How does fiscal federalism affect the relationship between the federal and state governments?

Reform of the systems of intergovernmental fiscal relations in Central and Eastern Europe is both complementary to and a necessary part of the economic and political reforms underway. As these countries transform themselves from planned economies to market economies and from communist regimes to democracies, the previous assignments of fiscal functions and power sharing arrangements between different levels of government are no longer viable nor desirable. Each country must institute a system of intergovernmental fiscal relations compatible with the emerging order.

The initial conditions and the reforms currently under consideration indicate major differences among these countries. The federal states of Czechoslovakia, the Soviet Union, and Yugoslavia have three distinct levels of government: the federation, republics, and communes. The primary intergovernmental fiscal issue is the delineation of powers between the federal government and the republics. In contrast, the unitary states of Bulgaria, Hungary, Poland, and Romania have essentially two levels of government: central and regional-local governments. The primary intergovernmental fiscal issue is to what extent decentralizing expenditure functions and tax collection to subnational governments is politically and economically desirable.

This paper examines federalism issues and issues of decentralization within unitary states separately by (i) identifying possible problems that might arise if currently discussed reform proposals are adopted; (ii) discussing the tradeoffs that policymakers face in designing their intergovernmental fiscal systems; and (iii) analyzing alternate systems in developed market economies, with a view to deriving relevant lessons from these varied experiences.

Prior to 1990, Central and Eastern European countries had rigid unitary intergovernmental fiscal systems (with the exception of Yugoslavia). An economic plan guided both enterprises and government agencies. The Ministry of Finance, acting under auspices of the planning agency, managed budgetary procedures. The center determined all aspects of tax policy: the tax base, tax rate, exemptions and deductions, method of collection. Taxes were collected primarily through state banks via automatic transfers from public enterprises (Tanzi (1991)). Republic and local government autonomy in fiscal matters was confined to appointing local budget officials (who were then responsible to the center) and filing expenditure requests to higher-level authorities. Since the plan generally provided for uniform levels of services, it precluded independent local decisions on the level or composition of expenditures.

Enormous redistribution was carried out within the system, giving rise to extensive bargaining, similar to that in western democracies, and tended to soften the rigid edifice of the command economy. At the same time, bargaining made the system of intergovernmental finance less transparent and caused frequent deviations from proclaimed policy.

The excessively centralized systems described above are no longer compatible with the emerging market-orientation and incipient democracy. Once Soviet control began to loosen in 1989, and the political and economic reforms began to take shape, similarities in intergovernmental fiscal arrangements in these countries rapidly disappeared. Three trends have emerged. Czechoslovakia, the Soviet Union, and Yugoslavia have federal constitutions that confer special status on the republics, insuring that the republics are much more than just an intermediary level of government between the federal and local governments.1 Intergovernmental fiscal relations are increasingly becoming a more charged economic and political issue in these countries. The republics now appear to be gaining power at the expense of the federal governments and even preempting the emergence of increased local autonomy. In Yugoslavia, and more recently in the Soviet Union, the federal government depends on annual contributions from the republics for a portion of its funding. This represents a sharp divergence from existing federal systems in the West, in which the center tends to be a major tax collector and the flow of intergovernmental transfers is predominately from the top down. The primary reform issues in the three federations are therefore the balance of fiscal power and the assignment of tax and expenditure functions that the republics should cede to the federal government.

The four unitary states have central governments which have undisputed jurisdiction and cede powers to local governments in order to enhance national well being. The primary reform issue in these countries is the extent to which decentralization is desirable and compatible with political and economic changes. Hungary and Poland are developing decentralized systems in which local governments are likely to have a great deal of autonomy in expenditure and tax matters, while the regional governments are likely to remain insignificant and under the control of the central government. In Romania and Bulgaria, the system continues to be predominantly centralized, leaving lower levels of government with relatively little autonomy. In the federal states, the devolution of governmental functions from the republics to local governments is a parallel issue likely to gain more political exposure once the primary federal institutions are more clearly defined.

Federal States and Minimum Central Government

Although the federal constitutions of Czechoslovakia, the Soviet Union, and Yugoslavia designate their republics as sovereign nation-states, these constitutional arrangements were not in force previously. Instead, it has been argued that a “Bolshevik federation” existed, in which democratic centralism, the organizing principle of the Communist Party, had ascendancy over federalism as the principle of state order.2 With the demise of communist party rule, the absence of a sound foundation for federalism became apparent, and the political vacuum has been increasingly filled by nationalist political groups.

Provided these countries remain united, a federal government with minimum powers is the most likely outcome. This section constructs an approximate description of the minimum functions of a central government within a federation by relying on economic theory, actual practice in these countries, and the accumulated experiences of contemporary Western federations. In examining the general characteristics of contemporary federations, special consideration is given to the institutional arrangements in Yugoslavia and Switzerland, since these countries have perhaps dealt with the issue of a minimum central government most intensely in recent years.3 Using this information, a list of high priority federal functions and a list of low priority federal functions is formulated. A hypothesis is that setting up a federation in which the central government has insufficient powers is likely to have excessively high economic costs.

Specific Fiscal Federal Arrangements

Yugoslavia

The unique fiscal system in Yugoslavia has evolved in the direction of a federation with minimal federal powers.4 Rather than being a simple federal system—with central, republic, and local governments—until recently a parallel system of Self-Governing Interest Communities existed with responsibility for about two thirds of total public services. Different Self-Governing Interest Communities operated at the republic and local levels overseeing health care, education, social security (retirement, disability, and unemployment), and most public infrastructure. Each had its own source of revenue consisting of either an enterprise income or a payroll tax.5

Using 1986 as a base year, total public expenditures in Yugoslavia amounted to approximately 33 percent of GDP, of which the federal government, the republics, and the local governments accounted for 7 percent, 5 percent, and 3 percent, respectively, and the Self-Governing Interest Communities accounted for about 18 percent. Federal revenue collection was restricted to customs duties (24 percent of total revenues) and the federal sales tax (36 percent). Contributions of republics to the federal government (39 percent) were the other primary source. Republics collected income and payroll taxes from the enterprises (26 percent of 1986 total revenues), republic sales taxes (19 percent), the share of federal sales taxes (45 percent), and the qualifying republics received development grants and loans (5 percent). The communes collected local sales taxes (49 percent of local revenue), income taxes (34 percent), and property taxes (3 percent) and received intergovernmental grants (8 percent).

Federal government expenditures consisted of defense (70 percent), veterans’social insurance (16 percent), federal administration (6 percent), and grants to republics (4 percent). Expenditures of the republics consisted of contributions to the federal government (48 percent), economic services (16 percent), and social services (8 percent). Local expenditures consisted of public services (75 percent), social services (3 percent), and economic services (4 percent).

The federal development fund was designed to finance investment in the less developed republics and the province of Kosovo. The fund, which was financed by taxes on enterprises, comprised about 1.5 percent of GDP. A large portion of the loans went directly to enterprises in qualifying republics. The system did not work well; the developed republics complained that overall transfers were excessive, misused, and did not contribute to economic development; the recipient republics complained of the insensitivity of donor republics to their economic problems.

Intergovernmental Finance in Developed Market Economies

The systems of intergovernmental finance in Western federations have evolved gradually, much like their market and political institutions; the present systems result from historical circumstances and political events and reflect cultural traits. In contrast, the socialist countries are starting with relatively open-ended situations, in which the past offers few institutional guidelines owing to the enormous transformations taking place. Thus, the challenge in reforming their systems of fiscal federalism is to create government institutions compatible with what will exist in the future. For these reasons, examination of the existing fiscal systems in Western federations is appropriate. Though no single model of an efficient federal system exists, these federations exemplify the range of possible solutions.

Among the six major Western federations (Australia, Austria, Canada, Germany, Switzerland, the United States), the share of local expenditures in total government expenditures varies from 7 percent in Australia, to 26 percent in Switzerland; the states’ or provinces’ share of total expenditures varies from 16 percent in Austria, to 48 percent in Canada.6 The share of local receipts of transfers from higher-level governments varies from 16 percent of total local revenue in Switzerland to 48 percent in Canada; the share of intergovernmental grants in total receipts of states or provinces varies from 16 percent in Germany to 50 percent in Australia. Each country has unique features. In Australia local government is of modest importance and the state governments depend heavily on federal transfers; Switzerland is characterized by strong local governments with relatively little dependence on transfers; the United States has a pass-through transfer system from the federal government to state government to local government; Germany and Austria have a high degree of horizontal fiscal equalization; and in Canada provincial revenue collection is relatively high (Bird (1986)).

Unworkable intergovernmental arrangements have often been observed (e.g., in the United States during the Confederate period). But a wide variety of systems do work. The determining factors in such cases often have to do less with the particular pattern of tax and expenditure assignments than with administrative and common-sense aspects of the system. As a result, even in countries that are more satisfied with their systems (Austria, Switzerland, and Germany, as opposed to Canada, the United States, and Australia) policymakers are constantly considering alternative reforms. The most common reform is aimed at simplifying the system of intergovernmental grants; recently some have sought to increase regional equalization and harmonize the taxes levied by different levels of government.

Switzerland

Switzerland, perhaps the most decentralized Western federation, is widely regarded as having something close to the minimum central government functions. In its long history, Switzerland has passed through several cycles of federalism and confederatism.7 Since the mid-nineteenth century, the powers of the central government have been steadily increasing, primarily because the cantons have recognized the desirability and feasibility of increased benefits of coordination. Throughout, a system which combines representative democracy with approval by referendum and requires an extraordinary majority to enact most federal-level changes has been in force.

Overall government expenditures stood at 27 percent of GDP in 1989, split almost evenly between the three levels of government. Federal goverment expenditures comprise social security (21 percent), defense (19 percent), transportation and roads (14 percent), and education (9 percent). Canton expenditures consist of education (28 percent), health (17 percent), other social services (12 percent), and transportation and roads (11 percent). Local expenditures are allocated to education (22 percent), health (15 percent), other social services (11 percent), and environment (10 percent).

Central government revenues come from direct federal turnover and excise taxes (52 percent), personal and corporate income taxes (41 percent), and nontax revenues (7 percent). The cantons depend upon personal income taxes (32 percent), intergovernmental grants and federal revenue sharing (27 percent), nontax revenue (19 percent), and other direct taxes on businesses and wealth (18 percent). Localities’ revenue sources consist of direct taxes (50 percent), nontax revenues (32 percent), and intergovernmental grants and revenue sharing (18 percent).

Significant intergovernmental grants and revenue sharing in the budgets of the cantons and localities indicate the importance of equalization in the Swiss fiscal federal system. The distribution of these funds is based on various formulas dependent upon tax effort and tax capacity, among others. The objective of intergovernmental transfers is to enable the cantons to provide similar levels of services without imposing excessively heavy tax burdens relative to other cantons. Dafflon (1991) estimates that 27 percent of the transfers from the center to the cantons are exclusively for income equalization.

Overall, the Swiss system appears quite successful. The gap between cantons with high and low per capita incomes has diminished since the 1950s. Moreover, “the resistance of the rich cantons is amazingly weak, probably in large part because a considerable portion of the financial help … to the poorer cantons flows back to them” (Frey (1977), p. 101). However, because of the restrictions placed on the fiscal powers of the central government, activist macroeconomic management of the economy is essentially forfeited (Bieri (1979)).

Minimum Powers of a Central Government Within a Federation

No scientific method exists for determining the minimum powers of a central government within a federation.8 The minimum powers are linked to the advantages of maintaining a federation, as opposed to separating into fully independent countries or forming a confederation. Certain central government activities have the potential to significantly increase collective welfare within each republic; alternatively, decentralization of certain activities to the individual republics would result in significant welfare losses. These activities can be classified as minimum functions of a central government. Another class of activities exists whose potential gain from central coordination are of a lower order of magnitude; centralization in these cases is a matter of country preference rather than economic efficiency.

High Priority Federal Functions

The most compelling economic functions of a central government within a federation are promoting internal free trade, facilitating international trade, maintaining macroeconomic stability, and providing public goods that benefit the entire country.

The benefits of free trade, long established in economic theory, are now widely accepted by politicians and the public, and supported by evidence that the potential economic gains from free trade are high. The maintenance of a free trade zone implies substantial regulatory powers for the federal government, but only modest expenditure. The appropriate federal regulatory powers to promote internal trade include:

• a. regulation of movement of goods and factors between republics;

• b. enforcement of inter-republic private contracts;

• c. settlement of federal level disputes between republics;

• d. prohibition of discrimination based upon republic origin of: (i) products, (ii) workers, (iii) capital; prohibition of discriminatory commodity taxation;

• e. promotion of market competition;

• f. coordination of business and labor regulations in order to simplify the economic environment in which these factors function; and

• g. supply and control of a common currency.

The second major function of the center is the formulation of foreign trade and foreign relations policy, a nearly automatic consequence of having a free trade zone. This function implies federal control over customs policy, collection of tariffs, exchange rate policy, and certain diplomatic functions.

Substantial gains to centralization also exist in macroeconomic stabilization policy. Maintaining macroeconomic stability in a country is by its very nature a collective activity and follows immediately from free-trade functions (Pisany-Ferry (1991)). Given a common currency, one centralized agency must control money creation. If monetary policy is decentralized, there would be an incentive for each republic to create excessive amounts of money to realize short-run gains. The resulting cost, an inflation tax, would be borne by the entire federation. In this manner, each republic would compete for seigniorage, and the result would be excessive inflation. Centralized inflation policy implies federal regulation of banks as well.9

Other macroeconomic stabilization powers of the federal government are presently somewhat more controversial. To ensure macroeconomic stability, the federal government must be able to contain its budgetary deficits through recourse to its own revenue sources.10 Recent and past experience as well as theory indicate that contributions from member republics are not a reliable means for financing federal operations. The system in operation in Yugoslavia, and more recently in the Soviet Union, has resulted in disgruntled republics withholding contributions.11 From economic theory, such behavior is predictable as a consequence of problems arising from maintaining a cartel arrangement, or, equivalently, the free-rider problem. Provided the other republics or members of a union make their contributions, a republic can maximize its own welfare by evading payment. Owing to the non-excludibility of national (countrywide) public goods, the resulting loss in federal services would be small in relationship to the savings realized by withholding its contributions. Furthermore, withholding contributions or the threat to withhold payment could enable a republic to increase its influence over federation policies.12

For these reasons, the federal government must be able to collect funds directly from economic agents within republics, without depending upon explicit compliance by the republic governments. Customs duties and the value-added tax are logical federal taxes; with both, uniform tax rates throughout the federation are advisable, in one case to prevent distortions and, in the other, to avoid excessively complicated accounting procedures. If these taxes are not sufficient or their rates are limited by constitutional controls, other own sources of revenue must be ceded to the center, such as federal excise duties.

Another macroeconomic tool that could be crucial to sound management of a federation is a limitation on republic and local government budgetary deficits. In the extreme, large budgetary deficits can cause macroeconomic instability. If moral suasion is insufficient to control large deficits during a crisis, the federal government may need to resort to some form of regulatory control.

The final compelling candidate for minimum functions is national (country-wide) public goods. The two primary examples are defense and interregional economic infrastructure, both of which offer advantages of economies of scale. Interregional economic infrastructure, such as transnational transportation systems, can promote economic development and therefore make centralization more attractive. However, regional and local economic infrastructure can be effectively provided by republic and local governments.

Lower Priority Central Government Operations

Certain activities of central governments in Western federations reflect national preference, and no compelling economic efficiency arguments seem to guide their assignment. Negotiation between the republics could lead to a consensus for the inclusion of such activities in the domain of the federal government. However, a federation can endure decentralization of all these activities without suffering significant welfare losses, and given the high value that some republics attach to sovereignty, there is no reason to insist on automatic centralization of low priority activities.

Regional Equalization

A country’s system of intergovernmental finance reflects that country’s concepts of justice and normative views of the role of the state. Therefore, the extent of federal equalization of state and regional income varies widely among the Western federations. For instance, the Australian and German systems enact extensive regional redistribution; Canada provides more provincial-based redistribution; and the United States tends to let regions fend for themselves.

Presently, no consensus for centralized regional redistribution exists in the three federal states under consideration; the republics are unwilling to sacrifice autonomy in order to enhance regional and local equality. Instead, most development aid is likely to be determined on a bilateral republic basis, while only a reserve fund for disaster relief could be envisioned at the federal level in the near future.

Social Insurance, Health, and Education

Expenditures on social insurance, health, education, and other social programs account for the largest share of central government expenditure in all the Western federations. Government supply of social insurance can be justified because the presence of risk may lead to incomplete private markets. The economic justification for public support of health and education is to enhance economic development through investment in human capital, and to promote equality.

The reasons for assigning these functions to the federal government is to ensure equal access to all citizens, and to enhance regional economic equality. Given this equalization-based argument, social insurance, health, and education cannot be designated as minimum functions of a central government within a federation. Furthermore, some would argue that regional uniformity is not desirable in some circumstances. An advantage to decentralization is that it allows regional governments to adjust the mix of social expenditures in accordance with the preferences and needs of its citizens (see below). Thus, correction of market failures can take place at republic and local levels. Interrepublic negotiation, possibly assisted by the federal government, can correct interrepublic market failure or benefit spillovers.

Economic Infrastructure and Environmental Protection

Most public infrastructure is either regionally based (e.g., local transportation, support of industry and agriculture), or need not be supplied by government at all (e.g., energy). Where economic infrastructure has interregional elements (e.g., flood control, transnational transportation), there are potential gains to centralization. However, even for these functions, cooperation between two or more republics to internalize the externalities often can solve the allocation problems (following the Swiss example). The same applies to environmental protection.

Consequences of Insufficient Federal Powers

To sum up, the (high priority) minimum federal powers that emerge from this analysis are: (a) regulation of interregional trade; (b) control over the exchange rate and regulation of foreign trade; (c) control over the money supply, own revenue sources, and some limitations on sub-central government deficits; and (d) supply of national (country-wide) public goods where significant economies of scale exist.

Ceding insufficient powers to the center to carry out its assigned tasks can involve substantial welfare losses. In all cases, decentralization of the (high priority) minimum functions would hinder the smooth functioning of the economy, and, in certain circumstances, destroy economic initiatives, thus leading to diminished economic activity. Republic level limitations on free trade and factor mobility would lower collective welfare and the GDP. Decentralized control of foreign trade could lead to trade restriction and a consequent hinderance of domestic economic activity and economic development. Decentralized macroeconomic stabilization policy could lead to inflation, unemployment, and disruption of financial markets. Decentralized supply of national public goods would normally lead to suboptimal levels of public expenditure and, in the case of interregional economic facilities, a decrease in economic activity.

How strong are these minimum powers compared with the current proposals for reform of the federal systems in Czechoslovakia, the Soviet Union, and Yugoslavia? In some respects they are stronger: joint foreign economic policy, own revenue sources for the federal government. In some respects they are weaker: limited federal involvement in social security, transportation, energy, and economic infrastructure.

Fiscal Decentralization Within Unitary States and Republics

The previous section examines assignment of powers between the central government and republics within a federal system. This section analyzes assignment of powers between local governments and the central government within a unitary state and the parallel issue of delineation of authority between local governments and republics within a federation. The appropriate power-sharing arrangement in a given country depends upon collective goals and priorities, both social and economic. Nevertheless, certain general guidelines exist that can be applied to all countries.

Fiscal Decentralization in Central and Eastern Europe

Up till now the Central and Eastern European countries have had excessively centralized systems of government and will undoubtedly move in the direction of greater decentralization (except possibly Yugoslavia). The current trend toward devolution of power to local governments varies considerably. Hungary and Poland have initiated reforms that portend of a fundamental shift towards decentralization; a brief review of their systems follows.

Poland

In 1988, central government expenditures in Poland accounted for nearly 40 percent of GDP, of which one tenth were intergovernmental transfers. Revenues were derived from enterprise taxes (30 percent), social security and payroll taxes (24 percent), and the turnover tax (27 percent). Local government expenditures were 14 percent of GDP; grant receipts were 27 percent of revenues, enterprise taxes were 25 percent, and turnover tax revenues were 12 percent. In 1989, partial indicators show that over 40 percent of voivodship (or provincial) expenditures were for health, 10 percent for education, and 9 percent for economic services. The localities used 42.5 percent of their resources for education, 15 percent for economic services, and 9 percent for health.13

The recently enacted reforms set up a unitary system with the voivod-ships remaining part of the central government and the localities or communes becoming independent entities. The localities have been given responsibility for municipal services including primary education, water and sanitation, roads, housing, fire prevention, sports, and culture. Their most notable source of power is ownership of local housing within their jurisdiction and commune-subordinated public enterprises. The most notable absence from local responsibility is health. Revenue assignments are as yet unspecified, except that the turnover tax is being replaced by a value-added tax with revenues reverting to the center (Prud’homme (1990)).

Hungary

In 1989, central government expenditures in Hungary were 56 percent of GDP, of which one eighth were intergovernmental transfers. Central government revenues came from turnover taxes (32 percent), social security taxes (29 percent), enterprise profit taxes (15 percent), and nontax revenues (15 percent). Expenditures consisted of social security (29 percent), economic services (25 percent), and other social services—education, health, housing, recreation (8 percent). Local government expenditures were 15 percent of GDP, of which education was 31 percent, health was 19 percent, housing and recreation were 12 percent, transportation was 11 percent, and other economic services were 11 percent.

Fundamental changes in the structure of intergovernmental relations were introduced in 1990.14 Localities are responsible for municipal services, education, health, and social care. Counties have been given responsibility for transportation. Revenue collection is to be highly centralized, less than one fifth of local revenue is to come from own revenue sources. General purpose grants and special purpose grants, with equalization features, are expected to provide half of local revenues; social security system funding of local health expenditures and the local share of personal income tax collections will provide 30 percent. Although the local revenue sources are still unspecified, they will probably consist of fees, land taxation, and asset-based revenue from land, housing, and possibly public enterprises.

Expenditure Assignment

The activities that are appropriate for a central government within a unitary state are not necessarily limited to the minimum functions of a central government within a federation. Lower priority activities are also candidates for centralization within a unitary state and at the republic level within a federation. From an expenditure standpoint, the most important of these functions are regional equalization, social insurance, health, and education. Since all of these activities have significant redistributional consequences, the essential issue is the amount of redistribution that is to be enacted and the extent to which redistribution activities of the government should be centralized.

Redistribution

While the appropriate level of government-sponsored redistribution is unquestionably a country-specific normative choice, the central government has significant efficiency advantages over local governments in enacting family-level income redistribution. The primary reason is that the ability of localities to provide support for low income groups is severely limited by interjurisdictional mobility of the poor, the rich, and businesses. Local redistribution induces relocation by providing an incentive for families that benefit from the policies to move in, and an incentive for those that the locality asks to pay for the programs to move out. The greater the extent of mobility, the more difficult and costly it is to redistribute income. In contrast, centralized redistribution of income between regions within a country or a republic tends to provide a disincentive for interregional mobility and is administratively compatible with family-level income redistribution. Additionally, the tendency of central governments to provide uniform services to all regions, and to impose equal tax rates in all regions, promotes regional and family-level equality. Many consider regional uniformity of education, health, and other human services to be socially desirable. Centralized redistribution policy implies substantial expenditure activities—or at least financing responsibility—for the central government in a unitary state, or for republic governments in a federation.

Local Public Goods

In countries with a relatively strong taste for equalization, the rubric of income redistribution can be legitimately used to justify extensive centralization in the supply of government services. However, from an allocative efficiency standpoint, there is wide scope for decentralization. Virtually every type of municipal service is amenable to local control, as are most other traditional government activities (other than the aforementioned national public goods).

The ancient organizational principle of subsidiarity holds that decisions should be made by the smallest group that is directly affected. In delineating how much government decentralization is desirable, a similar concept emerges by analogy from the theory of decentralized markets. Since competitive (decentralized) markets are more efficient, centralized controls by government should be limited to cases where a clearly identified market failure exists. The same rule is appropriate for intergovernmental relations: unless there is a compelling reason to centralize, decentralization is always preferred. An extensive body of economic literature supports decentralization of local public goods, that is, programs that provide benefits within a limited geographic area.

Perhaps the most important advantage to decentralization is the natural motivation for local governments to act efficiently. Competition of local governments with other localities for residents and businesses creates strong incentives for local governments to find the policies that satisfy the desires of current or potential residents and businesses. The possibility of mobility of economic agents between adjacent localities ensures that both land values and the economic vitality of a community are linked to the quality of local government policies—residents and businesses communicate their desires to local governments by “voting with their feet.”15 Although there are problems with this model—income distribution and benefit spillovers—if the realm of local powers is confined to basically nonredistributive functions, and assignment of tasks takes account of benefit regions, decentralization can work to improve the efficiency of government.

Additional advantages accrue to having smaller units of governance. First, since there is a reverse correlation between group size and the cost of reaching decisions, localities can use more simplified decision making processes, such as New England town meetings. Second, citizens can more easily monitor public policies because of their proximity and the relative simplicity of smaller units. Third, smaller bureaucracies are more efficient because they avoid the pyramid effect. Finally, decentralization permits variety. There is a greater possibility to adapt the mix of local public services to regional needs and individual preferences. This non-uniformity of services among localities can facilitate a segmentation of individuals based upon preference groups and thereby enhance global welfare. However, if segmentation is based on income levels rather than preferences, regional diversity merely functions to prevent income equalization rather than serve citizen preferences.

The Trade-Off

In practice, a centralized system (a) provides service standards to each locality, (b) applies equal taxes, and (c) facilitates regional and personal redistribution. At the opposite extreme, decentralized systems (a) allow autonomy to localities, (b) enhance responsiveness of local governments, and (c) provide for relatively modest redistribution. In theory, a strict autonomy-equity trade-off is not necessary; both goals can be accomplished via a decentralized system embellished with complicated intergovernmental grants. In practice, however, an extensive system of grants causes nontransparency and effectively limits local autonomy. Therefore, attempts to institute regional equalization diminish the advantages of decentralization. Such countries as Canada and Australia are continually reforming their systems in an attempt to obtain simultaneously local autonomy and regional equalization. In practice, Canada has achieved a large measure of local autonomy with fairly limited equalization, while Australia has a great deal of income equalization with limited autonomy. Neither has managed to do both with unmitigated success and each suffers from excessive complexity.

On the other hand, using the fiscal federal system as a means of redistribution is not ideal and may be inappropriate in Central and Eastern Europe. There are many ways to carry out redistribution of income; economic theory suggests that asset-based schemes are the most efficient. Since these countries are undergoing massive transformations in all areas, there is little reason to burden the fiscal federal system with responsibility for redistribution when better methods exist. Overall, this analysis favors extensive decentralization of expenditure responsibilities in both the unitary states and within the republics.

Tax Assignment

In considering tax assignments, property taxation is the only inherently local tax, while customs duties are the only inherently central tax. However, centralized tax collection often has administrative advantages. For example, if labor and capital are highly mobile, highly redistributive taxes should be centralized to avoid locational distortions. But this does not provide an a priori justification to exclude localities from using any given tax. Widely different patterns of tax assignments exist in the industrialized nations, and no one system has compelling efficiency advantages over another. Furthermore, no economic justification exists for prohibiting overlapping tax assignments, and in many countries different levels of government indeed use the same taxes without negative consequences.

Thus, like with expenditure assignments, we cannot offer convincing generalizations regarding the optimal tax assignments. These should be viewed as matters of collective preference, common sense, and influenced by existing administrative arrangements.

The pattern of tax assignments observed among the Western unitary states, however, does not show the same degree of diversity as in the federal states. The localities tend to rely on property taxes and intergovernmental grants as the main sources of revenue and tend to supply municipal services and education. The central governments in Spain, Italy, Greece, France, and the United Kingdom all split their revenue sources fairly evenly between social security taxes, indirect taxes (excises and value-added taxation), and individual income taxes. The main expenditure functions of the central governments in these countries comprise social security, health, and defense, with significant expenditures on education and economic services. Current reforms are moving the intergovernmental systems in many unitary states toward greater decentralization (Denmark, Greece, France, and Italy).

Practical Guidelines

Although there is a great deal of latitude in designing well-run fiscal federal systems, a certain number of practical guidelines can be gleaned. First, a transparent system of intergovernmental relations is desirable, in which the level of government responsible for each service and the associated funding are clearly identifiable. The advantages of decentralization rely on direct citizen involvement in local government decisions. Experience indicates that the public will not bother to be informed about the intricacies of excessively complex systems. Even experts can disagree on the facts in countries with complicated fiscal systems and this can lead to distorted policies based upon public misunderstandings. Second, the arrangement should be simple in order to minimize administrative, compliance, and legal costs. Third, the financial setup should ensure marginal cost taxation. On the margin, the level of government that makes a particular expenditure decision should be responsible for raising the associated revenues. This provides an important automatic expenditure control mechanism and is a necessary condition for constructive local competition between governments.

Finally, within a decentralized system certain types of uniformity are beneficial. Tax base harmonization can enhance administrative simplicity and decrease compliance costs, as can coordination of certain business regulations. Coordination of policies should be instituted at an early stage; experience indicates that it becomes excessively costly and administratively difficult to coordinate policies once they are already in place.

Conclusions

Two general conclusions emerge from the analysis of the intergovernmental fiscal systems in Central and Eastern Europe. In federal states, the federal government can perform certain high priority functions to the benefit of all. Republics should guard against excessive decentralization that strips the federal government of minimal powers necessary to perform these functions efficiently. From an economic standpoint, dissolution of a federation is preferable to the problems that might arise from a federal government that is too weak. In contrast, within the republics and in unitary states, extensive decentralization of governmental powers to communes or localities is compatible with economic efficiency.

The analysis has, by necessity, glossed over some very crucial issues. One such issue is the widespread institutional arrangement of public enterprises supplying municipal and social services (particularly in remote regions). Privatization of these enterprises could lead to pressure for local governments to underwrite the financing of their public services. This raises some difficult legal and economic issues. How will the localities fund these services, and are these services appropriate for public supply in their present form? To what extent might these services themselves be privatized or funded through user fees?

The paper did not cover the specific intergovernmental institutions in Bulgaria, Czechoslovakia, Romania, and the Soviet Union. In the two federal states, the fiscal arrangements are very much in flux and appear to be headed in the direction of looser federations. These countries will undoubtedly struggle with some of the fiscal issues that Yugoslavia has experimented with over the past two decades. The two unitary states are still in the early stages of defining the nature of their political and economic reforms and the issue of decentralization of government activities remains uncertain.

How does the relationship between the federal government and state government different from the relationship between state and local governments?

What is the relationship between the federal government and state governments?

What is the fiscal relationship between state and local government?

What is fiscal federalism and how does it work explain?