The Effects Of Fiscal Federalism

Central thesis – Indian states are not yet ready for full fiscal federalism. (Partial fiscal federalism may be beneficial, but full fiscal federalism might adversely affect economic health and well-being)

I) WHAT IS FISCAL FEDERALISM

WHAT IS IT?

Fiscal federalism is a prime topic of discussion in most countries right now. In both developed as well as developing economies, a turn to devolution to improve the performance of the public sectors is being considered. Major programs have been introduced to shift decision-making from the center to provincial and local governments. It is crucial to first understand what fiscal federalism is, in order to appreciate its implications.

Fiscal decentralization can be defined as a two-dimensional policy

If such complete autonomy is lacking in either or both of these, then there is partial fiscal federalism.

BRIEF HISTORY

The effect of fiscal federalism on the quality of governance is mainly studied through two areas – the classical theory and the second generation theory.

Classical theory:

The classical approach is defined by three main contributions – Tiebout (1956), Oates (1972), and Brennan and Buchanan (1980).

In Tiebout’s model of local public good provision, decentralization coupled with mobile households solves the problem of the efficient provision of public goods. Essentially local governments compete in offering a mix of tax and public goods, and citizens decide where to live according to their preferences about tax and public

It draws on two basic sources – work on political processes and behavior of political agents, and work on information asymmetry. Unlike the first generation theory which largely assumed public officials work for the common good to maximize social welfare, this work takes as its point of departure the assumption that participants in political processes (both voters and officials) have their own objective functions that they seek to maximize in a political setting that provides the constraints on their behavior. It basically emphasizes much more on the public-choice approach introduced above. The outcomes from collective choice institutions depend in fundamental ways on the information that the various agents possess. In particular, in settings of asymmetric information, some participants have knowledge of certain things such as preferences, cost functions, or effort; knowledge that is not available to other participants, and hence optimality decisions in this setting would be quite different from those under perfect information. In short, the second generation theory provides “new literature on fiscal federalism that examines the workings of different political and fiscal institutions in a setting of imperfect information and control with a basic focus on the incentives that these institutions embody and the resulting behavior they induce from utility-maximizing