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, Kirchgassner, 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, Montreal, 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

Confederal system Unitary system AnarchyFederal system

Rather centralised Rather decentralized

Figure 1-2 The two dimensions of government system

decentralized

SwitzerlandSpain

in co nstitutio na l termunitary federal

France Germany

centralized

Figure 1-3 Lijphart's classification

decentralised

• Switzerland

• Spain

• Germany

• Portugal

centralised

unitary federalunitary federal

1.2 Fiscal federalism: a European approach

Figure 1-4 Relational web in a decentralised government system

federal/central

3 … Regions1 2 (Cantons)

1.1 1.2 1.3 1.4 … local

government

Median Voter

Citizens Residents

1.3 Decentralization: an essay of typology

Table 1-5 Two types of (de)centralization

types of (de)centralization

top-down bottom-up

= become local = remain local

• Displacement of the budget constraint towards the local • Increase the innovation potential at the local level Objectives

tiers (displacement of outlays rather than devolution of competencies)

• maintain a large diversity of mix "local public goods and

services – local financing (taxes or user charges)

• Increasing national welfare (better adjustment " offer to • "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 evaluation

Fulfilment of the objectives decided by the centre protection of local jurisdictions against too much centralization

respect of local choices for public services

Modality • local autonomy • deconcentration

• delegation • subsidiarity

• devolution • decentralized (horizontal) cooperation

• horizontal et vertical competition • (political) benchmarking

• Dominant vertical relations between the centre and the • conflict central/local (if society is heterogeneous, local Dominant model

regions, the centre and the communes, respectively the regions and the communes.

decisions are different from those which would result from 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. • horizontal / vertical co-operation and competition

• Information asymmetry in favour of the centre • dominant preference of local residents

Table 1-6 Public finance according to the form of government

" decentralized public finances" "fiscal federalism"

Government system

Federal centralized (Germany) Unitary decentralised (Spain) Unitary centralized (France)

Federal decentralized (Switzerland)

Constitution Institutional organisation of the State

• institutions are organised in a formal "constitution" • the (historical) territorial map exists before the Constitution,

(number of government layers, territorial design, competencies, finances, rule for the assignment of resources and transfers) )

which is designed ex post. The Constitution takes as they are the territorial limits of the constituent states.

• The Constitution reflects a voluntary association of sovereign

• the constitution fixes the design of subnational member states (a Confederation) and fixes the intergovernmental cooperation rules.

governments (SNG)and fixes the rules for intergovernmental relations

• Competencies belong de facto to the local and regional

• powers and competencies which are not explicitly given 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)

to SNG are de facto in the power of the centre

• national preferences are dominant

• 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

• importance of specific conditional grants • budget autonomy and accountability : limited number and Types of inter-governmental transfers amount of specific conditional grants

• equalization transfers aimed at reducing fiscal disparities • equalization transfers with the objective of reducing

between member states, but no objectives of interpersonal redistribution

disparities in local budget (reducing individual inequality caused by disparities in the local provision of public services and local taxation )

• « principal– agent » model • negotiation model Model for inter-governmental relations • in unitary centralized nation, the principal defines the

competencies and finance of SNG in view of the central interest

• information asymmetry and moral hazard

Case studies • federal centralized (Venezuela, Austria, India) • « dialogue/diplomacy » between provinces and the central

government in Canada • semi-federal States or unitary decentralized (Spain,

• Switzerland: cooperation between the federal state and the Nederland, Sweden)

cantons; horizontal cooperation between the cantons; concordats; Ministerial (Functional) Conferences of the Cantons; consultation, initiative, referenda

• unitary centralized State (France, United-Kingdom)

• mix federalism (Germany, USA)

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

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.

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.

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.

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

i = nB market good = 1 B 1 1i

ndcba ====== S ... S S S S S1 11111collective good

i S S = -1 N 1 local public service S

with = the parameter of divisibility

if = 0 N-0 = 1, and therefore S1 1 = S1 Samuelson's pure collective good

1 = S1 1/N = S1/N = a pure market good, distributed between the N consumers, = 1 N-1 = 1/N and therefore Si

each for 1/N of the total offer,

0 < <1 a collective good that is more (towards 1 = local) or less (towards 0 = central) divisible,

1 < 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 self-defeating 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 decentralisation Tiebout's model jurisdiction

vote with the feet S1 S2 choice minority choice

8 5

I 10 8 8 go to II 10 + 5 S1 S1

16 12

II 5 5 move to I 16+8+12 S2 S2

III 20 12 12 move to II 20 S1 S1

majority 36 46 46 + 25

Not satisfied 35 25 0

Specialisation Specialisation, respect of minorities, proximity, Merit good 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

1 concepts of fiscal decentralization X 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 X

5 expenditure assignment X X X X X X

6 revenue assignment X X X X X X

X X

7 local revenues / taxes X X X X X

territorial variant of the benefit principle X X 8 intergovernmental grants, equalization X X X X X X

9 financing infrastructure X X

10 Budgeting X X X X

11 borrowing and debt X X X X X

12 poverty alleviation X

13 accountability and transparency X X X

14 measures of decentralization X X

measures of fiscal disparities X 5 tax administration X

16 Metropolitan areas X

17 fiscal competition X X

18 functional federalism: drawing new boundaries, alternative institutional X X structure X

19 minimum service level, guaranteed access to local public goods 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 Politics Social h ist ory

Public finance Possible relationships between jurisdictions

Social contex t

allo c atio n demographyvertical

redistrib utio n human geographysocio-cultural context"choice"

"agency"stabilisation

traditionshorizontal

L ocal public goodsConstitutional rights Economic context

indivisibilityinstitutions activities

economynon-rivalryinitiative

"local" dimension Spill-over effects referendum

procedures of consultationInternation al

nationalnegativ external effectsother criteria of decentralisation reg ional

local

Context of public economy

expendituresrevenuesorganisation of the activities of the public authorities

Decision matrix

Major topics >

v 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

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 13 topics ntation

case 13 topics study

Contextu- 13 topics alisation

Politics 13 topics

Theory

13 topics