" demand of a minority of residents, they may put pressure onto the intermediate layer for satisfaction, and so on
between the intermediate and central layers. This is particular sensitive in regime of direct democracy with initiative and referendum, as it is the
case in Switzerland. A successful demand addressed to a higher layer will not necessarily means that the higher layer will take over the
responsibility and function at stake, but that it will enact minimum standards that have to be respected a the local, respectively regional, levels.
In so doing, the higher government layer ensures that minorities, wherever they live, can access to minimum levels of specific collective goods
and services. Minimum standards also allow those LGUs to provide more a bette quality if they so wish.
1.6 The role of institutional constraints
For Switzerland:
•
Taking minorities into account
Cross-cutting cleavages in languages, religion, economic development, urban versus rural territorial development, prevent that minorities are
always minorities.
•
Procedure of consultation
Draft laws are subject to a procedure of consultation through which political parties, professional associations, lobby groups can express their
opinion on the policy ends and means before debate in Parliament.
•
Double majority procedure (both Chambers in Parliament; majority of the people and the cantons in constitutional federal
ballot)
At the federal Parliamentary level: bi-cameral system. Major legislative acts have to be approved by the Council of State and the National
Council. The Council of State has two MPs per canton whatever the population size or the economic weight of the cantons.
changes in the federal constitution have to be approved by a double majority: of the voters and of the cantons.
•
Initiative et referendum
Initiative and referendum are the "voice issue" in Hirsh's terminology. "Voice" mitigates the "exit" solution.
1.7 What have economists to say about federalism and decentralization?
Major topics in intergovernmental fiscal relations
major topics
WBI
T.-M.
Bird
UI
CoE
LH3
X
1
concepts of fiscal decentralization
X
X
X
2
political mechanism necessary to make fiscal decentralization work
X
X
X
3
constitutional and legal framework
X
X
X
4
macro-economic perspective
X
X
5
expenditure assignment
X
X
X
X
X
X
6
revenue assignment
X
X
X
X
X
X
7
X
X
X
X
X
X
X
X
8
local revenues / taxes
territorial variant of the benefit principle
intergovernmental grants, equalization
X
X
X
X
X
X
9
financing infrastructure
X
X
X
X
10 Budgeting
X
X
X
11 borrowing and debt
X
X
X
12 poverty alleviation
X
13 accountability and transparency
X
14 measures of decentralization
measures of fiscal disparities
5 tax administration
X
X
X
X
X
X
X
17 fiscal competition
X
19 minimum service level, guaranteed access to local public goods
X
X
16 Metropolitan areas
18 functional federalism: drawing new boundaries, alternative institutional
structure
X
X
X
X
X
X
X
Sources: WBI: World Bank Institute 2001; Ter-Minassian T. (ed.), 1997; Bird R. M., 1999; Conway F. et al., 2000; Council of Europe, 1998; Dafflon B.,
Jeanrenaud C. and Kirchgaessner C., (2003),
A multi-disciplinary approach
Fiscal Federalism
Public finance
allocation
Politics
Possible relationships between
jurisdictions
vertical
redistribution
"choice"
stabilisation
Local public goods
indivisibility
"agency"
horizontal
Constitutional rights
non-rivalry
"local" dimension
Spill-over effects
negativ external effects
other criteria of decentralisation
Social history
Social context
demography
human geography
socio-cultural context
traditions
Economic context
institutions
activities
initiative
economy
referendum
International
procedures of consultation
national
regional
local
Context of public economy
expenditures
revenues
organisation of the activities
of the public authorities
Major topics →
↓ Criteria
Allocative efficiency
Legal compliance
Olson equivalence principle (BCL)
Intergovernmental room of
manoeuvre
Fiscal competition
Governance
Productive efficiency
Scale economies
Congestion effect
Spillovers
Managerial abilities
New topic ?
13. Fiscal risks
12. accountability and transparency
11. borrowing and debt
10. Budgeting
9. financing infrastructure
8. Intergovernmental transfers
7. local revenues / taxes
territorial variant of the benefit
6. revenue assignment
5. Assignment of functions
4. macro-economic perspective
3. constitutional and legal framework
2. political mechanism necessary to
make fiscal decentralization work
1. concepts of fiscal decentralization
Decision matrix
Equity
Inter-individual disparities
Intergenerational equity
Regional disabilities
Stabilisation
Fiscal policy
Growth
Macroeconomic adjustment
Political accountability
Preferences
Transparency and information
Participative democracy
Subsidiarity
Social objectives
Sustainability
Poverty Reduction
Protection of minorities
Autonomy / secession
Implementation based on the decision matrix
impleme
ntation
case
study
Contextualisation
Politics
Theory
16 crieria
13 topics
13 topics
13 topics
13 topics
13 topics