Perspectives on Fiscal Federalism

1. INTRODUCTION The conversations about fiscal federalism, decentrali- zation and devolution have been evolving in the literature since the second half of the 20th century. In the United States and all around the world, the matter of governance and decentralization are on the agenda. Decentralization has been seen as the main institutional framework, and is widely believed to provide benefits. “It is often suggested as a way of reducing the role of the state in general, by fragmenting central authority and introducing more intergovernmental competition, and checks and balances. In a world of rampant ethnic conflicts and separatist movements, decentralization is also regarded as a way of diffusing social and political tensions and ensuring cultural and political autonomy” (Bardhan, 2002). The idea of giving more fiscal authority to local governments is attractive; competition between jurisdictions is believed to minimize inefficiency, force local representatives to respond better to their constituents and give more for tax dollars paid. The individual, under conditions of de- centralization and interjurisdictional mobility has more power over government; as public authority moves down to the lower levels the individual is better exposed to competition and choice, and can “vote with his feet”. This paper aims to find the routes of fiscal federalism by first understanding what is meant by federalism, as it does not simply refer to a form of governance, then laying out the classical foundations of this theory (trumped by Wallace Oates), and followed by some departures from the classical thoughts into some new streams of literature on the matter. The discourse around fiscal federalism becomes important in times where politically, countries are strengthening the powers of the executive, and when the administrative state has changed so much. It is the hope that this paper will clarify what fiscal federalism is and consider whether such a reform is beneficial. BACKGROUND AND HISTORY Before we can discuss the relevance of fiscal federalism,let us first decipher what is meant by federalism. Elazar(1972) offers a definition for federa-lism. He claims that itcan be defined as “the mode of political organization thatunites separate polities within an overarching politicasystem by distributing power among general andconstituent governments in a manner designed to protectthe existence and authority of both. In its simplest form,federalism means national unification through themaintenance of sub-national systems. In a large sense, it isa mode of political activity that requires the extension ofcertain kinds of cooperative relationships throughout anypolitical system it animates” (2-3). The federal system was created with the intention ofcombining the different advantages which result from themagnitude and littleness of nations (De Toqueville, 1980).Let us briefly discuss the set-up of such a multi-tiergovernment. In the Rawlsian “original position” legislators formulate a constitution, which in this contextwould be a set of rules by which to govern public projects.The social objective is simply to maximize the expected netvalue of a project and the welfare. Hierarchy, is thusjustified only if it generates positive social benefits to coverthe costs of having another tier, only if welfare isimproved and justified to add tiers under the central unit.The decision for or against decentralization depends onthose rules the central legislature formulated for guidanceand operations (Rubinchick-Pessach, 2005). Numerous problems arise in such a system where one central financial authority contains constitutionally independent financial units within it (under it). In federalism, two of such financial systems operate based on the resources provided by the individual citizens. Each unit of government is operationally limited by its specific geographical boundaries and is dependant only on the resources provided by those within its area for the provision of public services. Subordinate units, if required to provide certain functions independently will end up with fiscal inequalities between them unless the fiscal capacities between units is equivalent (Buchanan, 1950). This foundation of what a federation means allows us now to move forward in our progress towards what fiscal federalism is. According to Musgrave (1965) the traditional approach of fiscal theory was in the context of a unitary government. The general theory of taxation and expenditure was seen in unitary terms at first, following Keynes’ theory that changed the focus more toward government finance for stabilization; yet no discussion of hierarchical fiscal units or multi level finance was yet introduced. Yet in the United States where the fiscal structure is highly decentralized traditional forms of finance had to be revisited; this involves both political and economic reinterpretations of fiscal federalism. “There are good theoretical reasons for reorientation of fiscal thinking in multi-unit terms. The very theory of social wants remains at the core of fiscal economics. Certain wants cannot be satisfied through the market, but must be provided for by government because the resulting benefits accrue to all members of the“group” independent of individual contributions. Membership in the group, however, fre-quently depends of spatial considerations” (Musgrave, 1965). What Musgrave is directing our attention to is that certain types of public services concern a certain region or locality; thus supplying goods and services that should serve the needs and preferences as reflected by certain communities or regional units. We must also remember that these units may not be homogenous within a region and are heterogeneous by the nature of individuals being different from one another. “It follows from the nature of social goods that services are consumed in relatively equal amounts by members of a beneficiary group. Since the cost is shared among the members, it is the interest of the individual to associate with others whose preferences for social goods are similar to his own” (3). Musgrave’s short introduction, and this particular argument link the conversation to Tiebout (1956) famous piece which makes an important foundational argument on which fiscal federalism will rest its blocks. Who then sets out to show that the arguments made by Musgrave (1965) in applied economic theory “market type” that solution is not applicable to the determination of expenditure on public goods, that is national income allocated non-optimally is notapplicable when speaking of local expenditures. Tieboutargues that local expenditures are not only at thecentral level; actually they are quite significant at the localevels. He posits that an individual will pick the communitywhich best suits his patter of preference of public goods.“The greater the number of communities and the greatervariance among them, the closer the consumer will come tofully realizing his preference position” (Baker and Elliott,1990). In the Tiebout model households are highly mobile,and they “vote with their feet”, that is they choose where toreside based on what locality provides the fiscal packagethat would best fit their tastes and preferences. Tiebout(1956) further claims in his article that the policies thatpromote mobility and increase the consumers’ knowledgewill improve governmental expenditure allocation. Given fulmobility of consumer-voters, “The solution, like the generaequilibrium solution for private spatial economy, is the bestthat can be obtained given preferences and resourceendowments” (Baker and Elliott, 1990). In fiscal federalism,where the provision of public goods is in the hands of sub-national governments tailored to the preferences of aheterogeneous population, is beneficial from the Tieboutmodel point of view. The outcome is individuals sorted intodemand-homogenous jurisdictions which provide differentamounts of public goods based on the preferences of eachof these groups of individuals. At this point some mainfoundations have been set down and we can proceed withthe specifics of classical fiscal federalism. Classical fiscal federalism On this part the author will mainly depend on the work ofOates as he is the main classical writer on this issue. In theintroduction to his book, fiscal federalism he states that hisstudy rests on Musgrave (1959) conceptuali- zation of therole of the public sector. From Musgrave’s perspective thata free market economy without a government sector is likelyto malfunction, Oates comes to an understanding that thepublic sector has three primary economic problems;equitable distribution, maintaining stabilization and efficientpattern of resource allocation, these problems areinterrelated. What Oates sets to achieve is a case offederalism, for that purpose he provides a comparativediscussion of the advantages and disadvantages of havinga completely centralized government versus a highlydecentralized form of government (Oates, 1972). A unitary form of government is much more capable thana decentralized government of meeting its economicresponsibilities of stabilization, realizing equitabledistribution of income and provision of efficient levels ofoutput of public goods. Yet, the decentralized govern-ments also have some advantages over its counterpart.They provide for public goods consumption tailored more to the preferences of the constituents of the locality, and by promoting increased innovation and competition of local governments decentralization might increase efficiency in the production of public goods. Lastly, a system of local governments might provide for better public decision making, by compelling more recognition of the costs of public goods and services. Oates then suggests that we combine the advantages of both systems of governance under a federal organization, as this represents a compromise. The central government is responsible for the stabilization of the economy, for achievement of equitable distribution of income and for providing certain public goods that influence the welfare of all the members of the society. Its sub-entities will supply those public goods and services that are of interest to the residents of the specific jurisdiction (Oates, 1972; Baker and Elliott, 1990). As Oates indicates, there is a difference between the economic and the political science meaning of federalism. His suggestion is the use of an economic definition; this is due to the economists’ concerns are pattern of resource use and income distribution. Decentralization provides a mechanism where levels of public goods provision can be tailored to individual preferences; the economist’s concern is merely that decisions regarding levels of provision reflect the interests of the constituents. Therefore, Oates defines federalism economically as; “Federal Government: a public sector with both centralized and decentralized levels of decision making in which choices made at each level concerning the provision of public services are determined largely by the demand for these services of the residents of (and perhaps others who carry on activities in) the respective jurisdiction” (Oates, 1972). To the economist constitutional structure assumes importance only to the degree that it affects respon- siveness of the provision of local services to the local preferences (Stegarescu, 2005). Most importantly in Oates’ view, most if not all systems are federal, from an economic perspective; the public sector of all countries could be federal and the distinction is only in the degree of centralization (Oates, 1972; Baker and Elliott, 1990). The presentation of Oates’ main article and claims are important to comprehend because a lot of the sub- sequent literature on the subject in following years made reference to his assertions. In a later piece Oates (1999) provides the brief points most pertinent to the basic theory of fiscal federalism. The hope in advocating for fiscal federalism (decentralization) is that as local governments are closer to the people they will better know and address the people’s preferences, and will have an ability to find innovative new ways to provide goods and services to the constituents of the sub units (jurisdictions).Yet the goal of restructuring the public sector is not onlydecentralization, but rather an alignment if governmentaresponsibilities and fiscal instruments with the proper leveof government. The central question of fiscal federalism iswhich functions and instrument are suited for centragovernment and which to the levels of that government?.. As we have outlined the functions of government earlier, amain point according to Oates is that efficient levels of locaoutputs at the local levels will likely vary across jurisdictionsdue to differing costs and preferences; if we are tomaximize social welfare, local outputs will have to vary.The main basic principle of fiscal decentralization is thatprovision of public services should be located at the lowestlevel of government encompassing spatial relevant costsand benefits. The decentralization theorem, “in the absence of cost-saving from the centralized provision of a good and ofinterjurisdictional external effects, the level of welfare wilalways be at least as high (and typically higher) ifPareto-efficient levels of consumption of the good areprovided in each jurisdiction than in any single, uniform leveof consumption is maintained across all jurisdictions. In thisway the theorem establishes, in the absence of other kindsof offsetting benefits from centralized control, a presumptionin favor of decentralized finance” (Oates, 1972). The theorem rests if grounds of economic efficiency andsimply presumes that centralized provision will entaiuniform level of output across all jurisdictions. Yet there isan inherent assumption regarding access to information.Oates (1999) observes that there is a knowledgeasymmetry, presumably the local level possess moreinformation regarding individual preferences and costconditions. Also, at the central level there is politicapressure that constrains its ability to provide higher levels ofservices to some places and not others. And here he statesa major assumption in his theory that constraints on centragovernment tend to require a degree of uniformity inprovision; the constraints prevent central government fromproviding optimal pattern of local outputs. Anotherimportant assumption of the theory is that the magnitude ofwelfare gains depends on the heterogeneity in demandsacross the jurisdictions and inter jurisdictional differences incosts (1123). Oates (1999) also observes that gains fromdecentralization, although enhanced by mobility, are notwholly dependent on mobility. He finds that even whenthere is no mobility the efficient levels of outputs of “local”public goods will typically vary across jurisdictions (1124).In the creation of his model it is important to note thatOates (1972) assumes that each government maximizesthe surplus of the aggregate constituents,yet there is apossible problem in local provision and that is not payingattention to benefit spillovers to other districts. Another assumption mentioned earlier is that a centralized system government provides uniform level of spending which cannot address local individual preferences. The earlier discussed paragraphs attempted to give a brief review of the main relevant points that describe what fiscal federalism is about. Yet there are a lot of issues tied and related to the basic tenets of the theory. Most of the literatures in one way or another beg to determine whether decentralization is actually beneficial and if so in what ways is it advantageous to centralization. Shadbegian (1999) studies the validity of three theories concerning public sector spending. Grossman and West (1994) have also researched these hypotheses regarding government expenditure. THREE HYPOTHESES REGARDING LEVELS OF GOVENRMENT SPENDING The Wallis hypothesis Increased fiscal decentralization would lead to bigger state and local governments. “since individuals have more control over public decisions at the local level than at the state of national level, they will wish to empower the public sector with a wider range of functions and responsibility where these activities are carried out at more localizes levels of government” (Oates, 1985). His argument is based on the possibility of transferring governmental functions and responsibilities from the higher to the lower level of government. If indeed they are transferable than as decisions become decentralized, higher levels of government will spend less while lower levels will spend more (Shadbegian, 1999; Grossman and West, 1994). The Brennan/Buchanan hypothesis Budgetary decisions conform to the revenue maximizing monolithic government, Leviathan and not to the median voter. Brennan and Buchanan (1980) argue that the greater the level of decentralization the higher the level of competition among jurisdiction; the smaller the share of aggregate government expenditure. “Total government intrusion into the economy should be smaller, ceteris paribus, the greater the extent to which taxes and expenditures are decentralized” (185) (Shadbegian, 1999; Grossman and West, 1994). Brennan/Buchanan collusion hypothesis It is possible that as decentralization occurs, the component governments in a federal system are colluding and forming a cartel, which dampens the competitive influence of decentralization to expand the budget. Brennan and Buchanan (1980) note that the possibility for collusion should be included in the “all things being equal” (185) and that it is expected that in a federal decentralized system there would be pressure on the lower levels of government due to the high levels of competition to secure arrangements and moderate competitive pressures (182). This argument has two testable implications: total government size will and ceteris paribus, increase with the level of collusion and the size of each level of government will and ceteris paribus, increase as the level of collusion increases (Shadbegian, 1999; Grossman and West, 1994). Now that we have outlined these three very important hypotheses regarding government spending, based on the two articles earlier, many research efforts have been put forward to test these three hypotheses in the literature. Due to time constrains the writer will present the findings as they are articulated in the articles. Shadbegian (1999) tested the validity in order to suggest a model for the United States. The results show that the hypotheses complement one another and contribute to understanding of size of government. Using state level panel data the author was able to prove each one of the hypotheses. Grossman and West (1994) were able to find in their empirical study simultaneous support for the Wallis hypothesis, as greater power passes down closer to the citizenry they are more willing to grant those governments a broader range of powers. As for the first Leviathan hypothesis, the authors found support and that federal share of aggregate spending decreases while local share increases with decentralization, and they also were able to support the collusion argument. Both articles conclude that decentralization by itself is not a strong enough constraint on the Leviathan, since competitive pressures of fiscal federalism are offset by collusion among all levels of government. IS FISCAL FEDERALISM BENEFICIAL OR NOT? While the basic arguments of fiscal federalism and aswehave seen thus far the answer whether decentralization isbeneficial or not as a policy is not so simple. Muchliterature has addressed this issue from many differentangles, basic economic models were used and new modelsfor federalism have been offered. A short review of thisissue is offered in this part of the work. At the offset it seemsthat there are many political, social and economicfactors that should be considered in addressing the issueof decentralization, yes or no? The decision whether to decentralize or not depends on the constitutional definitions designed by legislature. This is true not just for the Unites States, but for whatever country is considering decentralization. Decentralization is a complex process and a product of many factors, as has been stated and including cultural heritage and geography. In an important study, Pannizza (1999) starts out by pointing that across countries there are different institutional arrangements and different levels of centrali- zation. He sets to identify empirical regularities to explain cross-country differences in the levels of centralization; the findings indicate that country size, per capita income, ethnic fractionalization and level of democracy are negatively correlated with fiscal centralization. Building on Panizza’s model and testing fiscal decentralization within a country Arzaghi and Henderson (2005) hypothesize that the degree of variation of institutional and fiscal decentralization across countries is explained by basic economic and demographic variables. What they find is that per capital income, population, land area and population concentration in large cities largely affects decentralization. Income and population growth lead to decentralization along with population decentralization. Economic and demographic growth processes explain the variation in centralization. They also note that constitutional federalism encourages effective federalism and fiscal decentralization. Wallis and Oates (1988) historically view the evolution of fiscal decentralization in the state and local sector. They view and test empirically different theories to explain differences in fiscal decentralization. “We found that the extent of fiscal centralization varies inversely and significantly with population size and urbanization, we have found a positive relationship between fiscal centralization and the level of per capital income” (Rosen, 1988). Pannizza, and Arzaghi and Henderson indicate that the correlation between income per capital and centralization is inversely. “Our overall econometric results point to these divergent forces. If population and urbanization continue to grow, this will create pressures for more decentralizes government” (Rosen, 1988). Besley and Coate (2003) preserve the uniform cost sharing for public projects, but relax Oates’ assumption regarding uniform public spending across regions. In their models they see central governments as comprising of locally elected representatives; doing this required modeling the behavior of the representatives and districts’ choices about the type of representative to elect. Their findings suggest that detailed modeling of the political decision making is important to understanding the trade-offs between centralization and decentrali- zation.

federalism Under the concepts of public choice and political economy that focuses on political processes and the behavior of political actors, the SGT began to develop. Unlike the first-generation theory (FGT) which largely assumed that public administrators work hard on achieving the common good, the SGT revolves around the willingness of the public to participate in political processes (both voters and officials) have their own objectives and purposes that they work hard to maintain in a political setting that provides the constraints on their efforts. New public management (NPM) is a theory of governance that is heavily influenced by market theory and economic decision-making, public choice, principal agent theory and transaction cost economics in particular (Hood, 1991; Kaboolian, 1998), rather than civic choices. Ostrom and Ostrom (1971) as advocates of public choice, point to what they, see as Wilson’s major thesis statement: “but there is one rule of good administration for all governments alike. So far as administrative functions are concerned, all governments have a strong structural likeness more than if they are to be uniformly useful and efficient, and they must have a strong structural likeness”(Wilson,1887).The authors emphasize that by good administration Wilson meant order of hierarchy in a rank system subject to political direction. The ranks will be a corps of technically trained civil servants; Wilson wanted them schooled and drilled “after appointment, into a perfected organization, with an appropriate hierarchy and characteristic discipline” (Wilson, 1887). Locke’s theory of self-interest has its own consequences in the field. One of the major founders of the national performance review, Kamensky (1996), states that the new public management is connected with the public choice movement whose central backbone is that “all human behavior is dominated by self-interest”. In addition, the SGT have evolved due to the information revolution in the age of globalization and financial crisis in the various countries all over the world. Information is power and the outcomes from collective- choice institutions depend in basic ways on the information that the various organizations and actors possess. In settings of asymmetric information, where some business partners or entities have knowledge of such things as preferences, cost functions, or effort, knowledge, governments alone cannot decide alone on how to draw their financial policies. The SGT is revolving around this information and how it can be obtained, analyzed and used to draw better well-framed federal fiscal policies (Oates, 2005).

The origins of the etymology of the term governance theauthors claim are of two traditions, the study of institutions(multi layered structural context) including public choice;the second tradition is network theory (role of multiplesocial actors in networks). As O’Toole (1997) has shown,the phenomenon of networks has added intersubjectivityand interdependence, and a need for collaboration amongactors with differing and at times conflicting interests andmotivations. CONCLUSION This paper aimed to present some of the discourse andthought on the subject of fiscal federalism. Theconclusion presented by Inman and Rubinfeld (1997)seems to pull the idea together. There is variation, thereare political, environmental, social dynamics taking placewithin and across countries and throughout the globe. Thetheory of fiscal federalism seem to point to beneficialeconomic outcomes, yet it is not a definite replacement;under certain conditions at certain times it morecentralization seems appropriate. Therefore, the questionis not whether decentralization is beneficial, but ratherwhen and to what degree? As was pointed in few places inthe paper the written agreement (constitution) of thelegislature is the key to the beginning of the conversation.Perhaps as technological, social, economic and politicalelements change within a country so should the degree ofdecentralization. Economically speaking, each countyshould strive to the utmost degree of decentralization aspossible to most efficient, and to be as close to thecurrent preferences of the citizenry, as suggested byOates (1972). REFERENCES Baker S, Elliott C (1990). Readings in Public SectorEconomics. Lexington D.C Heath and Company. Bardhan P (2002). Decentralization of Governance andDevelopment. J Econ Perspect., 16(4): 185-205. Besley T, Coate S (2003). Centralized versus Decentralizedprovision of local Public Goods a political economy approach. J.Public. Econ.,87:2611-2637. Brennan G, Buchanan JM (1980). The Power to Tax,Analytical foundations of a fiscal constitution. Cambridge:Cambridge University Press. Brueckner JK (2006). FiscaFederalism and Economic Growth. J. Public. Econ., 90:2107-2120. Buchanan JM (1950). Federalism and Fiscal Equity. Am.Econ. Rev.,40(4):P583-599. Elazar DJ (1972). American Federalism. New York: Harperand Row Publishers. Grossman PJ, W est EG (1994). Federalism and theGrowth of Government revisited. Public Choice, 79: 19-32. Henderson JV, Arzaghi M (2005). Networking Off MadisonAvenue, Center for Economic Studies, U.S. Census Bureau. W orking p. 05- 15. Hood C (1991). A Public Management for all Seasons? In J.M. Shafritz, A.C. Inman RP, Rubinfeld DL (1997). Rethinking Federalism. J. Econ. Perspect, 11(4):43-64. Kaboolian L (1998). The New Public Management: Challenging the Boundaries of the Management vs. Administration Debate. Public Adm. Rev., (58) 3:189-193. Kamensky J (1996). Role of Reinventing Government Movement in Federal Management Reform. Public Adm. Rev., 56(3): 247-56. Musgrave RA (1965). Essays in Fiscal Federalism. W ashington D.C: Brookings Institute. Musgrave RM (1959). The Theory of Public Finance. New York: McGraw-Hill. O’Toole LJ (1997). Treating Networks Seriously, Practical and Research Based Agendas in Public Administration. Public Adm. Rev.,57(1): 45-52. Oates W E (1972). Fiscal Federalism. New York: Harcourt Brace Jovanovich. Oates W E (1999). An Essay on Fiscal Federalism. J. Econ. Lit., 37(3): 1120-1149. Oates W E (2005). Toward A Second-Generation Theory of Fiscal Federalism. Int.Tax Public Financ., 12 :349–373. Oates W E (1988). Searching for Leviathan: An empirical study. Am. Econ. Rev., 75: 784-757. Ostrom V, Ostrom E (1971). Public Choice. A Different Approach to the Study of Administration. Public Adm. Rev., 27: 203-216. Panizza U (1999). On the determinants of Fiscal centralization, Theory and evidence. J. Public. Econ., 74:97-139. Rosen HS (1988). Fiscal Federalism, Quantitative Studies. Chicago: The University of Chicago Press. Rubinchick-Pessach A (2005). Can decentralization be beneficial? J. Public. Econ., 89:1231-1249. Shadbegian RJ (1999). Fiscal Federalism, Collusion, and Government Size: Evidence from the States. Public Financ. Rev., 27(3): 262-281. Stegarescu D (2005). Costs Preferences and Institutions, An Empirical Analysis of the Determinants of Government Decentralization. Centre for Eur. Econ. Res., Mannheim, Germany. pp. 1-7. Tocqueville AD (1980). Democracy in America. New York: Knopf Press. Wilson WW (1887). The Study of Public Administration. J. Polit. Sci. Q., 2(2):197-222.