At its most general level, the term ‘fiscal federalism' covers the delegation of the power to tax and spend from a central government to peripheral regional or local authorities. The economic principle behind this delegation of fiscal right is that because (the assumption of) differences in preferences between regions it is more efficient for provision of public services to be decentralised. Within this, responsibility for macroeconomic stabilisation remains with the central government. Regions within a state have a fairly limited ability to respond to external shocks - and rightly so: in an open economy, with all the exchange rate volatility and the leakages from fiscal stimuli, their capability to engage in anything like currency or general macroeconomic stabilisation is severely restricted. Fiscal federalism is essentially a balance between the specification of local preferences and the stability of overall macroeconomic policy. The central government has - or at least should have - say over macroeconomic stabilisation and other public goods such as defence or other non-local public goods, but the provinces are more likely to be able to provide efficient output than uniform service provision from the centre.

More specifically, from an economic perspective there is a degree of fiscal federalism in every layer of governance within an economic unit (such as a state). In this sense the term is unfortunate because, as Oates puts it “it suggests a narrow concern with budgetary matters. The subject of fiscal federalism]…[encompasses much more, namely the whole range of issues relating to the vertical structure of the public sector” (Oates; 1999; 1121). Division of spending is a de facto result of the need to provide services at peripheral levels, so the term is both tautological and lacks breadth. Fiscal federalism is the balance between the efficiency of central government and the non-duplication of tasks versus the efficiency gained by lower deadweight losses associated with more adequately providing regional services are more closely tailored to the utility maximising preferences of the locality. However, the needs and access to resources of provinces leaves the whole country open to a treasure trove of moral hazard problems because local authorities have an apparent tendency to engage in pro-cyclical expenditure (Wibbels & Rodden; 2004; 5) because not only - as is normal with any fiscal regime - revenue fluctuations are pro-cyclical, but expenditure, particularly in the case of welfare provisions such as health spending, tends to increase when there is more money available. Such is the nature of local public services; naturally when there is more wealth and increased tax revenue, voters will opt for improved services at higher expense. This is completely the opposite of the standard Keynesian interpretation of how fiscal policy should be run, in which savings should be made in boom years and spending should be a tool during recessions, in order to smooth the business cycle (Wibbels & Rodden; 2004; 2-3).

The central moral hazards are twofold. First that the central government's main fiscal policy objective will be for consistency and stability over business cycles, the other is that too great a leeway in the provision of services at local level could upset the wider economy of the state. Regions on the whole do not concern themselves with how their actions might affect their neighbouring localities (FIND), and this can be extended to the whole economy, meaning that pro-cyclical tendencies will be across the board and the reverse of the endeavours of central government for smoothed business cycles. If regions do not per se care about neighbouring regions' policies, implicitly it means they do not concern themselves on the effect of their policies on the central government, unless there are rules attached, which there often are, precisely because regional governments implicitly cannot be trusted to behave (FIND). It is not entirely their fault however, since it is likely, as stated above, that the policies with which they are entrusted are likely to be those which are to be called for when there is a tax surplus. Furthermore, regional policies are a reaction to circumstances within that region, which means by extension that regional polities are unfettered by the economic situation of their neighbours and the aggregate economy. This applies as much within countries as within the EU, where shocks to regions or localised fiscal indiscipline may be ignored, making coordinated fiscal policy a challenge. ((FAILING ALL ELSE, RODDEN)

Within states (and not the EU where the Treaty forbids it) central governments reaction to this risk will be to impose certain restrictions of the remit of local governments to tax, spend and what type of expenditures are permitted. In certain cases, regions may have deficit limits imposed, or even the wholesale prohibition of debt issuance at a local level. No-bailout clauses may be constitutional in character to prevent regions systematically spending more than they can raise, but this depends on the credibility of the central governments resolve to let a region default and will be discussed later. Because the risk of competition between regions could upset the economic stability of the entire polity, policies that in some cases could acceptably or even efficiently be administered at local levels are taken over by the centre. If welfare provisions such as unemployment benefit were organised at regional levels, these could more adequately be tailored to the needs of the population than blanket unemployment benefits regardless of relative regional price-levels. However, allowing regions to administer the policy themselves would generate the risk of imbalances between regions.

The effects of this imbalance can best be illustrated with an example. Suppose a federal state, A, has two regions, North and South. These two regions have the power over only two policy areas, namely unemployment and income tax. Initially, North and South have equal levels of unemployment and identical tax rates on income. Wealth is equally distributed between regions, but individuals can be unevenly rich or poor, even if in aggregate the income of the regions is identical. However let us suppose that in the first period, the local government of the North, unannounced, decides that it prefers more social spending. If unemployment benefit is raised, the rate of taxation on income must also be raised to pay for it. In the second period, rich voters will move from North to South, and will meet the unemployed or poor coming the other way. This of course assumes that individual's only concern is for the maximisation of their wealth. In the third period, North would face a higher cost with a reduced tax base, and South would expect to experience higher revenues and reduced costs. This example demonstrates that where there is factor mobility, the risk of tax or spending competition is destructive and unsustainable.

This applies but within a fiscally federal country as much as within the EU; tax competition can undermine the economies of associated regions, so some oversight of their fiscal policies is necessary to prevent this sort of destructive activity. That fiscal federalism has horizontal as much as vertical elements is a result of this, because in a federation regions may even decide to finance and operate different services at different levels. A logical consequence of the disparity in fiscal policy is the attempt to neutralise fiscal differences between jurisdictions, and this is particularly the case in the EU, an example of which is the lower limit of 15% on VAT in every member state. (FIND)

    1. Harmonisation of Fiscal Policy.

It is debatable how much, if any, tax harmonisation is required between regions for a tax federation to be serviceable. An objective is overall tax neutrality to avoid movements of the tax base into neighbouring jurisdictions, but also to ensure that depressed regions do not lag too far behind the rest of the country. This is the purpose of fiscal federal equalisation payments between German Bundesländer.

but particularly in a monetary union taxation and spending remains as the only tool to absorb asymmetric shocks. Opinions vary upon how much tax harmonisation is required relative to the alternative market

The above example is a case of what in theory would end in a ‘race to the bottom'.


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