Fiscal Federalism

Tatiana Moºteanu
Ph.D. Professor
Mihaela Iacob
Candidate Ph.D. Assistant
Academy of Economic Studies, Bucharest

Abstract. The central budget of a country collects only a fraction of the total fiscal revenues and
executes only o fraction of the national public expenditures, the rest of the revenues and expenditures
becoming the responsability of subnational governments. The economist Charles Tiebout developed a
theoretical model which although makes an imperfect description of the reality, shows that people’s
mobility is being influenced by tax rates and the amount of state/local expenditures. Thus, he suggests
that the degree of responsibility that can be appointed to the local budgets should subscribe to the tax –
benefits ratio, the extend of the positive externalities and the scale economies of public goods. Also, the
issue of revenues distribution among communities is being raised, being identified three kinds of grants
used by the public authorities: matching grants, block grants and conditional block grants. In the con-
cept of fiscal federalism there can be found a limited analogy between national public finance theory
and international public finance theory, with the international taxation as the pivotal element.

Key words: optimal fiscal federalism; the Tiebout Model; intergovernmental grants; international taxation.

Fiscal federalism describes a system of taxes, on one equitable and harmonious distribution of public goods
side, and public expenditures, on the other side, where the and the fiscal burden, and also to the regulation and control
responsabilities of collecting the revenues and of the of externalities.
expenditures is divided between different levels of A very important feature of public finance is the optimal
government. fiscal federalism, where the question of what kind of
activities should be performed at federal level and which
1. Fiscal federalism at national level ones at state/local level is being raised. It is more convenient
that some services are the responsability of state and local
At country states level, there are different levels of authorities, because it ensures a better connection of the
government, starting from the national ones to the smallest real needs to the offered services, leading in the end to
local units of government. We have, for example, the increasing the efficiency of providing public goods and
national level (or federal, for the federal states) and local services. On the other hand, it is not wrong to assert that in
Fiscal Federalism

level, depending on the size of a country and its political some circumstances fiscal federalism may not serve the
and administrative structure. best national interest. The disadvantages are displayed by
According to this system of organization, national the possibility of emerging problems regarding the
governments assist subnational governments to the reaching to the final beneficiary of some key public

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Theoretical and Applied Economics
services. In the end, the great challenge is represented by
%
the development of a transparent funding system for the 100
subnational administrations. 80
Local
60
State
1.1. Fiscal federalism in The United States of America 40
Federal
20
From the historical point of view, the federal 0
government of The United States of America played a 1902 1927 1952 1977 2002
relatively limited role in many aspects of the economical
and social live. As it can be observed from the below figure, Source: Gruber, (2005), “Public Finance and Public Policy”,
in 1902 the federal government represented only 34% of figure 10-1, p. 249.
the total governmental expenditures (federal, state and Figure 1. The shift of fiscal federalism (% of total governmental
local), while to the local and state governments were expenditures)
appointed 58% and 8%, respectively. The federal
government was restricted to expenditures for national The revenue sources and the categories of expenditures
defence, external relationships, postal services. State and for the state and local administrations vary very mucy from
local governments were held responsabile for education, the ones of the federal administration.
police, public roads, social security, medical care, n For the expenditures, at state and local level, the largest
hospitals, etc. Different levels of government were operating expenditures are the ones with education, followed
in their area of action, and rarely interfering with one by medical care and citizens’ safty. On the other hand,
another. The expenditures of state and local administrations the largest federal spendings are with medical care,
were mainly financed from their own resurces. Less than social security and national defence. The federal
1% of their revenues came from budgetary grants. government role in financing education is very small.
The situation changed dramatically in the next 50 years. n For the revenues, the states collect for their budget
In 1953, the federal government represented 69% of the only 17% of their revenues from income tax, while
total expenditures and the local and state governments this category is the main revenue source for the
20% and 11%, respectively. Moreover, 10% of the state federal adminstration. An important revenue source
and local authorities’ revenues came from grants. This shift at local level is represented by the property tax,
was due to three factors. First of all, in 1913 it was permitted levied on land and bildings.
to the federal government to tax individual’s income, which
1.2. Fiscal federalism in countries all over the world
was forbidden until then by the Constitution. Secondly, in
1930 were launched several programs as a response to the Compared with other developed countries, subnational
Great Depression of 1929-1933. There were initiated governments of the USA collect revenues in a greater
several projects that simply changed the relationship proportion and also spend o greater fraction of the total
between the different levels of government. Budgetary budgetary expenditures than other countries. A recent study
grants increased exponentially and many projects, as the conducted by the member states of the OECD (Gruber, 2005,
motorway project, were financed by the federal government, p. 250), shortly presented in the adjacent table, shows that the
but were locally administrated. And not least, the average of the revenues collected at the subnational budgets,
government introduced programs of assistance and social in the year 2001, was 22% of the total budgetary resources. As
security, of which the most important The Social Security for the expenditures, the differences are less obvious, with an
Program for Helping Elderly People and The Budgetary average of expenditures of the subnationale budgets for OECD
Grants System, which aim was to encourage each state to of 32%, compared with 40% in the United States.
provide social assistance to elderly, blind people or with
Expenditures/revenues of the state/local governments
other disabilities.
in total expenditures/revenues (2001)
The fraction of public expenditures, at federal, state
Table 1
and local level, in all the public expenditures, remained Expenditures (%) Revenues (%)
relatively constant in the last 50 years. Financing at federal Greece 5 3.7
Portugal 12.8 8.3
level increased, especially due to the introduction in 1960 France 18.6 13.1
of several social programs, that were financially suported Norway 38.8 20.3
United States 40 40.4
both by federal and state governments. Today, federal Danmark 57.8 34.6
budgetary grants account for approximately 20% of the OECD average 32.2 21.9
revenues of the local and state authorities, each. Source: Gruber, Jonathan, (2005). “Public Finance and Public
Policy”, table 10-1, p. 250.

22
 A high level of centralization is recorded in many Although the model is interesting, applying it into
countries, for example in Mexic, Austria, Norway, first of practice faces o series of difficulties. Moreover, it shouldn’t
all because local authorities do not have the legal rights to be neglected the fact that the model is based on a number
levy taxes on citizens, this rights being designated to the of hypothesis that are not in agreement with reality, for
central authority. example the perfect mobility of individuals, financing
In Romania, fiscal federalism took place at the begining public goods with a fixed-sum tax, the assumption that
of the 1990s, but, in fact, begun to function starting with public goods do not have externalities.
1998, along with the new Local Public Finance Law. This In practice, it is very difficult for an individual who
law gave legislative rights to local budgets equal with to established himself in a community to move. Maybe the
ones of the state budget. This way the aim was the most unrealistic hypothesis is that individuals have all the
consolidation of the local fiscal autonomy, by clarifying information with respect to the benefits provided by the
and extending the local control of the revenues, local administrations or the information with respect to
expenditures and the budgetary process. With regard to the taxes each individual has to pay. Additionally, for the
the revenues, there have been a few amendments which Tiebout Model to be applied, each person should have the
reduced the new legislation’s benefits. In 1999, the state possibility to choose freely from many towns the one that
budget law reinstalled grants and in 2002 the state budget satisfies him concerning public goods and services. Plus,
law inserted grants for education, roads and residences. the model supposes the existence of a large number of
In recent years, an amplification of the fiscal federalism towns, in which individuals can group themselves
process was recorded all over the world. In America, intense according to their similar preferences. However, it is
efforts, that intended to transfer the control and the impossible for a population to be divided in groups that
financing responsabilities of the public programs, have have the same preferences.
been carried out. In countries like Hungary, Italy, Koreea, Concerning the second hypothesis, financing public
Mexic and Spain efforts have been carried out to transfer goods with a fixed-sum tax, regardless of the income,
the responsabilities to the local level even for medical spendings or the wealth of the taxpayer, this from of
care, education, social security. Consequently, in many taxation is seen as being extremely inequitable, because it
countries, local budgets’ expenditures increased, most of doesn’t take into account the contributive situation of each
the times financed from central budget’s grants. taxpayer, being rarely used for financing budgetary
expenditures. In 1990, the British prime minister Margaret
1.3. Optimal fiscal federalism according to the Thatcher tried to introduce a fixed-sum tax, and the result
Tiebout Model was street demonstrations, which led to the Thatcher’s
Government resign.
In 1956, the economist Charles Tiebout tried to find Furthermore, it is assumed that public goods affect only
those elements that define the reach of the optimal level that town, without producing any effect on the vicinity, a
with respect to providing private goods and services and fact totally wrong. O series of public goods generate
that lack the providing of public goods and services. One of externalities, as for example the police, meaning that if the
the detected element was competition, the lack of it leading police department from a city is not well organized, the
to an inefficient outcome (Tiebout, 1956, pp. 416-424). criminal activity may extend to the nearby towns, public
Tiebout stressed out that the situation changes if public road maintenance, meaning that if the streets from a town
goods are provided to the population by the local are unpolished, then the drivers from nearby towns can
authorities (cities, towns) or the state authorities. He asserts suffer damages when they are passing through. And maybe
that, in this case, the competition increases, because each the most relevant exemple of public goods with
individual has the power of decision. If he doesn’t like the externalities is education, because the entire population
goods provided by a town, he can easily move to another, of a country benefits from educated citizens.
without this affecting his life. He went as far to affirm that, Although the Tiebout Model makes an imperfect
in some circumstances, public goods can be provided description of the reality, it is still true that people’s mobility
locally with maximum efficiency. The same principle is being influenced by tax rates and the amount of state/
which states that private goods reach the optimal level local expenditures. If the assumption regarding the
when the market is characterized by fair competition can population’s behavior is a correct one, the next step is
also be applied for public goods. The towns that don’t finding a principle by which a local authority can guide
Fiscal Federalism

ensure an efficient level of this goods may find themselves itself when providing public goods and services.
in the situation of losing their inhabitants, who will be The Model states that the degree of responsibility that
looking for new towns that can ensure the maximum of can be appointed to the local budgets is commanded by
their efficiency. the following three factors:

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Theoretical and Applied Economics
1. Tax – benefits ratio. This ratio reflects the perception The assistance granted at state level is partly based on
of the residents concerning the correlation between the the differences between the income per person and the tax
taxes they pay and the public goods and services that they rates. Federal and state assistance expands at local level of
in the end receive. The goods that reflect the highest government in order to provide the needed public goods
tax – benefits ratio, as local roads, should be provieded at and services. The government is often called to assist the
this level. Property taxes, the main revenue at local level, authorities at lower levels, which can not alone adjust their
if they are considerable, represent important sources used budget. The states also resort to federal subsidies in order
for increasing roads’ quality, from which the residents of to withstand the budgetary problems. The process is
that town will still benefit. Goods with a weaker tax – applied on a large scale and is called fiscal equalization.
benefits ratio, as social benefits for people with low A particularity of the public federal authority in
income, should be the responsabilty of federal or state America is that it doesn’t use grants for fiscal equalization,
authorities. If the residents of a town can see the direct this process being however used within the states for the
benefits they acquire from paying the fiscal obligations to local authorities’ financial support.
the local budget, especially in the form of property taxes, National assistance is extended to communities level,
they will be willing to pay them in the future. But if the as we previously reported, also because of the externalities.
connection is not perceived, they will move to a town that For example, a town may wish to build an industrial plant,
levies lower property taxes. Besides, if the local authorities in the vicinity of another town, the latter being affected be
introduced a social security program, individuals with high the pollution resulted. The national or state government
income would like to leave the town, moving somewhere can interfere, exercising its regulatory power, requiring for
else where there isn’t such a program and therefore the the implementation of antipollution measures or for
local authority levies smaller property taxes on its citizens. establishing the industrial plant somewhere else.
2. The extend of the positive externalities. If goods and The national government assists and subsidizes states
services provided in a public manner affect in a and towns with grants. There are three sorts of grants (tools)
considerable degree other communities, then the used by the authorities, as followed:
responsability for these goods should be designated to the n Matching Grants. These make a correlation between
superior forms of government (federal or state). the amount of grants transferred to local
3. The scale economies of public goods. Goods, such as communities and the amount of present
national defence, have great scale economies and can not expenditures for providing public goods. For
be efficiently provided at local levels. example, matching grants of one to one ratio for
Analysing these factors, Tiebout concluded that at local education mean one dollar funding from federal
level expenditures should focus on programs with little budget for each dollar spent for education at state
externalities and lower scale economies, for example road or local level. Correlative ratios vary mainly
maintenance, garbage collection, keeping the streets clean. between 0.01 and 1.
Local communities must have a limited role in providing n Block Grants. In this case, the money are simply
public goods that are based on distribution (as social programs) transferred to local communities, without
and that have large scale economies (national defence). constraining the way this money can be spent.
n Conditional Block Grants. The assigned money to
1.4. Revenue distribution among communities and local communities are aimed to be used only in a
categories of tools used particular manner.
A great part of the ideea of granting national assistance
The Tiebout Model gives a general framework for the to subnational political entities may establish the
approach of one of the most important problems of fiscal foundation for an international fiscal federalism, in an
federalism: if there should be a distribution of revenues international public finance system framework.
among communities. In a perfect world, there shouldn’t be
any distribution of revenues among local budgets. Each 2. Fiscal federalism at regional and international level
community has created an efficient structure for providing
public goods and any distributing process leads to a 2.1. Analogy with the national federalism
decrease of the efficiency. Taking into consideration that
the reality isn’t a perfect one, there are two arguments in A limited analogy between national public finance
favor of distributing revenues among the communities with theory and international public finance theory can be found
high income/expenditures and the ones with lower income/ in the concept of fiscal federalism. This issue has
expenditures: the failure of the Tiebout Model and the resemblances in countries that record shortage in the
presence of externalities.

24
balance of payment and receive structural adjustment loans are not immediately eager to submit to an international
from international organizations. It can be said that a form authority. International taxation confronts itself with a series
of fiscal federalism operates within the assistance system of political obstacles, but the opportunities are enormous.
granted to the national governments by the international At national level, many of the present fiscal system
organizations or within the international agreements for components were once impracticable, and in the United
pollution control, as is the case for Montreal Protocol, States, as we mention before, taxes on individual’s income
which regulates the emission of substances that damage were considered unconstitutional. The resistance to changes
the ozon layer and the climate. will continue to put its mark also on the international
This fact suggests that, at international level, some taxation system, but the long term trend of the political
economical and environmental problems, as common attitude with respect to funding some objectives is a positive
goods(1) management and environment protection, should one. It seems that the implementation of an international
mainly be the responsabiliy of particular international taxation system is only a matter of time. At least
organizations, like The United Nations. theoretically, approximately all countries expressed their
The more the form of government that executes the agreement regarding a mandatory regulated contribution
expenditures is in the same time the entity in charge with to the international organizations’ budget. A positive
collecting the needed resources, the more efficient the example in this regard is the one of the European Union,
operative decisions are. This would mean for the where there is already implemented in practice a
international organizations to possess independent harmonized regional system of taxation and the European
instruments in order to obtain resources for funding the Union has a limited economical jurisdiction over the
programs that are wished to be implemented. national governments in the same manner as The Federal
Government of the United States of America has jurisdiction
2.2. Implementation of the international taxation – over state governments.
a necessity for an optimal fiscal federalism
3. Final considerations
Notwithstanding, to be able to talk about fiscal
federalism at international level, first it has to be defined In any country, the central budget collects only a
the general framework of international public finance, a fraction of the total fiscal revenues and executes only o
relatively new and intensely debated among academicians fraction of the national public expenditures. The rest of
and economists concept. Of all the general framework’s the revenues and expenditures become the responsability
elements(2), like market failure, revenue distribution’s of subnational governments, for exemple state and local
equity, macroeconomic stabilization, the political process, ones. Carrying out a comparison with other developed
international organizations, international taxation and countries, the United States designate a large responsability
international common goods, taxation is the pivotal to the subnational governments.
element of an efficient international finance system. At It can also be discussed about fiscal federalism at
national level, collecting public revenues is done on international level, its defining and implementation having
compulsory and regular basis, elements of critical as the starting point the fiscal features of the national level.
significance that lack however from the international Because many countries from all over the world face
organization’s system that grants assistance. They take their imbalances, they should be assisted with the help of grants,
revenues on voluntary basis, this system proving inefficient in the same way state or local authorities benefit from such
most of the time. To define the concept of international subsidies. While matching grants are the best way of
taxation, at least the following elements should be encouraging a particular behavior for the subnational
considered: defining the taxation base, determine the tax governments, for maximizing the community’s welfare the
rates, methodes of collecting revenues, the conditions that most advised are the unconditional block grants. If we add
need to be accomplished before enforcing a convention to all of this the fact that there are externalities, positive or
or a treaty, the penalties for disregarding the conditions negative ones, that affect the whole population, a certain
and the withdrawal proceedings. fraction of a country’s revenues should be collected at
To ensure enforcement of taxes at international scale, international organizations’ level on compulsory basis,
the most important feature is, inevitably, of political nature. for the development of the global interest programs and
State countries hold on very much to their sovereignty and for internalizing of externalities
Fiscal Federalism

25
Theoretical and Applied Economics
Notes

(1)
Physical elements outside the national jurisdiction. Goods, for electromagnetic spectrum, are suggested to be included in The
example fishing in international waters, exploitation of marine United Nations Programs.
(2)
and flying space for shipping and flying, Antarctica and the As they were identified by Ruben P. Mendez (1992) in his
Southern waters of the Ocean, the geostationary orbit and the book „International Public Finance – A New Perspective on
Global Relations”, Oxford University Press.

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