An Essay on Fiscal Federalism

Wallace E. Oates

Outline of the Report

The traditional theory The welfare gains from fiscal decentralization The use of fiscal instruments Current topics related to Fiscal Federalism Conclusions

The Traditional Theory

Decentralization vs. Centralization A normative framework:
Fiscal instrument 1

FI 2

FI 3

FI 4

Function 1

Function 2

Function 3

Govt level 1

Govt level 2

The Traditional Theory

Macroeconomic stabilization Income redistribution

Decentralized levels of government Central government

What then is the role of the decentralized levels of government? - control for or regulate the levels of goods and services whose consumption is within their jurisdictions

The Welfare Gains

in the absence of cost-savings from the centralized provision of a [local public] good and of interjurisdictional externalities, the level of welfare will always be at least as high (and typically higher) if Pareto-efficient levels of consumption are provided in each jurisdiction than if any single, uniform level of consumption is maintained across all jurisdictions."

The Welfare Gains

Tiebout there is no the centerpiece of will Even if model - mobility, the theory the theory for measuring gains from local still hold. governmentswould o People still have varying preferences. o Samuelson condition: MRS = MC still applies. Welfare gains from decentralization would still exist.

The Fiscal Instruments

1. Taxation
Benefit taxation local governments Nonbenefit taxation central government

2.Intergovernmental grants and Revenue sharing

Conditional spillovers form internalization of

Problems on jurisdictional boundaries

Unconditional form fiscal equalization

Equity and Economic efficiency issues

Current topics on Fiscal Federalism

Laboratory federalism
Policy testing is risky.

Interjurisdictional competition
It creates race-to-bottom distortions.

Environmental federalism
Environmental degradation due to interjurisdictional competition Central governments role should come into play.

Current topics on Fiscal Federalism

Political Economy of Fiscal Federalism
Increased political participation expense of economic efficiency at the

Market-preserving Federalism
Issues on soft-budget constraints

Fiscal decentralization in the developing and transitional economies

Relationship of fiscal decentralization and economic development

Conclusions
There are gains from proper allocation of government functions and examination and appropriate assignment of fiscal instruments. The central government must work for things that decentralized levels of govt could not handle by themselves. Though the traditional theory could serve as a framework in studying fiscal federalism, it should be further examined and evaluated.