«Comparative Conclusions on Fiscal Federalism a n wa r s h a h 1 Fiscal federalism is concerned with the public finances of the various orders of ...»
The tax powers of state governments are wide in Switzerland, Canada, the United States, Brazil, and Nigeria and are quite restrained in South Africa, Australia, Spain, and Malaysia (figure 2). Expenditure autonomy as determined by the percentage of expenditures financed by the ownsource revenues of states is high in Malaysia, Nigeria, Switzerland, Germany, Canada, and the United States but low in India and Spain (with the exception of the two regions) (figure 3). State tax autonomy (having responsibility for base and rate determination of own taxes) is high in Australia, Canada, Switzerland, the United States, Nigeria, India, and Brazil but constrained in Germany, Spain, Malaysia, and Russia. In the latter countries, states may be given some discretion in setting tax rates but tax-base determination is a federal responsibility. Further, regional governments in Russia do not have revenue autonomy. Taxing e-commerce and mobile factors are important issues imposing limitations on state finances in the United States and India.
Comparative Conclusions 381Figure 2 Subnational own-revenues as a% of subnational expenditure Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington, dc: International Monetary Fund.
The income and the sales tax system is harmonized in Australia, Canada, Germany, Malaysia, Russia, Spain, and Switzerland; it is not harmonized in Brazil, India, and the United States. The lack of a harmonized tax system leads to high compliance costs for firms and individuals operating in a multistate environment. In the United States, the federal Constitution’s interstate commerce clause acts as a break against state taxes distorting interstate commerce; in addition, states are prohibited from taxing internal and external trade. In India, on the contrary, taxes on the interstate trade of goods is an important source of state revenues. In Brazil, sales taxation is uncoordinated among the federal, state, and local governments. The Brazilian Council of State Finance Ministers (confaz) has attempted to harmonize the state vats but with limited success. Fiscal incentives through the state vat system in Brazil have resulted in fiscal wars among states. In Canada, income tax harmonization was achieved through offering federal incentives to follow a common tax base. Sales tax harmonization through similar incentives had only partial success. Canada also introduced an important innovation in the 382 Anwar Shah Figure 3 Subnational own source revenues resources as a% of total government revenues Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington, dc: International Monetary Fund.
institutionalization of tax administration by creating an independent agency with oversight by federal and provincial orders and the private sector. In other countries, tax harmonization has been achieved by centralizing taxbase determination and/or tax collection.
The case study countries, with the exception of Nigeria, follow the golden rule principle in borrowing (i.e., borrowing for capital spending only), and they primarily depend on capital-market discipline to restrain such borrowing by state and local governments. In Nigeria, all borrowings by state and local governments require prior federal approval. In Malaysia, local borrowing is subject to state government supervision. Such direct borrowing is typically discouraged; instead, private-sector participation in infrastructure provision is encouraged. In Brazil, external debt requires approval by the federal Senate, and all borrowing is subject to legislated fiscal rules. Several federal countries have special arrangements to assist state and local borrowing for capital projects. In Australia, the Australian Loan Council facilitates such borrowing by making data on public finances available to the capital
Comparative Conclusions 383markets. In Canada, provincial Crown corporations that run on commercial principles assist local borrowing. In the United States, state bond banks (private agencies) collate local borrowing demands and issue bonds for the pooled demand. Also in the United States, interest on such borrowing by state and local governments is deductible against federal income-tax liability – providing a direct federal subsidy for such borrowing. In Switzerland, the Cooperative Centre of Swiss Local Communities provides capital finance to local governments.
There is no evidence of a race to the bottom due to state and local tax autonomy in the case study countries. Most countries do not show any serious tax competition, and where such competition has surfaced – such as in Brazil, Switzerland, and, to a more limited extent, India, Canada, and the United States – it has not resulted in a lower tax effort and lower quality of state and local public services.
In general, taxing powers in the sample countries are more centralized than dictated by fiscal federalism principles. Many factors may have been involved in achieving this result. This may have happened partly because most nations placed a premium on tax harmonization. Also, shifting expenditures downward was politically more feasible than allowing finance to follow function, and state and local politicians were less than enthusiastic about assuming taxing powers but very interested in receiving fiscal transfers from the national government with little accountability to local taxpayers.
Vertical Fiscal Gaps
A downside of over-centralized tax powers with decentralized expenditure responsibility is the creation of vertical fiscal gaps, or the mismatch between revenue means and expenditure needs among state and local governments (see table 4 for details). Vertical fiscal gaps and revenue autonomy in subnational governments remain concerns in those federal countries where the centralization of taxing powers is greater than is necessary to meet federal expenditures and federal fiscal transfers to meet national objectives as this results in extensive use of conditional transfers to exert undue influence on subnational policies. Further, such large gaps create democratic accountability deficits as state and local governments experience the pleasure of spending money without having to justify additional spending to their taxpayers.
This is a concern for state governments in Australia, Germany, India, Malaysia, Nigeria, Russia, Spain, and South Africa. In Nigeria, there is a special concern about the central assignment of resource revenues. In Germany, these concerns are prompting a wider review of the assignment problem and a rethinking of the division of powers among federal, Land, and local governments. A consensus is yet to be formed on a new vision of fiscal federalism in Germany.
384 Anwar Shah Table 4 Vertical fiscal gaps
Federal fiscal systems aspire to provide safeguards against the threat of centralized exploitation as well as decentralized opportunistic behaviour while decision making remains close to the people. In fact, federalism represents either a “coming together” or a “holding together” of constituent geographic units to take advantage of the greatness and littleness of nations.
But federal fiscal systems whose purpose is to accommodate such “coming together” or “holding together” may pose some risks for macro stability.
Two main issues raised by the case study countries on this count are (1) fiscal discipline and (2) intergovernmental competition.
Fiscal Prudence and Fiscal Discipline under “Fend-for-Yourself” Federalism
Fiscal lack of discipline among subnational governments is a matter of concern in federal countries in view of significant subnational autonomy combined with an opportunity for a federal bailout. In mature federations, fiscal policy coordination to sustain fiscal discipline is exercised through both executive and legislative federalism as well as by instituting formal 386 Anwar Shah and informal fiscal rules. In recent years, legislated fiscal rules have come to command greater attention. These rules take the form of budgetary balance controls, debt restrictions, tax or expenditure controls, and referendums for new taxing and spending initiatives. Most mature federations also specify “no bailout” provisions in setting up central banks. In the presence of an explicit or even implicit bailout guarantee and preferential loans from the banking sector, printing of money by subnational governments is possible, thereby fuelling inflation. Recent experiences with fiscal adjustment programs suggest that, while legislated fiscal rules are neither necessary nor sufficient for successful fiscal adjustment, they can help forge a sustained political commitment to achieve better fiscal outcomes, especially in countries with divisive political institutions or coalition regimes.
For example, such rules can be helpful in sustaining political commitment to reform in countries with proportional representation (Brazil) or multiparty coalition governments (India) or in countries with a separation of legislative and executive functions (United States and Brazil). Fiscal rules in such countries can help restrain pork-barrel politics and thereby improve fiscal discipline, as has been demonstrated by the experiences in Brazil, India, Spain, Russia, and South Africa.
Brazil’s success with fiscal rules from 2001–07 is particularly remarkable.
Germany, however, could not achieve fiscal discipline on the part of the Länder, even with fiscal rules, because the federal Constitutional Court had blessed federal bailouts, thereby creating soft budget constraints for them. A more recent decision (November 2006) by the same court to disallow a requested bailout by Berlin indicates a reversal of such policies. In the United States, fiscal conservatism on the part of states ensures fiscal discipline, but pork-barrel politics in the federal government has not been restrained by fiscal rules. Australia and Canada achieved the same results without having any legislated fiscal rules, whereas fiscal discipline continues to be a problem even though Germany has legislated fiscal rules. The Swiss experience is the most instructive with regard to sustained fiscal discipline. Two important instruments create incentives for cantons to maintain fiscal discipline. First, fiscal referendums allow citizens the opportunity to veto any government program; second, the legal provision enacted in some cantons to set aside a fraction of a fiscal surplus in good times works like a “debt brake” for rainy days (in the United States, these are called rainy-day funds).
Competition among state and local governments is quite common in most federal systems. It occurs through lobbying for employment by: generating federal or private-sector projects, including military bases; encouraging
Comparative Conclusions 387domestic and foreign direct investment; providing incentives and subsidies for attracting capital and labour; supplying public infrastructure to facilitate business location; providing a differentiated menu of local public services; offering one-stop windows for licensing and registration; and pursuing endless other ways of demonstrating an open-door policy for new capital and skilled labour. State and local governments also compete among themselves by erecting trade and tariff walls to protect local industry and business. They also try to out-compete each other in exporting tax burdens to non-residents and obtaining a higher share of federal fiscal transfers where feasible.
Preserving intergovernmental competition and decentralized decision making are important for responsive and accountable local governance in federal countries. The Swiss and the American experiences demonstrate the positive impacts of such a competition. “Beggar-thy-neighbour” policies have the potential to undermine these gains from decentralized decision making, as demonstrated by the recent “race to the bottom” experience in Spain and the so-called “fiscal wars” in Brazil and Switzerland.
State inheritance taxes have been eliminated through interjurisdictional competition for rich residents in Australia, Canada, and Switzerland. In Switzerland, such competition is further advanced through regressive income tax schedules. Mergers of cantons to abate such competition in Switzerland have been ruled out by referendums. To limit the adverse effects of such competition, a partnership approach that facilitates a common economic union through the free mobility of factors by ensuring common minimum standards of public services, no barriers to trade, and wider information and technological access offers the best policy alternative in regional integration and internal cohesion within federal nations. It is not a matter of “to compete or to cooperate” but, rather, of how to make sure that all parties compete and cooperate but do not cheat.
4 i n t e r g o v e r n m e n t a l f i s c a l tr a n s f e r s
In all the case study countries, the federal government collects more revenue than is needed to satisfy its own expenditure/regulatory responsibilities. Such fiscal surplus enables the federal government to use its spending power to pursue national objectives through the use of fiscal transfers.
These transfers help achieve national objectives while supporting decentralized decision making. Federal government fiscal transfers finance nearly two-thirds of subnational expenditures in Spain and South Africa and less than 20 percent of such expenditures in Canada, Switzerland, and Nigeria (figure 4). The design of such transfers plays a critical role for efficiency, equity, and accountability in a federal system. Three important objectives of such transfers in the case study countries are (1) bridging 388 Anwar Shah Figure 4 Transfers as a % of subnational expenditure Sources: Various chapters in this volume; Government Finance Statistics Yearbook (various issues) Washington, dc: International Monetary Fund.
vertical fiscal gaps, (2) bridging the fiscal divide within nations, and (3) securing a common economic union through establishing national minimum standards in social and infrastructure services. The following paragraphs discuss how these objectives are addressed through fiscal transfers in the case study countries.
Bridging vertical fiscal gaps