Fiscal Issues in Federal Nations: Issues and Options

1
Fiscal Issues in Federal NationsIssues and
Options

• Robin Boadway
• Queens University, Canada
• Notes for the Workshop on Fiscal Policy in a
  Federal Cyprus, February 5, 2009

2
Overview

• Review of the key features of federal fiscal
  structures
• Division of responsibilities and federal
  influence over states
• Some issues in federal-state fiscal relations
• Responses to permanent, cyclical and asymmetric
  shocks
• How much decentralization is desirable?

3
Federal Fiscal Architecture

• Assignment and exercise of fiscal
  responsibilities a compromise
• To achieve the advantages of decentralization
• To maintain national efficiency and social policy
  objectives
• Additional fiscal objectives
• Respond to permanent shocks/asymmetries
• Respond to cyclical shocks
• Respond to asymmetric shocks

4
Some Features of Federations

• Decentralization of discretionary fiscal
  borrowing powers and to states
• Some state fiscal responsibilities have national
  consequences
• Free internal mobility of labour and capital
• Social protection a shared responsibility
• Vertical fiscal gap
• System of equalizing transfers

5
Federations vs. Economic Unions

• Relatively strong central government with taxing
  and spending powers
• Equalizing transfers
• Common currency but typically absence of explicit
  Growth and Stability Pacts (though often
  self-imposed balanced-budget constraints)
• Harmonized tax systems
• Some harmonization of social protection
• Some federal influence over state decisions

6
Division of Fiscal Responsibilities

• State expenditures comparable to federal
• Local public goods and services
• Some major social protection programs
• Infrastructure
• Some power may be shared, with one level
  paramount
• Revenue decentralization varies greatly,
  depending on access to broad-based taxes

7
Federal Influence over States

• Federal-state transfers (spending power)
• Close the fiscal gap
• Equalize and insure states against shocks
• Influence state spending priorities programs
• Other sources of federal influence
• Disallowance judicial review
• Mandates
• Moral suasion

8
Power to Borrow

• Federal government unconstrained
• State borrowing practices varies
• May have full discretion subject to capital
  market
• May be constitutional or legislative constraints
  on state borrowing, or requirement for referendum
• Typically no analog of SGP constraints with
  penalties
• Municipalities borrow for capital spending only
• Federal transfers can influence state borrowing
  (positively or negatively)

9
Other Constitutional Provisions

• May be broad policy objectives, constraints or
  directives
• Internal economic union provisions
• Equalization provisions
• Social economic rights
• Regulation of capital, labour and product markets
  may be shared
• Federal responsibility for treaties may have
  implications for states

10
Issues in Federal-State Relations

• Social protection
• State delivery of key programs, but federal
  interest
• Role of spending power, with limits
• Tax harmonization
• Use of shared tax bases
• Difficulties of sharing VAT
• Internal economic union
• Judicial vs. negotiated vs. spending power
  remedies
• Role of federal oversight more generally
• Equalization a key issue ???

11
Responses to Permanent Asymmetries

• Automatic redistribution through federal fiscal
  policies depending on revenue centralization
• Fiscal transfers to compensate for differences in
  fiscal capacity and need
• Decentralization makes it more difficult
• Depends on extent of national solidarity
• Migration of labour conflict with transfers
• Investment flows to capital-scarce states
• Potential for wasteful state competition
  favouring better-off states (e.g. natural
  resources)

12
Responses to Cyclical Shocks

• Standard prescription temporary deficits and
  surpluses with structural balance
• Many problems even in a unitary nation
• Debt not a full measure of government liabilities
• Permanent spending tax changes hard to undo
• Lags in discretionary fiscal policy
• More complicated in a federal setting
• Little federal control over state borrowing

13
Responses to Cycles, contd

• State policy may pro-cyclical depending on
• Automatic stabilizers
• Ability to borrow, revenue raising powers
• Federal influence limited by decentralization
• Federal inability to commit to transfers
• May pass on deficit to states in recession
• Soft budget also possible but less likely
• Equalization can be destabilizing if based on
  average state fiscal capacity

14
Responses to Asymmetric Shocks

• Automatic regional insurance through federal
  budget, depending on decentralization
• With respect to decentralized revenues,
  equalization automatically stabilizing,
  especially if formula-based
• Dangers of soft budget constraint if grants
  discretionary
• Balance-budget constraints counterproductive

15
How Much Decentralization?

• Main issue facing federations How much
  decentralization of revenue raising?
• Decentralization of revenue raising must involve
  some broad-based tax
• VAT difficult to decentralize administratively
• Income tax decentralized in harmonized way
• Payroll taxes good candidates (dual income tax)
• Decentralization makes discretionary fiscal
  policy more difficult

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Decentralization, contd

• Decentralization induces fiscal capacity
  differences
• Might reduce national solidarity
• Makes equalization more difficult
• Makes response to asymmetric shocks harder
• Decentralization might enhance accountability
• Reduces dependency
• Encourages responsible (hardened) budgets
• Prerequisite for credit market discipline

17
Decentralization, contd

• Decentralization might increase fiscal
  competition
• Good or bad?
• Might favour richer states
• Decentralization reduces influence of federal
  government
• Reduced chances of tax harmonization
• Reduces policy harmonization for social
  protection
• Checks intrusive federal use of spending power

18
Political Economy Issues

• Apparently, decentralization is much easier than
  recentralization
• Some evidence that decentralization improves
  governance and reduces corruption
• Debt performance seems to be better in
  decentralized countries, especially the states
• But, little evidence that imposed federal
  controls and constraints on states work capital
  markets and bond rating agencies more effective
• Federal-state arms-length commissions and loan
  councils might be useful as accountability
  institutions