Theories of Fiscal Federalism and the European Experience

Authored by: Alberto Majocchi

The Ashgate Research Companion to Federalism

Print publication date:  August  2009
Online publication date:  April  2016

Print ISBN: 9780754671312
eBook ISBN: 9781315612966
Adobe ISBN: 9781317043454

10.4324/9781315612966.ch24

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Abstract

Within the global field of public finance, fiscal federalism addresses the vertical structure of the public sector, and the model to which the literature refers is that built initially by Musgrave (1959) and then developed by Oates (1972). In this model the economic functions are assigned to the different levels of government according to a scheme where the central government has basic responsibility for macroeconomic stabilization and for income redistribution. In addition to these functions, the central government provides goods and services consumed by the entire population, while local governments provide goods and services whose consumption is limited to their own population. These conclusions follow from some very simple assumptions:

The redistribution function should be centralized because the mobility of persons – which increases as the size of the territorial area diminishes – may cause locally implemented redistribution policies to fail. In fact, any jurisdiction which unilaterally imposes higher taxes on the rich encourages the loss of mobile resources, including both capital and high-income residents. Alternatively, jurisdictions which unilaterally offer large subsidies to the poor will attract outsiders to share the benefits. Consequently, where the intention is to adopt a strongly redistributive policy, the financial resources will be lacking because expenditure is very high and the tax base has shrunk, while in the other areas the budget will show a substantial surplus because the tax base has expanded.

The stabilization function should also be centrally managed. The reason in this case is the greater effectiveness of fiscal policy, which depends on the propensity to import and, therefore, on the level of the multiplier. Lower levels of government are more open to trade. Consequently, expenditure remaining equal, a larger amount of benefits in terms of income and employment will arise outside the territorial area in which the resources necessary to finance expansionary policy have been collected. In the presence of strong positive externalities, the supply of the public good “stabilization” may therefore be sub optimal.

Only the allocative function should be distributed geographically, because the task of supplying public goods should be assigned to the level of government within whose territory the majority of the benefits of spending occur. Hence, the production of local public goods should be undertaken by the lower levels of government, in that “a varied pattern of local outputs in accordance with local tastes will be Pareto superior to an outcome characterized by a centrally determined, uniform level of output across all jurisdictions” (Oates 2005, 353).

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