Comparative Perspectives on Fiscal Federalism Systems

Abstract

This chapter presents a comparative analysis of central elements of fiscal federalism systems in the eleven countries surveyed in previous chapters. The analysis examines the assignments of expenditure responsibilities among orders of governments, the allocation of taxation powers, regulatory functions, intergovernmental transfer systems, and mechanisms for macroeconomic management including fiscal rules, restrictions on subnational government borrowing, and instruments for tax harmonization. The analysis highlights the diversity of fiscal federalism systems as well as common features, and emphasizes how fiscal arrangements impact fiscal decentralization, the revenue-raising autonomy of subnational governments, fiscal disparities across subnational units, accountability, and fiscal discipline, among others.

There is great diversity across federal systems in how fiscal arrangements are designed. This applies to the allocation of spending responsibilities and taxation powers among orders of governments, regulatory functions, fiscal transfer systems, fiscal rules, and policy harmonization mechanisms. Central elements of fiscal arrangements generally reflect the character and specificities of each federation. At the same time, fiscal arrangements are critically important for many defining features of federal countries including the effective autonomy of subnational governments, accountability and fiscal discipline, economic efficiency, fiscal disparities across subnational units, and so on.

The eleven fiscal federalism systems reviewed in previous chapters highlight such diversity. Some of them are relatively centralized including those of Australia, India, Italy, and Spain. In these countries, the central government plays a relatively dominant role in the taxation system and in the provision of public services, sometimes through influence on subnational government programs. Other countries, such as Canada, Switzerland, the United States and to some extent Brazil, are more decentralized with subnational governments having substantially more autonomy in formulating public services programs and in raising revenues. Some federations are characterized by cooperative decision-making and interdependency. That is the case, to varying degrees, for Germany, Ethiopia, and South Africa. In some countries, there are asymmetries in the extent of fiscal decentralization with some subnational units having more autonomy and responsibilities than others (e.g. Spain, India, Italy).

This chapter provides a comparative overview of fiscal federalism arrangements in these eleven countries highlighting both the diversity of fiscal arrangements and some common features. Section 1 discusses the assignment of expenditure responsibilities among orders of government. The allocation of taxation powers is reviewed in Sect. 2 with a particular focus on how the structure of tax systems determines the effective revenue-raising autonomy of subnational governments. Section 3 looks at fiscal transfer systems with some emphasis on how different systems pursue equalization objectives. Section 4 discusses macroeconomic management focusing particularly on tax harmonization, fiscal rules, and restrictions on government borrowing. Finally, common challenges to fiscal federalism systems are briefly outlined in the last section.

1 Expenditure Responsibilities

There are many common features in the assignment of expenditure responsibilities. Central governments are typically responsible for functions that have an important national dimension, that involve interregional spillovers and for which policy harmonization across subnational units is especially important (Anderson, 2008; Boadway and Shah, 2009). This includes foreign affairs, international trade, national defense, monetary policy, the regulation of rail and air transportation and usually financial markets regulation, telecommunications, as well as competition and industrial policy. State governments are generally involved, to varying degrees, in the areas of education, health care, social welfare services, natural resources, and environmental management, sometimes through exclusive responsibilities and sometimes through concurrent or shared responsibilities. Local governments are usually responsible for public services for which benefits are largely local in nature and for which delivery is more effectively managed at the local level. This includes policing, water supply and sewer services, local roads and transit, housing, recreation and culture, fire protection, among others.

The eleven fiscal federalism systems reviewed in this book are generally in line with the standard allocation of responsibilities although the central government is much more influential in the core areas of education, health care, and social welfare services in some cases while state and local governments enjoy more powers and autonomy in others (see Table 1).

Table 1 Decentralization of expenditure responsibilities

1.1 Decentralization, Concurrent Responsibilities, and Central Government Influence

In some countries, state governments hold most responsibilities and legislative authority with respect to education, health care, and social services, and enjoy high autonomy in fulfilling these responsibilities. That is the case in Australia, Canada, Switzerland, and the United States. Canadian provinces have exclusive legislative powers in health care and education. The role of the federal government is essentially limited to providing some of the funding and establishing broad conditions in the case of health care. In the US, the federal government has had some influence on state education policies by imposing student achievement standards, but states otherwise have high autonomy in legislating and managing the education system. In both Canada and the United States, while provincial and state governments hold legislative powers in education, the education systems are partly managed by special-purpose local governments (i.e. school boards in some Canadian provinces, school districts in the US). The extensive responsibilities and legislative authority held by Australian and Canadian provinces, Swiss cantons, and US states have resulted in considerable diversity in programs and levels of expenditures across subnational units in these countries.

In most of the eleven federations surveyed, however, central governments are more actively involved in the provision of core public services. In India, Union and state governments have concurrent responsibilities in education, health care, social security, environmental management, and economic and social planning. In Germany, there are several areas of concurrent legislation of the federal government and the Laender, with federal paramountcy in general. In practice, the federal government exerts considerable influence on subnational policies through legislation that affects the administrative functions of Laender or municipalities, even though such legislation requires the approval of the Bundersrat in which Laender are represented. In Spain, education and health care are, in effect, shared responsibilities of the Autonomous Communities and the central government. Autonomous Communities are responsible for delivering services in these areas while the central government sets regulations over various dimensions of service provision including minimum standards of services, conditions for access to services, etc.

In these three countries, despite the existence of concurrent or shared responsibilities in many areas, state governments hold substantial autonomy and legislative authority, although to varying degrees. Subnational autonomy in the provision of core public services is much more limited in other countries such as Ethiopia, South Africa, and Italy despite the existence of concurrent or shared responsibilities.

In Ethiopia, states are responsible, or share responsibilities with the federal government, for delivering many public services such as health care, education, public safety, and for managing the natural resource sector and labor markets. However, the federal government has considerable influence on how states fulfill their responsibilities through the establishment of national standards and policies. As a result, the effective autonomy of state governments is quite limited. In South Africa, provincial governments have considerable responsibilities but little effective autonomy. In most cases, provincial governments have concurrent responsibilities with either the federal government (e.g. health, education, welfare services, public transportation) or with both the federal government and local governments (e.g. housing, environment, roads). Generally, subnational governments are responsible for delivering services subject to the policies, regulations, and standards set by the federal government. In Italy, regional governments have responsibilities in many areas including education, health care, social assistance, and environmental management. However, regional government responsibilities are essentially concurrent responsibilities over which the central government exercises high influence by defining principles, levels of services, standards, etc. In effect, the autonomy of regional governments in areas of concurrent responsibilities is extremely constrained.

In Brazil, the role of local governments is particularly important, especially in health care and education. The Brazilian Constitution recognizes local governments and assigns them considerable spending and taxation responsibilities. Despite constraints imposed by federal legislation, local governments enjoy significant autonomy, more so than state governments. Education, health care, social assistance, and public safety are concurrent responsibilities, although in practice the federal government is largely responsible for social assistance while local governments are more heavily involved in education and health care and state governments play a more important role with respect to public safety. Local governments also have constitutional recognition in Switzerland, India, and South Africa, but do not enjoy as much autonomy as in Brazil, especially in the case of India.

1.2 Distribution of Expenditures

Diversity in the allocation of responsibilities and in the effective roles played by each order of government in providing public services leads to wide variations in the share of expenditures by each order of government. As depicted in Fig. 1, the expenditures of state and local governments combined in total government expenditures (excluding intergovernmental transfers) are above 65% in Canada and over 50% in India, South Africa, Switzerland, and the United States, while it is below 30% in Italy. The relative role of local governments in subnational expenditures is particularly important in the United States, Brazil, and Germany, and very limited in Australia.

Fig. 1

(Sources IMF Government Finance Statistics and various chapters from this book. Data is for 2019 for all countries except Ethiopia [2017], India [2017], and South Africa [2018]. Data not available for local governments in Ethiopia and in India. Data for local governments in Italy includes all subnational governments)

Share of expenditures, excluding grants paid to other governments, in total government expenditures (%)

1.3 Asymmetry in the Allocation of Responsibilities

In some countries, there are asymmetries across subnational units in the allocation of responsibilities. That is the case in Italy, where asymmetries exist between the fifteen ordinary regions and the five special regions. Special regions have bilateral relations with the central government and hold a wider range of responsibilities and higher effective autonomy than ordinary regions. Some autonomous communities in Spain also hold more responsibilities than others, in the area of policing for example, although such asymmetries have become more limited over time. Asymmetric arrangements also exist in India where some states have special status. These states are mainly located in mountainous areas and tend to be disadvantaged economically. Special status provides these states with some advantages such as exemptions from some union taxes and more generous grants from the Union government, some intended to promote economic development. In Canada, there are three northern and sparsely populated territories with fiscal arrangements with the federal government that are different than those applying to the ten provinces. A different system of federal transfers applies to these territories and the federal government plays a more extensive role in the provision of some public services such as health care.

2 Taxation Powers and Revenue Decentralization

Generally speaking, personal incomes taxes, corporate income taxes, and taxes on international trade tend to be more centralized while subnational governments generally have more access to sales and value-added taxes, property taxes, and several narrow-based taxes and use fees such as real estate transfer taxes, alcohol and fuel taxes, motor vehicle taxes and parking fees (Anderson, 2010). That is generally the case in the eleven countries surveyed here, with a few notable departures from the standard assignment.

2.1 Tax Decentralization and Revenue-Raising Autonomy

State level governments have access to the personal and corporate income taxes in some of the more decentralized federations such as Canada, the United States, and Switzerland. This is a key distinguishing feature of tax systems in these countries. In Canada, the federal and provincial governments have unrestricted access to almost all main broad-based taxes with the exception of taxes on natural resources which are reserved for provincial governments and taxes on international trade which are available only to the federal government. The personal and corporate income tax bases are jointly occupied by the federal and provincial governments. Although there exist tax collection agreements between federal and provincial governments, provinces enjoy full autonomy and set their own income tax policies independently of the federal government.

As in Canada, the United States constitution gives full access to most major tax bases to the federal and state governments. States have high revenue-raising autonomy, which has led to considerable diversity in relative reliance on different taxes across states, even more so than in Canada. In Switzerland, the autonomy of cantons over tax policy is also guaranteed by the constitution. Cantons have access to personal income taxes, corporate income taxes, wealth and inheritance taxes, among others, and the constitution provides them freedom to set tax rates, as well as defining the tax bases and special provisions.

State level governments in all other federations have less access to broad-based taxes and enjoy less revenue-raising autonomy (see Table 2). In Australia, all main broad-based taxes are levied by the federal government. That includes personal income taxes, corporate income taxes, the value-added tax, customs duties, and various excise taxes. Subnational governments levy less than 20% of total government tax revenues. In South Africa, the constitution gives provinces the power to impose surcharges on all taxes, except the corporate income tax, the VAT, and custom duties, subject to the approval of the federal government. In practice, however, provincial governments collect very little own-source tax revenues. In fact, local governments have more flexibility than provincial governments with respect to their own tax sources, in particular the property tax.

Table 2 Taxation powers and revenue decentralization

2.2 Asymmetries in Taxation Powers

There are asymmetries across subnational units in the allocation of tax powers in Spain and Italy, although taxation remains relatively centralized in both countries. In Spain, Autonomous Communities under the common regime have a fair degree of autonomy in setting tax rates, credits, and other special provisions for some of the main revenue-raising taxes including the personal income tax, and taxes on wealth, and inheritances. In the case of the Autonomous Communities operating under the charter regime (Navarre and Basque Country), these taxes, among a few others, are fully decentralized. This is an important element of asymmetry in the Spanish fiscal federalism system. In Italy, ordinary regions have very little taxation autonomy. Most of their tax revenues come from devolved taxes, which are largely set and controlled by the central government with limited regional flexibility, regional surtaxes imposed on central government taxes, and a few own taxes which raise relatively little revenues. Overall, in ordinary regions, tax revenues account for less than half of total regional government revenues, the rest coming from transfers. The constitution provides more taxation autonomy to special regions. For example, they have more flexibility in setting tax rates on devolved taxes. However, given that all the main revenue-raising taxes are largely occupied by the central government, in practice the effective taxation autonomy is relatively limited even in the case of special regions.

2.3 Shared Taxes and Formula-Based Revenue-Sharing

In some federations, there are constitutionally based shared taxes and revenue-sharing systems. In Germany, for example, the main broad-based taxes are shared taxes. The revenues from the personal income tax, the VAT, and the withholding tax are shared between all three levels of government in predetermined proportions while revenues from the corporate income tax are shared equally between the federal government and the Laender. Through representation in the Bundersrat, Laender determine, jointly and cooperatively with federal government representatives, the definition of tax bases and tax rates for these shared taxes. Hence, both levels of government have limited exclusive autonomy in terms of taxation.

There is an extensive constitutionally established revenue-sharing system in Brazil that also applies to the main broad-based taxes. Revenues from the federal income tax and tax on manufactured goods are shared in fixed proportions among the three levels of government while revenues from state value-added taxes, motor vehicle taxes, rural property, and other minor taxes are shared with local governments. The federal government has little discretion over the size of the revenue-sharing transfers and these transfers are largely unconditional. Hence, despite having relatively limited taxation autonomy, subnational governments have high revenue autonomy given that their shares of revenues collected on several tax bases are constitutionally guaranteed.

In India, revenue-sharing with state governments applies for all Union government taxes which includes all the main broad-based taxes. The percentage of revenues transferred to states and the allocation among states is determined by the Union government based on recommendations from an independent expert commission. The distribution of revenues among states is formula-based. It takes into account several criteria and is intended to act as an equalization mechanism based on interstate disparities in both fiscal capacities and expenditure needs.

2.4 Own-Source Revenues of Subnational Governments

The own-source revenues of subnational governments combined is above 50% of total government revenues in Canada, and above 40% in Switzerland and the United States (see Fig. 2). At the other end of the spectrum, that proportion is below 20% in South Africa and Italy. Subnational governments in India, Germany, and Brazil have substantial own-source revenues, although much of these revenues come from shared taxes over which subnational governments have little discretion. At the same time, their share of revenues from shared taxes is determined by formula-based revenue-sharing systems. Hence, subnational governments in these countries enjoy strong revenue autonomy but little tax policymaking authority.

Fig. 2

(Sources IMF Government Finance Statistics and various chapters from this book. Data is for 2019 for all countries except Ethiopia [2017], India [2017], and South Africa [2018]. Data not available for local governments in Ethiopia and in India. Data for local governments in Italy includes all subnational governments)

Share of revenues, excluding grants received from other governments, in total government revenues (%)

2.5 Natural Resource Taxation

In all federations that are well endowed in natural resources, the assignment of tax powers and the allocation of resource revenues are sources of tension. Natural resources are often highly concentrated geographically implying that subnational ownership and taxation of resources generate fiscal disparities among subnational units. At the same time, centralized management and taxation of natural resources is often perceived as unwarranted, especially when extraction activity imposes local environmental costs (e.g. Boadway and Shah, 2009; Anderson, 2010).

In some federations, subnational ownership of resources is established by the constitution. That is the case in Canada. The Canadian Constitution gives exclusive jurisdiction over natural resource management to provincial governments as well as the exclusive right to impose taxes on renewable and non-renewable resources. This is an important source of horizontal disparities and tensions. In the United States, the federal government can impose royalties on resources extracted offshore or from federal lands. States have the power to levy taxes on fossil fuels and the majority of them do so. In Australia, state governments own natural resources and impose various resource royalties. In Brazil, royalties on natural resources are shared between all three levels of government, on a derivation basis, with local governments being the main beneficiaries. As in Canada and Australia, resources generate substantial government revenues in resource-rich areas and are sources of horizontal fiscal disparities.

2.6 Vertical Fiscal Gaps

In all federations, there is greater decentralization in terms of expenditures than in terms of taxation. This implies that subnational governments’ own-source revenues fall short of their expenditures. In other words, it gives rise to vertical fiscal gaps that are filled by intergovernmental transfers. The size of vertical fiscal gaps varies widely across countries, as reported in Table 3 where vertical fiscal gaps are measured by the difference between the revenue share and the expenditure share for each level of government.

Table 3 Vertical fiscal gaps

Vertical fiscal gaps at the state level are largest in South Africa, where the own-source revenues of provincial governments represent less than two percent of total public sector revenues. Vertical fiscal gaps are also sizeable in Ethiopia, India, Australia, and Spain. In some countries, vertical fiscal gaps are larger at the local government level than at the state level. That is the case when local governments rely more heavily on transfers to finance their expenditures. This holds in Brazil, Canada, Germany, and the United States. Based on vertical fiscal gaps, the relative fiscal autonomy of local governments is greater than that of state level governments in Australia, South Africa, Spain, and Switzerland.

3 Fiscal Transfer Systems

The intergovernmental transfer system is a critical pillar of any fiscal federalism system. In addition to filling the vertical fiscal gap, and therefore accommodating greater decentralization of expenditures than taxation, it serves several other purposes (Boadway, 2007). Most importantly, it contributes to horizontal equity by equalizing fiscal capacities across subnational units. Intergovernmental grants are also used to pursue various national objectives such as achieving standards in the provision of public services, inducing policy harmonization across subnational units, and promoting economic efficiency and development. Transfers also play a risk-sharing function among subnational governments (von Hagen, 2007).

3.1 Subnational Governments’ Reliance on Transfers

State level governments finance most of their expenditures with their own revenues in some countries while they are heavily dependent on transfers in others, as shown in Fig. 3. Transfers received by states represent less than 20% of state governments’ expenditures in Germany and Canada, and less than 30% in Switzerland, Brazil, and the United States. In contrast, that proportion is around 70% in Ethiopia and close to 100% in South Africa. In some countries, local governments rely much more heavily on transfers than state level governments. That is the case in Germany, Canada, and Brazil. The opposite holds in Switzerland, Australia, and South Africa.

Fig. 3

(Sources IMF Government Finance Statistics and various chapters from this book. Data is for 2019 for all countries except Ethiopia [2017], India [2017], and South Africa [2018]. Data not available for local governments in Ethiopia and in India. Data for local governments in Italy includes all subnational governments)

Transfers received by state and local governments as a percentage of their expenditures (%)

3.2 Equalization

The key objective of equalization is pursued, to varying degrees, in the transfer systems of all eleven countries surveyed in previous chapters. However, there is a variety of ways in which transfer systems are designed to do so. In some countries, equalization transfers are based on estimates of both fiscal capacities and expenditure needs and transfer systems aim for a high equalization standard (see Table 4). That is the case in Australia where equalization transfers are financed from the federal goods and services tax (GST). The allocation of transfers is based on fiscal capacities and expenditure needs, estimated from three-year averages of revenues collected across states and levels of services provided. The system is designed to ensure that each state has the capacity to provide the same level of services assuming equal revenue-raising effort and equal efficiency. Canada’s equalization system has a similar objective, i.e., ensuring that all provinces have the capacity to provide comparable public services at comparable tax rates. However, transfers are determined only by disparities in fiscal capacities, not expenditure needs.

Table 4 Intergovernmental transfer systems

Germany’s equalization program is mainly implemented through VAT revenue redistribution. This is part of the revenue-sharing system among the three levels of governments but the allocation of VAT revenues across Laender involves an equalization component. There are also additional transfers from the federal government to Laender intended to further close fiscal disparities and to address specific fiscal needs of some Laender. Overall, the standard of equalization is very high, leaving little post-transfer fiscal disparities across Laender.

In South Africa, equalization transfers are mandated by the constitution to provide subnational governments with an equitable share of national revenues. The allocation formula takes into account different indicators of expenditure needs, such as population in various age-groups and poverty rates, as well as provincial GDP as a proxy for fiscal capacity. However, given the extremely centralized nature of the tax system, the weight of provincial fiscal disparities in determining the allocation of transfers is small. Transfers are largely determined by provincial expenditure needs. The federal government also provides unconditional transfers to local governments which are largely based on expenditure needs but also take into account revenue-raising capacity. Despite this, the equalization impact of transfers in practice, both at the provincial and local levels, is relatively limited.

Some equalization systems involve horizontal transfers, although that is quite uncommon. It is the case in Switzerland where two types of equalization transfers to cantons are in place, one type targeting differences in cantonal tax capacities and the other intended to compensate for differences in expenditure needs. The first type is a horizontal transfer system in which cantons with above-average tax capacities contribute to the pool of funds while cantons with below-average capacities receive an equalization payment intended to bring their tax capacity to 85% of the national average. Tax capacities are based on income, profits, and wealth taxes. The second type of equalization involves transfers from the federal government to cantons with relatively high expenditure needs. Measures of expenditure needs are based on geographic and topographic factors (e.g. mountainous area) and socio-economic factors (e.g. population density).

In some countries, there are asymmetries in how the transfer system applies to different groups of regions. That is the case in Spain and Italy. In Spain, equalization transfers are provided to Autonomous Communities that are under the common regime (all but two). Transfers are calculated based on expenditure needs and fiscal capacities. For fundamental public services, expenditure needs calculations take into account the total population, as well as the proportion of elderly and of school-age children, the size of the geographic area and population dispersion, among others. Autonomous Communities under the charter system (Navarre and Basque Country) are not part of the equalization system. In fact, because tax decentralization is much more pronounced in Navarre and Basque Country than in the rest of the country, and given their relatively high fiscal capacities, these two Autonomous Communities are making net transfers to the central government which are intended as their contributions to financing some public services provided by the central government. Hence, these two Autonomous Communities are financing all of their expenditures out of their own revenues.

Italy is slowly transitioning to an equalization system involving fiscal capacity and expenditure needs equalization among regions. Fiscal capacity calculation will take into account regional devolved taxes, regional surtaxes on personal income taxes, and the regional share of the VAT. The equalization system applies only to ordinary regions. In the case of special regions, regional government funding is largely based on revenue-sharing of national taxes. The regional share of revenues is transferred on a derivation basis and the regional share of revenues varies across regions. Therefore, ordinary regions and special regions are subject to completely different transfer systems.

Some countries do not have intergovernmental transfers explicitly designed as equalization transfers, although transfers may still have implicit equalizing effects. For example, there is no explicit system of federal-state equalization transfers in the United States. There is, however, an implicit equalizing element in federal-state transfers for Medicaid to the extent that these are matching grants (so involves some implicit needs equalization) with matching rates being higher for relatively poorer states. Federal grants to school districts are based on low-income concentration so are also implicitly equalizing. There is no system of equalization transfers in Brazil either. There is an extensive constitutionally established revenue-sharing system and sizeable conditional grants, but with relatively limited redistributive effects.

3.3 Decision-making Process for Transfer Systems and Advisory Fiscal Commissions

In some countries, the size and allocation of transfers are largely determined by the central government. This is essentially the case in Switzerland, for example. Centralized decision-making results in transfer systems that are generally more flexible and responsive to fiscal shocks or to changing circumstances. However, it also tends to provide the central government with more power to influence subnational programs, sometimes excessively (Spahn, 2007). At times, there is also a tendency for central governments to reduce transfers to subnational governments in response to their own fiscal pressures resulting in distortions to the optimal allocation of public funds.

In other countries, transfers are determined, at least to some extent, through intergovernmental consultations and negotiations (Shah, 2007). In Canada, for example, federal-provincial meetings sometimes lead to negotiated changes to the transfer system. This provides opportunities for provinces to participate in the decision-making process, although achieving consensus is always difficult given competing provincial interests. In other countries, subnational influence on the transfer system is achieved through subnational representation in national institutions. In Germany, Laender has some impact through representation in the Bundersrat, the upper house of parliament. The House of Federation in Ethiopia, which is the upper house of Parliament and is composed of members elected by state councils, has the power to review and approve budgetary measures of the national governments that impact states including intergovernmental transfers. In fact, the total pool of funds available for equalization is determined by the federal government but the House of Federation determines the formula for allocating transfers across states.

Transfers are, in other countries, determined on the basis of recommendations from advisory commissions. In India, the Finance Commission provides recommendations about the vertical and horizontal distribution of revenues from Union taxes as well as about the size and allocation of specific-purpose grants to states. The commission is appointed by the President and is renewed every five-year. The commission is independent from the union and state governments, it is composed of experts on intergovernmental fiscal issues, and its recommendations are usually adopted by the government. In Australia, the Commonwealth Grants Commission is an independent expert body responsible for assessing the fiscal capacities and spending needs of states that are used to determine equalization payments. The Commission is appointed by the federal government, partly based on consultations with the states. Once appointed, the commission is largely independent. The commission has an advisory role only, but its recommendations are usually adopted by the government.

In contrast to the cases of India and Australia, advisory commissions are not always as influential. In South Africa, the Financial and Fiscal Commission is responsible for making recommendations about the size and allocation of federal transfers to provincial and local governments. The constitution, which establishes the commission, requires that the recommendations be taken into account by the government. However, there is no obligation for the government to adopt them, and in practice, recommendations are not always adopted. The Financial and Fiscal Commission is also consulted on matters of government borrowing and debt.

Fiscal commissions sometimes play various roles with respect to fiscal monitoring and dispute resolution. In Spain, implementation issues and disputes about the revenue assignment system are referred to the Fiscal and Financial Policy Council, which is an intergovernmental body with members from the central government and from the Autonomous Communities. It is responsible for assessing the revenue assignment system and submitting reform recommendations to the National Parliament. In Italy, the Permanent Conference for the Coordination of Public Finance is an advisory body that provides advice regarding the equalization system and budgetary objectives and monitors the public finances of subnational governments to ensure compliance with budgetary objectives.

4 Macroeconomic Management

Rules and mechanisms to induce good macroeconomic governance are crucial in federal systems, especially when fiscal decentralization is relatively pronounced. Harmonization of tax policies is important for the efficiency of internal economic unions. Fiscal rules and coordination mechanisms are central in maintaining fiscal discipline and achieving sound public finance management.

4.1 Tax Policy Harmonization

Some federal systems have been more successful than others at inducing tax policy harmonization and mitigating harmful tax competition (see Table 5). Canada, for instance, has done well in this area despite very pronounced tax decentralization. While Canadian provinces have substantial autonomy in setting tax policy, tax collection agreements between the federal and provincial governments have succeeded in maintaining a relatively harmonized system, both vertically and horizontally. In the case of the corporate income tax, for example, tax collection agreements preclude provincial governments from adopting measures that would discriminate against corporate taxpayers from other provinces. Tax collection agreements also include a formula-apportionment system that serves to allocate the taxable income of firms that operate in multiple provinces. This mitigates tax avoidance practices by firms as well as tax competition incentives of provincial governments. Likewise, in Spain, while Autonomous Communities operating under the common regime have considerable autonomy in setting tax rates and tax credits for most direct taxes, they generally use essentially the same centrally defined tax bases, so the tax system remains relatively well harmonized. However, there is much less harmonization between the Autonomous Communities under the common regime and those under the charter regime where policymaking over direct taxes is almost fully decentralized. In Ethiopia, harmonization of state and federal tax systems is required by the Federal Financial Administration Law and coordinated by the federal ministry of finance. Harmonization is certainly facilitated by the high degree of tax centralization relative to most other federal systems, but the mechanisms in place have nonetheless been relatively successful.

Table 5 Macroeconomic management

Other countries have not had as much success at inducing tax policy harmonization. In the US, there are wide variations in income tax rates across states, as well as in the definition of taxable income because of state-specific provisions. As a result, there is limited harmonization of income tax systems across states. In Switzerland, harmonization of cantonal tax policies is relatively limited. Moreover, the high level of autonomy of cantons and tax policy flexibility has apparently led to considerable tax competition. There is little harmonization of state value-added taxes in Brazil where substantial variations exist in rates applying on different types of goods or according to the origin or destination of interstate sales. This lack of harmonization is an important source of economic inefficiency given that the state value-added tax is the tax instrument that raises the most revenues in the Brazilian federation.

4.2 Restrictions on Borrowing at Subnational Level

Various types of restrictions on subnational borrowing, especially at the local level, apply in all countries. For example, long-term borrowing by municipalities is only allowed for the financing of capital expenditures in Australia, Canada, Germany, and South Africa. In Ethiopia, the federal government sets conditions under which states can borrow and all state borrowing must be approved by the federal ministry of finance. In Switzerland, cantons are required by law to maintain budget balance in the medium term and most cantons have debt brake laws intended to limit the growth of public debt, in most cases with reasonable success. In South Africa, the right to borrow from states and municipalities is guaranteed by the constitution but subject to various conditions and controls. In Australia, some local governments must borrow directly from state governments, and state budgetary deficits and borrowing are coordinated by the Australian Loan Council.

4.3 Fiscal Rules , Coordination, and Fiscal Discipline

Some fiscal coordination is ensured in Germany through the Stability Council, which is composed of federal and Laender ministers of finance. The Council monitors compliance with fiscal rules regarding budgetary balance and recommends adjustment measures when the federal government or state governments do not comply. In Spain, the Budgetary Stability and Financial Sustainability Law requires all governments to achieve structural budget balance, with exceptions allowed during emergencies or serious economic crises. The law also imposes a ceiling on the growth rate of government expenditures, which cannot exceed the medium-term growth rate of GDP. At the same time, central government funds (Fund for Financing Autonomous Communities) have been used to provide liquidities to subnational governments running deficits. While the Budgetary Stability and Financial Sustainability Law has had some success, the mechanisms put in place to provide liquidities in response to subnational fiscal imbalances have arguably led to a soft-budget constraint problem. In Brazil, the Fiscal Responsibility Law was put in place in 2000 to achieve more fiscal discipline at all three levels of government. The law imposes limits on debt and debt service payments as a share of current revenues, as well as constraints on the establishment of new recurrent spending. In Switzerland, the strong direct democracy tradition has contributed to fiscal discipline at the cantonal level. In most cantons, significant increases in government expenditures require public approval by referendum as long as a successful petition is launched to request it.

5 Challenges to Fiscal Federalism Systems

There are many common challenges to fiscal federalism systems. Most importantly perhaps, achieving and maintaining fiscal balance, both vertically and horizontally, is a constant concern in most of the countries surveyed. For many of them, the vertical fiscal balance is currently threatened by the fiscal implications of demographic trends. Government functions that are most heavily impacted by population aging, including health care, public services targeted at the elderly such as long-term care, as well as pensions and income support programs for retirees are often largely performed by subnational governments. In countries where that is the case, demographic trends are imposing great fiscal stress on subnational governments and tend to produce vertical fiscal imbalances. This generates pressure for more revenue decentralization. That is the case in Canada, for example, where the expenditures of provincial governments on health care are growing much more rapidly than other public spending and than public sector revenues. It is also the case in the United States where, in addition to rapidly rising public health care costs, underfunded pension systems are imposing severe fiscal pressure on many state and local governments. Several other countries are facing similar issues, to varying degrees.

Subnational governments in all countries surveyed are calling for greater revenue decentralization and subnational revenue autonomy, some with more success than others. At the same time, revenue decentralization tends to exacerbate the potential for horizontal fiscal imbalances. The capacity of transfer systems to maintain horizontal fiscal balance is challenged in several countries. This has been a concern in Brazil, Ethiopia, India, South Africa, and Spain, for example. In some countries, especially Australia, Brazil, and Canada, horizontal imbalances tend to be aggravated by the unequal distribution of natural resource revenues.

In several of the countries surveyed, there are strong pressures for disentangling some of the functions and tasks of different orders of government to improve effectiveness in the delivery of public services and promote accountability. Such pressures tend to emerge in countries where central government influence in areas of concurrent or shared responsibilities is perceived to be excessive. In recent times, this has been the case in Germany, Spain, Switzerland, South Africa, and Italy, for example. Clarifying roles and responsibilities is crucial to safeguarding effective subnational autonomy. It is also critical for government responsiveness to shocks or to changing circumstances, as was highlighted in many countries following the start of the Covid-19 pandemic. Some lack of clarity about the powers and responsibilities of different orders of government with respect to public safety and public health in emergency situations has been problematic in some countries, at least in the early stages of the pandemic. At the same time, the pandemic also highlighted the need for intergovernmental coordination and cooperation in the areas of public health and public safety.

Fiscal arrangements, especially the tax system, are important to the efficiency of internal economic spaces in federations. In some countries, tax policy harmonization is a key concern. The lack of effective harmonization mechanisms can lead to tax competition, which has arguably been the case in Switzerland where cantons enjoy high autonomy in setting tax policies. Limited harmonization of tax policies can also impede interregional trade patterns. This has been an issue with respect to value-added taxes in Brazil. There are also concerns about variations in the structures and rates of income taxes in the United States, Spain, and Canada.

Finally, maintaining fiscal discipline is a difficult challenge in all federal systems. Designing fiscal arrangements leads to tensions between, on the one hand, sharing fiscal risks across subnational governments and promoting horizontal fiscal balance, and on the one hand, maintaining strong incentives for fiscal discipline. The dramatic impacts of the Covid-19 pandemic on budgetary balances will only make this challenge more difficult.