An Essay on Fiscal Federalism

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					Journal of Economic Literature
Vol. XXXVII (September 1999) pp. 1120–1149

                                                                      Oates: An Essay on Fiscal Federalism

             An Essay on Fiscal Federalism
                                       WALLACE E. O ATES1

               1. Introduction                        planning that, in the view of many, has
                                                      failed to bring these nations onto a path
     vogue. Both in the industrialized and
in the developing world, nations are
                                                      of self-sustaining growth.
                                                         But the proper goal of restructuring
                                                      the public sector cannot simply be de-
turning to devolution to improve the per-
                                                      centralization. The public sector in
formance of their public sectors. In the
                                                      nearly all countries consists of several
United States, the central government
                                                      different levels. The basic issue is one
has turned back significant portions of
                                                      of aligning responsibilities and fiscal in-
federal authority to the states for a wide
                                                      struments with the proper levels of gov-
range of major programs, including wel-
                                                      ernment. As Alexis de Toqueville ob-
fare, Medicaid, legal services, housing,
                                                      served more than a century ago, “The
and job training. The hope is that state
                                                      federal system was created with the in-
and local governments, being closer to
                                                      tention of combining the different ad-
the people, will be more responsive to
                                                      vantages which result from the magni-
the particular preferences of their con-
                                                      tude and the littleness of nations” (1980,
stituencies and will be able to find new
                                                      v. I, p. 163). But to realize these “dif-
and better ways to provide these ser-
                                                      ferent advantages,” we need to under-
vices. In the United Kingdom, both Scot-
                                                      stand which functions and instruments
land and Wales have opted under the
                                                      are best centralized and which are best
Blair government for their own regional
                                                      placed in the sphere of decentralized
parliaments. And in Italy the movement
                                                      levels of government. This is the sub-
toward decentralization has gone so far
                                                      ject matter of fiscal federalism. As a
as to encompass a serious proposal for
                                                      subfield of public finance, fiscal feder-
the separation of the nation into two in-
                                                      alism addresses the vertical structure of
dependent countries. In the developing
                                                      the public sector. It explores, both in
world, we likewise see widespread inter-
                                                      normative and positive terms, the roles
est in fiscal decentralization with the ob-
                                                      of the different levels of government
jective of breaking the grip of central
                                                      and the ways in which they relate to one
  1 Professor of Economics, University of Mary-       another through such instruments as
land, and University Fellow, Resources for the Fu-    intergovernmental grants. 2
ture. I am most grateful for a host of helpful com-
ments on an earlier draft from Robert Inman,
Ronald McKinnon, Daniel Rubinfeld, Robert               2 This economic use of the term “federalism” is
Schwab, John Wallis, Barry Weingast, and three        somewhat different from its standard use in politi-
anonymous referees; for research assistance from      cal science, where it refers to a political system
Tugrul Gurgur; and for the splendid editorial         with a constitution that guarantees some range
guidance of John Pencavel and John McMillan.          of autonomy and power to both central and
                              Oates: An Essay on Fiscal Federalism                                    1121

   My purpose in this essay is not to                   should have the basic responsibility for
provide a comprehensive survey of fis-                  the macroeconomic stabilization func-
cal federalism. I begin with a brief re-                tion and for income redistribution in
view and some reflections on the tradi-                 the form of assistance to the poor. In
tional theory of fiscal federalism: the                 both cases, the basic argument stems
assignment of functions to levels of gov-               from some fundamental constraints on
ernment, the welfare gains from fiscal                  lower level governments. In the ab-
decentralization, and the use of fiscal                 sence of monetary and exchange-rate
instruments. I then turn to some of the                 prerogatives and with highly open
new directions in recent work in the                    economies that cannot contain much of
field and explore a series of current top-              the expansionary impact of fiscal stim-
ics: laboratory federalism, interjurisdic-              uli, provincial, state, and local govern-
tional competition and environmental                    ments simply have very limited means
federalism, the political economy of fis-               for traditional macroeconomic control
cal federalism, market-preserving feder-                of their economies. Similarly, the mo-
alism, and fiscal decentralization in the               bility of economic units can seriously
developing and transitional economies.                  constrain attempts to redistribute in-
Some of this research is expanding the                  come. An aggressive local program for
scope of the traditional analyses in im-                the support of low-income households,
portant and interesting ways. This will                 for example, is likely to induce an influx
provide an opportunity both to com-                     of the poor and encourage an exodus of
ment on this new work and to suggest                    those with higher income who must
some potentially fruitful avenues for                   bear the tax burden. 3 In addition to
further research.                                       these functions, the central government
                                                        must provide certain “national” public
       2. The Basic Theory of Fiscal                    goods (like national defense) that pro-
       Federalism: Some Comments                        vide services to the entire population of
                                                        the country.
   The traditional theory of fiscal feder-
                                                           Decentralized levels of government
alism lays out a general normative
                                                        have their raison d’etre in the provision
framework for the assignment of func-
                                                        of goods and services whose consump-
tions to different levels of government
                                                        tion is limited to their own jurisdic-
and the appropriate fiscal instruments
                                                        tions. By tailoring outputs of such goods
for carrying out these functions (e.g.,
                                                        and services to the particular pre-
Richard Musgrave 1959; Oates 1972).
                                                        ferences and circumstances of their
At the most general level, this theory
contends that the central government                       3 It is straightforward to show that a system of
                                                        decentralized poor relief is characterized by a gar-
                                                        den-variety externality that results in suboptimal
decentralized levels of government. For an econo-       levels of support for the poor. More specifically,
mist, nearly all public sectors are more or less fed-   increases in support payments in one jurisdiction
eral in the sense of having different levels of gov-    confer external benefits in the form of a reduced
ernment that provide public services and have           number of poor households elsewhere. On this,
some scope for de facto decision-making authority       see Charles Brown and Oates (1985). There is,
(irrespective of the formal constitution). In retro-    moreover, evidence for the U.S. that state-level
spect, it seems to me that the choice of the term       decisions on levels of welfare support are interde-
“fiscal federalism” was probably an unfortunate         pendent; Luz Amparo Saavedra (1998), among
one, since it suggests a narrow concern with budg-      others, finds that states have responded to de-
etary matters. The subject of fiscal federalism, as I   creases (increases) in benefit levels in other states
suggest above, encompasses much more, namely            by reducing (raising) their own benefits to welfare
the whole range of issues relating to the vertical      recipients. For an excellent survey of this whole
structure of the public sector.                         issue, see Jan Brueckner (1998).
1122         Journal of Economic Literature Vol. XXXVII (September 1999)

constituencies, decentralized provision                say, “local” in its incidence. The spe-
increases economic welfare above that                  cific pattern of goods and services pro-
which results from the more uniform                    vided by different levels of government
levels of such services that are likely                will thus differ to some extent in time
under national provision. The basic                    and place. 5 This is to be expected.
point here is simply that the efficient                Nonetheless, there remains much to be
level of output of a “local” public good               said for the basic principle of fiscal de-
(i.e., that for which the sum of resi-                 centralization: the presumption that the
dents’ marginal benefits equals mar-                   provision of public services should be
ginal cost) is likely to vary across                   located at the lowest level of govern-
jurisdictions as a result of both differ-              ment encompassing, in a spatial sense,
ences in preferences and cost differen-                the relevant benefits and costs.6
tials. To maximize overall social welfare                 Let me offer three observations on
thus requires that local outputs vary                  the general theory. First, the founda-
accordingly.                                           tions of the Decentralization Theorem
   These precepts, however, should be                  need some elaboration. The theorem is
regarded more as general “guidelines”                  itself a straightforward normative propo-
than firm “principles.” As has been                    sition that states simply that “ . . . in
pointed out in the literature, there is                the absence of cost-savings from the
certainly some limited scope for decen-                centralized provision of a [local public]
tralized macroeconomic efforts (Ed-                    good and of interjurisdictional exter-
ward Gramlich 1987) and for assistance                 nalities, the level of welfare will always
to the poor. In particular, there is a                 be at least as high (and typically higher)
theoretical case for some poor relief                  if Pareto-efficient levels of consumption
at local levels (Mark Pauly 1973), and                 are provided in each jurisdiction than if
the fact is that state and local govern-               any single, uniform level of consump-
ments undertake a significant amount of                tion is maintained across all jurisdic-
redistributive activity. 4                             tions” (Oates 1972, p. 54). The theorem
   Moreover, this prescription is a quite              thus establishes, on grounds of eco-
general one. It does not offer a precise               nomic efficiency, a presumption in fa-
delineation of the specific goods and                  vor of the decentralized provision of
services to be provided at each level of               public goods with localized effects.
government. And indeed the spatial pat-                While the proposition may seem almost
tern of consumption of certain goods                   trivially obvious, it is of some interest
and services like education and health is              both in terms of setting forth the condi-
open to some debate. As a result, we                   tions needed for its validity and, with
find in cross-country comparisons some                    5 For two useful treatments of the assignment of
divergence in just what is considered,                 specific public services to the appropriate level of
                                                       government, see Anwar Shah (1994, ch. 1) and
   4 However, Martin Feldstein and Marian Vail-        Ronald McKinnon and Thomas Nechyba (1997).
lant Wrobel (1998) present some recent evidence           6 In Europe, proponents of fiscal decentraliza-
suggesting that state government attempts to re-       tion refer to the “principle of subsidiarity.” The
distribute income are largely unsuccessful. They       precept here is that public policy and its imple-
find that progressive state income taxes in the U.S.   mentation should be assigned to the lowest level
have had little impact on the net-of-tax relative      of government with the capacity to achieve the ob-
wage rates of skilled versus nonskilled workers.       jectives. This principle has been formally adopted
Their claim is that the mobility of workers across     as part of the Maastrict Treaty for European
state borders undoes efforts at redistribution—and     Union. Its intellectual roots, interestingly, are
does so very quickly. The result is no redistribu-     found in twentieth-century Catholic social philoso-
tion, only deadweight losses from inefficient          phy. On this see Robert Inman and Daniel Rubin-
locational decisions.                                  feld (forthcoming).
                        Oates: An Essay on Fiscal Federalism                                1123

some further analysis, for providing          suggests that the magnitude of these
some insights into the determinants of        gains depends both on the extent of the
the magnitude of the welfare gains from       heterogeneity in demands across juris-
fiscal decentralization (Oates 1998).         dictions and any interjurisdictional dif-
   But there is more to the story. The        ferences in costs. In particular, we find
presumption in favor of decentralized         that the potential gains from decentrali-
finance is established by simply assum-       zation stemming from interjurisdic-
ing that centralized provision will entail    tional differences in demand vary in-
a uniform level of output across all ju-      versely with the price elasticity of
risdictions. In a setting of perfect infor-   demand. If the costs of provision are
mation, it would obviously be possible        the same across jurisdictions, but de-
for a benevolent central planner to pre-      mands differ, then the extent of the
scribe the set of differentiated local        welfare loss from a centrally imposed,
outputs that maximizes overall social         uniform level of output increases, other
welfare; there would be no need for           things equal, with the price inelasticity
fiscal decentralization (although one         of demand. 7 There is a large body of
might wish to describe such an outcome        econometric evidence that finds that
as decentralized in spirit!). The re-         the demand for local public goods is
sponse to this observation has been two-      typically highly price inelastic. This sug-
fold. First, one can realistically intro-     gests that the potential welfare gains
duce some basic imperfections (or             from decentralized finance may well be
asymmetries) in information. More spe-        quite large. 8
cifically, individual local governments          Pursuing this point into the realm of
are presumably much closer to the peo-        positive economics, we might expect
ple and geography of their respective         the magnitude of the potential gains
jurisdictions; they possess knowledge of      from fiscal decentralization to have
both local preferences and cost condi-        some explanatory power. Where these
tions that a central agency is unlikely to    gains are large, we would expect to find
have. And, second, there are typically        that the public sector is more decentral-
political pressures (or perhaps even          ized. In exploring this issue some years
constitutional constraints) that limit the    ago, I found some (perhaps vague) evi-
capacity of central governments to pro-       dence in its support: in a sample of
vide higher levels of public services in      countries, the fiscal share of the central
some jurisdictions than others. These         government varied inversely with an
constraints tend to require a certain de-
gree of uniformity in central directives.        7 In tax analysis, we are accustomed to a quite

There are thus important informational        different result: the deadweight loss varies directly
                                              with the price elasticity of demand. Here it is just
and political constraints that are likely     the reverse, since the distortion takes place on the
to prevent central programs from              quantity, rather than the price, axis. But interest-
generating an optimal pattern of local        ingly, if the source of the difference in efficient
                                              local outputs is cost differentials, then the gains
outputs.                                      from fiscal decentralization bear the opposite rela-
   My second observation concerns the         tionship to the case where their source is differ-
magnitude of the welfare gains from fis-      ences in levels of demand: these gains then vary
                                              directly with the price elasticity of demand (Oates
cal decentralization. We can, in princi-      1998).
ple, measure the gains from the decen-           8 For surveys of this econometric literature, see

tralized provision of public goods            Rubinfeld (1987) and Oates (1996a). For an at-
                                              tempt actually to measure the welfare gains from
relative to a more uniform, centrally de-     decentralization, see David Bradford and Oates
termined level of output. The theory          (1974); they find large gains.
1124         Journal of Economic Literature Vol. XXXVII (September 1999)

index of “sectionalism,” a measure of                     there were absolutely nothing mobile—
the extent to which people in geo-                        households, factors, or whatever—there
graphical subareas of a country identify                  would still exist, in general, gains from
“self-consciously and distinctively with                  decentralization. The point here is sim-
that area” (Oates 1972, pp. 207–208).                     ply that even in the absence of mobility,
More recently, Koleman Strumpf and                        the efficient level of output of a “local”
Felix Oberholzer-Gee (1998), in a more                    public good, as determined by the Sam-
sharply focused study of states and                       uelson condition that the sum of the
counties in the United States, find that                  marginal rates of substitution equals
the decision to allow counties a local                    marginal cost, will typically vary from
option to legalize the consumption of                     one jurisdiction to another. To take one
alcoholic beverages depends signifi-                      example, the efficient level of air quality
cantly on a measure of the heterogene-                    in Los Angeles is surely much different
ity in preferences across counties within                 from that in, say, Chicago.
each state. There is, I think, some inter-                   This point is of importance, because
esting work to be done in exploring the                   the Tiebout model is often viewed as a
extent to which the potential gains from                  peculiarly U.S. construction. The rela-
decentralization can explain the ob-                      tively footloose households that it envi-
served variation in actual governmental                   sions, responding to such things as local
structure and policies. 9                                 schools and taxes, seem to characterize
   Third, I sense a widespread impres-                    the U.S. much better than, say, most
sion, suggested in some of the litera-                    European countries. As a result, ob-
ture, that the gains from decentraliza-                   servers outside the U.S. tend to believe
tion have their source in the famous                      that this strand of the theory of local
Tiebout model (Charles Tiebout 1956).                     finance is of limited relevance in their
In this model, highly mobile households                   settings. While there may well be some
“vote with their feet”: they choose as a                  truth to this, it most emphatically does
jurisdiction of residence that locality                   not follow that there are no longer any
that provides the fiscal package best                     significant welfare gains from the
suited to their tastes. In the limiting                   decentralized provision of public goods.
case, the Tiebout solution does indeed
generate a first-best outcome that mim-                           3. Fiscal Instruments in
ics the outcome in a competitive mar-                                 a Federal System
ket. But the gains from decentraliza-
tion, although typically enhanced by                         To carry out their functions, the vari-
such mobility, are by no means wholly                     ous levels of government require spe-
dependent upon them.10 In fact, if                        cific fiscal instruments. On the revenue
                                                          side, governments will typically have ac-
  9 Another interesting case is the setting of fed-       cess to tax and debt instruments. But in
eral standards for safe drinking water. After man-        a federal system there is a further
dating a set of standards for the quality of drinking
water to be met in all jurisdictions in the Safe Drink-   method for allocating funds among the
ing Water Act of 1974, the federal government has         different levels of the public sector: in-
backed off and now allows a range of exceptions in        tergovernmental grants. One level of
recognition of the large interjurisdictional differ-
ences in per-capita costs of meeting the standards        government may generate tax revenues
(U.S. Congressional Budget Office 1997).                  in excess of its expenditures and then
  10 In certain settings, mobility can itself be a
                                                          transfer the surplus to another level of
source of distorted outcomes. See, for example,
the seminal paper by Frank Flatters, Vernon               government to finance part of the lat-
Henderson, and Peter Mieszkowski (1974).                  ter’s budget. I want to review and
                        Oates: An Essay on Fiscal Federalism                      1125

comment briefly on the use of these          highly mobile economic units (be they
fiscal instruments in a federal fiscal       households, capital, or final goods). But
system.                                      this in itself is not correct. The real im-
                                             plication is that decentralized levels of
3.1 Taxation in a Federal System
                                             government should avoid nonbenefit
   The determination of the vertical         taxes on mobile units. Or, more accu-
structure of taxes is known in the litera-   rately, the analysis shows that on effi-
ture as the “tax-assignment problem”         ciency grounds decentralized govern-
(Charles McLure 1983). And the basic         ments should tax mobile economic units
issue here is the normative question:        with benefit levies (Oates and Robert
Which taxes are best suited for use at       Schwab 1991; Oates 1996b). Such eco-
the different levels of government? The      nomic units, in short, should pay for the
question is typically posed in a setting     benefits that they receive from the pub-
in which there exists a nation state with    lic services that local governments
a central government, where there is lit-    provide to them.
tle or no mobility across national bor-         The most well-known case of this is
ders; at decentralized levels, in con-       the earlier-discussed Tiebout model in
trast, economic agents, goods, and           which local jurisdictions use benefit
resources have significant mobility          taxes that effectively communicate to
across jurisdictional boundaries with        households the cost of consuming dif-
the extent of this mobility increasing at    ferent levels of local public goods; this
successively lower levels of government.     results in an efficient pattern of con-
“Local” government, for analytical pur-      sumption of these goods. But this is
poses, may sometimes be characterized        true not only for households. If local
as operating in a setting in which eco-      governments provide local inputs that
nomic units can move costlessly among        increase the productivity of capital em-
jurisdictions.                               ployed in their jurisdictions, then they
   The difference in the mobility of         should levy benefit taxes on capital in
taxed units at the central and decentral-    order to provide the set of signals
ized levels has important implications       needed for the efficient deployment of
for the design of the vertical structure     capital across localities (Oates and
of taxation. Taxes, as we know, can be       Schwab 1991). In sum, efficiency re-
the source of distortions in resource al-    quires not only that decentralized juris-
location, as buyers shift their purchases    dictions refrain from nonbenefit taxa-
away from taxed goods. In a spatial set-     tion of mobile economic units, but that
ting, such distortions take the form of      they actively engage in benefit taxation
locational inefficiencies, as taxed units    where the public sector provides
(or owners of taxed items) seek out ju-      services to these units.
risdictions where they can obtain rela-         The public sector must for various
tively favorable tax treatment. High         reasons rely to a substantial extent on
excise taxes in one jurisdiction, for ex-    nonbenefit taxes. Redistributive pro-
ample, may lead purchasers to bear un-       grams that provide assistance to the
productive travel costs in order to pur-     poor, for example, simply transfer in-
chase the taxed items in jurisdictions       come. But, as noted earlier, such pro-
with lower tax rates.                        grams are not well suited to use at de-
   Such examples can suggest the con-        centralized levels of government, where
clusion that decentralized levels of gov-    the mobility of economic units across
ernment should avoid the taxation of         local boundaries can undermine the
1126         Journal of Economic Literature Vol. XXXVII (September 1999)

workings of such programs. It is for this              analysis, moreover, establishes a pre-
reason that the literature suggests that               sumption for the taxation of relatively
nonbenefit taxes, to the extent they are               immobile economic units. A particularly
needed, are best employed by higher                    attractive tax base is unimproved land,
levels of government.                                  since a tax on a factor or good in per-
   But provincial, state, and local gov-               fectly inelastic supply will not be the
ernments do, in fact, make use of some                 source of any locational inefficiencies.
such levies. 11 In a seminal treatment of              Such taxes (and any associated benefits
this issue making use of an optimal taxa-              from spending programs) will simply be
tion framework, Roger Gordon (1983)                    capitalized into local land values. Thus,
has explored the ramifications of the                  fiscally hard-pressed city governments
decentralized use of a wide range of                   have at their disposal a tax base that
nonbenefit taxes. And Gordon finds sev-                cannot escape them through mobility.
eral forms of potential distortion that                There is some evidence in this regard
result from an individual jurisdiction’s               that the city of Pittsburgh, which has
ignoring the effects of its fiscal deci-               used a graded property tax under which
sions elsewhere in the system; these in-               land is taxed at five times the rate on
clude inefficiencies involving, for exam-              structures, has experienced an expan-
ple, the “exporting” of tax burdens,                   sion in building activity that might not
external congestion effects, and impacts               have been forthcoming in the presence
on levels of revenues in other jurisdic-               of a higher tax on mobile capital (Oates
tions, as well as certain equity issues                and Schwab 1997).
associated with a generally regressive
pattern of tax incidence. 12                           3.2 Intergovernmental Grants and
   The analysis suggests, moreover,                      Revenue Sharing
some guidelines for the use of such
taxes. A reliance on resident-based taxes                 Intergovernmental grants constitute a
rather than source-based taxes, for ex-                distinctive and important policy instru-
ample, can lessen tax-induced distor-                  ment in fiscal federalism that can serve
tions by reducing the scope for tax-ex-                a number of different functions. The lit-
porting (Inman and Rubinfeld 1996;                     erature emphasizes three potential roles
McKinnon and Nechyba 1997). 13 The                     for such grants: the internalization of
                                                       spillover benefits to other jurisdictions,
  11 There is a lively and important debate in the     fiscal equalization across jurisdictions,
local finance literature over whether or not local     and an improved overall tax system.
property taxation, as employed in the U.S., consti-
tutes benefit taxation. Bruce Hamilton (1975,             Grants can take either of two general
1976) and William Fischel (1992) make the case         forms. They can be “conditional grants”
that local property taxes combined with local zon-     that place any of various kinds of re-
ing ordinances produce what is effectively a sys-
tem of benefit taxation. Peter Mieszkowski and         strictions on their use by the recipient.
George Zodrow (1989) take the opposite view.           Or they can be “unconditional,” that is,
  12 See Inman and Rubinfeld (1996) for an excel-
lent restatement and extension of the Gordon
analysis. David Wildasin (1998a) provides a valu-      source-based taxes (or “origin taxes”) involve tax-
able survey of the various implications of factor      ing factors where they are employed and goods
mobility both for economic efficiency and for the      and services where they are purchased. Under
redistributive impact of public policy.                resident-based taxation, governments have much
  13 Resident-based taxes (also called “destination-   less capacity to export the incidence of their taxes
based taxes”) are levies on factors of production      onto economic units elsewhere. Source-based
(such as land, labor, and capital) based on the        taxes, however, are often easier to administer and,
owner’s residence and on goods and services based      in certain forms, tend to be more commonly used
on the residence of the consumer. In contrast,         by state and local governments.
                              Oates: An Essay on Fiscal Federalism                                    1127

lump-sum transfers to be used in any                    a necessary feature of fiscal federalism
way the recipient wishes. The theory                    (Dan Usher 1995; Robin Boadway
prescribes that conditional grants in the               1996). Economists normally think of re-
form of matching grants (under which                    distributive measures from rich to poor
the grantor finances a specified share of               as those that transfer income from high-
the recipient’s expenditure) be em-                     to low-income individuals. Intergovern-
ployed where the provision of local ser-                mental equalizing transfers require a
vices generates benefits for residents of               somewhat different justification based
other jurisdictions. The rationale here                 on social values. 16 In practice, such
is simply the usual Pigouvian one for                   equalizing grants play a major role in
subsidies that induce individuals (in this              many countries: in the fiscal systems of
case policy-makers or the electorate) to                Australia, Canada, and Germany, for ex-
incorporate spillover benefits into their               ample, there are substantial transfers of
decision-making calculus. The magni-                    income from wealthy provinces or states
tude of the matching shares, in such in-                to poorer ones. In the United States, in
stances, should reflect the extent of the               contrast, equalizing grants from the fed-
spillovers. 14                                          eral to state governments have never
   In contrast, unconditional grants are                amounted to much. Intergovernmental
typically the appropriate vehicle for                   grants in the U.S. typically address spe-
purposes of fiscal equalization. The pur-               cific functions or programs, but usually
pose of these grants is to channel funds                do not accomplish much in the way of
from relatively wealthy jurisdictions to                fiscal equalization. At the levels of the
poorer ones. Such transfers are often                   states, however, there are many such
based on an equalization formula that                   programs under which states provide
measures the “fiscal need” and “fiscal                  equalizing grants to local jurisdictions—
capacity” of each province, state, or lo-               notably school districts.
cality. These formulae result in a dis-                    Fiscal equalization is a contentious is-
proportionate share of the transfers go-                sue from an efficiency perspective.
ing to those jurisdictions with the                     Some observers see such grants as play-
greatest fiscal need and the least fiscal               ing an important role in allowing poorer
capacity. 15                                            jurisdictions to compete effectively with
   Although widely used, equalizing in-                 fiscally stronger ones. This view holds
tergovernmental grants are by no means                  that, in the absence of such grants, fis-
   14 Matching grants (possibly negative) can, in
                                                        cally favored jurisdictions can exploit
principle, also serve to correct some of the distor-    their position to promote continued
tions associated with the decentralized use of          economic growth, some of which comes
nonbenefit taxes (Gordon 1983).
   15 Fiscal equalization can also make use of             16 The issue here is that from the perspective of
matching grants. If the objective of the equaliza-      redistributing income from rich to poor, equaliz-
tion program is to equalize taxable capacity, the       ing intergovernmental grants are bound to have
granting government may choose to supplement            some perverse effects. For such grants, although
the revenue base of fiscally poorer jurisdictions by    transfering income from wealthy to poor on aver-
matching any revenues they collect by some speci-       age, will inevitably result in some income transfers
fied percentage. Such a measure has the potential       from poor individuals who reside in wealthy juris-
of allowing all jurisdictions to raise the same tax     dictions to rich persons in generally poor areas. In
revenues per capita for a given tax rate (irrespec-     this sense, such equalizing measures are not as ef-
tive of the actual size of their tax base). This form   fective as programs that redistribute income from
of fiscal equalization is sometimes called “power-      rich to poor individuals. But a society may well
equalization” and has gotten some attention in the      wish, for other reasons, to provide additional sup-
U.S. for state programs to achieve various equity       port for the provision of local public services (such
goals—most notably in the area of school finance        as schools) in relatively low-income areas (e.g.,
(e.g., Feldstein 1976; and Nechyba 1996).               Inman and Rubinfeld 1979).
1128         Journal of Economic Literature Vol. XXXVII (September 1999)

at the expense of poorer ones. Fiscal                  centrally administered, nonbenefit taxes
equalization, from this perspective,                   with a single rate applying to the na-
helps to create a more level playing                   tional tax base will not generate the
field for interjurisdictional competition.17           sorts of locational inefficiencies associ-
   But the case is not entirely persua-                ated with varying rates across decentral-
sive. Others have argued that fiscal                   ized jurisdictions. Moreover, central
equalization can stand in the way of                   taxes can be more progressive, again
needed regional adjustments that pro-                  without establishing fiscal incentives for
mote development in poorer regions.                    relocation. There is, in fact, consider-
McKinnon (1997a), for example, con-                    able evidence to indicate that state and
tends that in the United States, the eco-              local systems of taxes are typically more
nomic resurgence of the South follow-                  regressive than central taxation (e.g.,
ing World War II resulted from                         Howard Chernick 1992). There is thus
relatively low levels of wages and other               some force in an argument for “revenue
costs. It was this attraction of low wages             sharing” under which the central gov-
and costs that ultimately induced eco-                 ernment effectively serves as a tax-col-
nomic movement to the South, bringing                  lecting agent for decentralized levels of
with it a new prosperity. Fiscal equali-               government. 18 The central government
zation, from this perspective, may actu-               then transfers funds, in a presumably
ally hold back the development of                      unconditional form, to provinces, states,
poorer areas by impeding the needed                    and/or localities. It is certainly possible,
interregional flow of resources (both                  where the polity wishes, to build equal-
emigration and immigration) in response                izing elements into these transfers.
to cost differentials.                                 While there is here a real case for the
   But the primary justification for fiscal            use of intergovernmental grants, a most
equalization must be on equity grounds.                important qualification is that such a
And it is as a redistributive issue that it            system of grants must not be too large
continues to occupy a central place on                 in the sense of undermining fiscal disci-
the political stage. In some cases, as in              pline at lower levels of government
Canada, it may provide the glue neces-                 (more on this later).
sary to hold the federation together. In                  The prescriptive theory of intergov-
other instances, like Italy, it may be-                ernmental grants thus leads to a vision
come a divisive force, where regions,                  of a system in which there exists a set of
weary of large and longstanding trans-                 open-ended matching grants, where the
fers of funds to poorer areas, actually                matching rates reflect the extent of
seek a dissolution of the union. Fiscal                benefit spillovers across jurisdictional
equalization is a complex economic and                 boundaries, and a set of unconditional
political issue.                                       grants for revenue sharing and, per-
   The third potential role for intergov-              haps, equalization purposes. Such a
ernmental grants is to sustain a more                  conception has, however, only modest
equitable and efficient overall tax sys-
tem. For reasons we have discussed,                       18 This argument has even more force where, as
                                                       in some developing countries and emerging
                                                       democracies, provincial and local governments
  17 As Boadway and Flatters (1982) have shown,        simply lack the capacity for effective tax admini-
equalizing grants may be required to offset distort-   stration. In this setting, central transfers and/or
ing locational incentives where some jurisdictions     the piggybacking of supplementary rates on top
offer pecuniary fiscal advantages to potential resi-   of centrally administered taxes may be the
dents resulting, for example, from large, taxable      only realistic options. See, for example, Inman
natural resource endowments.                           (forthcoming).
                             Oates: An Essay on Fiscal Federalism                                   1129

explanatory power. We do, in fact, find                ward to show that a lump-sum grant to
federal matching programs that have                    a group of people is fully equivalent in
supported a number of state and local                  all its effects, both allocative and distrib-
activities with spillover effects, includ-             utive, to a set of grants directly to the
ing, for example, grants for interstate                individuals in the group. Moreover, this
highway construction. However, on                      result applies to an important class of
closer examination, important anoma-                   collective-choice procedures, encom-
lies appear. These grants are often                    passing several of the major models em-
closed, rather than open, ended. They                  ployed in the public-finance literature.
thus do not provide incentives for ex-                 These theorems, known as the “veil hy-
pansion at the margin. Moreover, the                   pothesis,” thus imply that a grant to a
federal matching shares are typically                  community is fully equivalent to a cen-
much larger than justifiable by any                    tral tax rebate to the individuals in the
plausible level of spillover benefits.                 community; intergovernmental grants,
More generally, in a careful study of the              according to this view, are simply a
intergovernmental grant system, Inman                  “veil” for a federal tax cut.
(1988) concludes that the economic the-                   The difficulty is that this hypothesis
ory of intergovernmental grants does                   has not fared well in empirical testing.
not provide a very satisfactory explana-               It implies that the budgetary response
tion of the structure of U.S. grant pro-               to an intergovernmental transfer should
grams; he finds that a political model                 be (roughly) the same as the response
can do a much better job of explaining                 to an equal increase in private income
U.S. grant programs. 19                                in the community. But empirical studies
   Some years ago, David Bradford and                  of the response to grants have rejected
I (1971a,b) tried to lay the foundations               this equivalence time and again. Such
for a positive theory of the response to               studies invariably find that state and lo-
intergovernmental grants by setting                    cal government spending is much more
forth a framework in which the budget-                 responsive to increases in intergovern-
ary decisions of the recipients of such                mental receipts than it is to increases in
grants are treated explicitly in a collec-             the community’s private income. And
tive-choice setting. In short, we treated              this has come to be known as the “flypa-
these grants, not as grants to an individ-             per effect”—money sticks where it hits.
ual decision-maker, but rather as grants               While this finding may not be all that
to polities that make budgetary deci-                  surprising, it is not so easy to reconcile
sions by some collective algorithm (such               with models of rational choice, for it
as simple majority rule). This exercise                suggests that the same budget con-
produced some intriguing equivalence                   straint gives rise to different choices de-
theorems. For example, it is straightfor-              pending on what form the increment to
                                                       the budget takes. There is now a large
   19 As Inman and Rubinfeld (1996) point out, the
                                                       literature that tries in a variety of ways
prescriptive theory of grants presumes a central
planner or political process that “will select so-     (some quite ingenious) to explain the
cially preferred policies” (p. 325). However, the      flypaper effect. 20 James Hines and
public-choice literature makes clear the potential     Richard Thaler (1995) have suggested
of central-government political mechanisms to
make inefficient choices concerning policies that      recently that this is just one of a more
affect various groups differently. In addition, a      general class of cases where having
grant-distributing agency may have its own objec-
tives; for an excellent study of how such objectives     20 For surveys and interpretations of this litera-
can influence the pattern of grants, see Chernick      ture, see Gramlich (1977), Ronald Fisher (1982),
(1979).                                                Oates (1994), and Hines and Thaler (1995).
1130      Journal of Economic Literature Vol. XXXVII (September 1999)

money on hand (e.g., from grants) has a      and troublesome issues of measurement
much different effect on spending be-        and interpretation in the Stine study.
havior than where the money must be          Subsequently, using national aggregate
raised (e.g., by taxation).                  data on the state and local government
   Much of the early empirical work on       sector, Shama Gamkhar and I (1996)
the expenditure response to intergov-        were unable to reject the hypothesis
ernmental grants studied the period          that the expenditure response to in-
from the 1950’s through the 1970’s,          creases and decreases in intergovern-
when these grants exhibited a continu-       mental grants has the same absolute
ing path of expansion. As a result, much     value per dollar of grants. Our findings
of the interest focused on the budgetary     are thus consistent with the proposition
response to increases in grants. How-        that the flypaper effect operates sym-
ever, in more recent times, efforts at       metrically in both directions. But much
fiscal retrenchment and devolution have      clearly remains to be done on this issue.
led to large cuts in a wide range of fed-
eral grant programs. And this has raised      4. A Note on Jurisdictional Boundaries
the interesting and important question
of whether the response to cuts in              The treatment to this point has im-
grants is similar in sign and magnitude      plicitly taken as given a pattern of
to the response to increases in these        boundaries that divide the nation-state
grants. Gramlich (1987), for example,        into a set of jurisdictions for decentral-
observed that during this period of re-      ized governance. The existence and
trenchment, state and local govern-          magnitude of spillover effects from lo-
ments responded to the cutbacks in           calized public policies clearly depend
grants by picking up much of the slack:      on the geographical extent of the rele-
they increased their own taxes and re-       vant jurisdiction. One way to deal with
placed in large part the lost grant funds    such spillovers is to increase the size of
so as to maintain levels of existing pro-    the jurisdiction, thereby internalizing
grams. If Gramlich is right, then we         all the benefits and costs. The problem,
should observe a basic asymmetry in re-      of course, is that such an extension may
sponse: the spending of recipients           involve welfare losses from the reduced
should be more responsive to increases       capacity to differentiate local outputs.
in grant monies than to decreases in         There is clearly some kind of tradeoff
these revenues. This issue is of some        here between internalizing spillover
importance if we are to understand the       benefits (and costs) and allowing local
budgetary implications of the ongoing        differentiation.
process of fiscal decentralization. In the      In practice, much of the problem
first study of this issue, William Stine     stems from a set of existing boundaries
(1994), examining the response of            that are largely historically and cultur-
county governments in Pennsylvania,          ally determined and that may make lit-
found just the opposite of Gramlich’s        tle sense in terms of the economic and
prediction: his estimates imply that         geographical realities. Consider, for ex-
these county governments not only            ample, the United States. Suppose that
failed to replace lost grant revenues,       we were to begin with a tabula rasa, a
but that they reduced their spending         completely undefined set of boundaries
from own-revenues on these programs          for states and localities. And we set for
as well, giving rise to a “super-flypaper    ourselves the task of laying out both a
effect.” There are, however, some tricky     rational set of levels of government and
                        Oates: An Essay on Fiscal Federalism                     1131

borders for the jurisdictions at each        pollutants that travel long distances
level of government. One thing seems         across the midwestern and northeastern
clear: such a system of jurisdictions        parts of the United States has led, un-
would bear little resemblance to our ex-     der congressional legislation in 1990, to
isting map. The states, in particular, are   the formation of an Ozone Transport
quite poorly designed to deal with the       Region (OTR) for the coordination of
provision of certain important public        efforts to manage air quality in eleven
goods, notably environmental resources.      eastern states and the District of Co-
To take one example, rivers were used        lumbia. Such regional organizations can
historically (for understandable rea-        be seen as the outcome of a kind of
sons) to mark off one state from an-         Coasian process in which interjurisdic-
other. But from the perspective of ef-       tional externalities are addressed through
fective management of a public good,         negotiation and coordinated decision-
this is the worst sort of border. It means   making. The history of such enterprises,
that two independent and autonomous          however, attests to their difficulty. The
jurisdictions are making decisions that      fascinating study by Bruce Ackerman et
affect the public good whose output          al. (1974), for example, of the attempt
they jointly share. It seems clear that it   to create a “model regional agency” in
would make much more sense to place          the form of the Delaware River Basin
such resources within a single jurisdic-     Commission reveals all the complexities
tion. My own surmise is that a much          and perverse incentives that can bedevil
more rational map would probably en-         such joint enterprises. Nevertheless,
tail (1) some fairly sizeable regional       such coordination does, in principle, of-
governments that extend over water-          fer an important avenue for addressing
sheds, air sheds, and other environ-         such interjurisdictional concerns.
mental resources; (2) metropolitan gov-
ernments that encompass center cities             5. Laboratory Federalism and
and the suburbs that house many city                     Welfare Reform
workers; and (3) smaller local govern-
ments that allow groups of residents to         It seems ironical in the light of the
determine services of relevance mainly       preceding treatment of principles (or
to themselves.                               guidelines) for fiscal federalism to find
   But political realities being what they   that welfare reform is in the vanguard
are, we can expect to continue our col-      of U.S. moves toward fiscal decentrali-
lective life with much the same map in       zation. The analysis suggests that the
place. There does, however, remain           threat of mobility of both low and high
some flexibility in terms of creating use-   income households will result in decen-
ful compacts or associations of jurisdic-    tralized policies that provide too little
tions to deal with particular issues. The    assistance to the poor (sometimes de-
management of the Chesapeake Bay,            scribed as a “race to the bottom”). Nev-
for example, is in important organiza-       ertheless, the decision has been made
tional ways now the joint enterprise of      to shift the primary responsibility for
the relevant states (Delaware, Mary-         poor relief back to the states. Under
land, Pennsylvania, and Virginia), and       measures signed into law in 1996, the
Washington, D.C., with an important role     federal government has replaced the
also played by the federal government.       longstanding federal entitlement pro-
Likewise, the recognition that the man-      grams, which came with both detailed
agement of ground-level ozone involves       rules and generous matching grants to
1132        Journal of Economic Literature Vol. XXXVII (September 1999)

the states, by a system of block grants                . . . It is one of the happy incidents of the
with few strings attached. The states                  federal system that a single courageous State
                                                       may, if its citizens choose, serve as a labora-
now have broad scope to determine                      tory; and try novel social and economic ex-
both the form and levels of assistance                 periments without risk to the rest of the
under their programs to assist poor                    country. (Osborne 1988)
households. 21
                                                      It is my sense that this is the primary
   How are we to understand this re-
                                                      thrust behind the current welfare re-
form? Does it represent an outright re-
                                                      form. There exists much disappointment
jection of the economic principles of
                                                      and dissatisfaction with the operation and
fiscal federalism? My answer is a quali-
                                                      results under the traditional federal wel-
fied no. There exists widespread recog-
                                                      fare programs. But we really don’t have a
nition of, and concern with, the likely
                                                      clear sense of how to restructure them to
shortcomings of a decentralized system
                                                      achieve our societal goals of providing
of poor relief. Policy makers are well
                                                      needed relief and, at the same time, es-
aware of the threat of strategic cuts in
                                                      tablishing an effective set of incentives
state levels of welfare support. But, as I
                                                      to move people off welfare and into jobs.
read it, we have decided to live with
                                                      The recent legislation that transfers the
this threat in order to seek out superior
                                                      responsibility for these programs back to
policy alternatives. And this brings us to
                                                      the states represents, I believe, a recog-
another dimension of fiscal federalism:
                                                      nition of the failure of existing programs
laboratory federalism.
                                                      and an attempt to make use of the states
   In a setting of imperfect information
                                                      as “laboratories” to try to find out what
with learning-by-doing, there are poten-
                                                      sorts of programs can work.22
tial gains from experimentation with a
                                                         There are, in fact, a number of im-
variety of policies for addressing social
                                                      portant and intriguing examples of poli-
and economic problems. And a federal
                                                      cies whose advent was at the state or
system may offer some real opportuni-
                                                      local level and that later became fix-
ties for encouraging such experimenta-
                                                      tures of federal policy. Unemployment
tion and thereby promoting “technical
                                                      insurance, for example, was a state-level
progress” in public policy. This point
                                                      policy before the federal government
was made long ago by James Bryce
                                                      made it effectively mandatory on a na-
(1888) who, in his insightful study of
                                                      tional scale in the 1930s. More recently,
the U.S. system of government, ob-
                                                      in the area of environmental policy, the
served that “Federalism enables a peo-
                                                      experience in a number of states with
ple to try experiments which could not
                                                      their own forms of Emissions Trading
safely be tried in a large centralized
                                                      was an important prelude to the adop-
country” (Vol. I, p. 353). Better known
                                                      tion, in the 1990 Clean Air Act Amend-
is a later statement by Justice Louis
                                                      ments, of a national trading program in
Brandeis, who wrote in 1932 that
                                                      sulfur allowances to address the prob-
    There must be power in the States and the         lem of acid rain. Without this experi-
  Nation to remould, through experimentation,         ence in a number of states, I seriously
  our economic practices and institutions to
  meet changing social and economic needs             doubt that policy-makers would have
                                                      been willing to introduce such a new
  21 For an excellent and recent review of this
                                                      and unfamiliar policy measure as trade-
whole debate in a historical context, see Therese     able emissions rights on a national
McGuire (1997). Rebecca Blank (1997) provides
a concise and insightful treatment of the new           22 For a concurring view, see Craig Volden
welfare legislation and its potential implications.   (1997).
                        Oates: An Essay on Fiscal Federalism                             1133

scale. More generally, since the dawn of      sarily need states as the “laboratories”
the nation, programs successfully devel-      for experiments. At the same time, one
oped at the state level have often pro-       might suspect that relatively indepen-
vided models for subsequent federal           dent efforts in a large number of states
programs.                                     will generate a wider variety of ap-
   States, of course, may learn from oth-     proaches to public policy than a set of
ers so that the diffusion of successful       centrally designed experiments.
policy innovations may be horizontal as          A basic problem here is that there
well as vertical. Both forms of diffusion     has been little in the way of a real the-
have been the subject of study by a           ory of laboratory federalism to organize
number of political scientists. Virginia      our thought and to guide empirical
Gray (1973) and Everett Rogers (1983),        studies. However, the beginnings of
for example, have found that the cumu-        some theory are emerging, and they are
lative distribution of states by date of      quite illuminating. Susan Rose-Acker-
adoption takes the S-curve shape, famil-      man (1980) and, more recently,
iar from the study of the spread of           Strumpf (1997) have taken two quite
other forms of innovation. Others, like       different formal approaches to policy
Jack Walker (1969), James Lutz (1987),        innovation in a federal system. One in-
David Huff et al. (1988), and David           sight emerging from their analyses is an
Nice (1994), have explored the geo-           important, if familiar and unsurprising,
graphical and other determinants of the       one. There exists a basic “information
pattern of adoptions by states. Empiri-       externality” in that states that adopt
cal studies of vertical diffusion are less    new and experimental policies generate
numerous. Thomas Anton (1989), Keith          valuable information for others. And
Boeckelman (1992), and Michael Sparer         this creates a standard sort of incentive
and Lawrence Brown (1996) have exam-          for free-riding. From this perspective,
ined the extent to which federal mea-         we might expect too little experimenta-
sures draw on the experience of the           tion and policy innovation in a highly
states. Some of this literature is rela-      decentralized public sector. Indeed, as
tively skeptical of the link. Sparer and      Strumpf shows, it is unclear whether a
Brown, for example, argue that (at least      centralized or decentralized outcome
for health care) “These laboratory adop-      will result in more policy innovation. 23
tions and adaptations are probably more          The underprovision of experimenta-
the exception than the rule” (p. 196).        tion at state and local levels can be ad-
   What are we to make of all this? A         dressed through a system of subsidies to
little reflection suggests first that there   encourage these activities. And this
is nothing in principle to prevent the        raises another point regarding existing
central government from undertaking           welfare reform in the U.S. Under ear-
limited experiments without commit-           lier programs, federal aid took a match-
ting the nation to an untested and risky      ing form such that the federal govern-
policy measure. Indeed, there have been       ment effectively shared the costs and
a number of such social experiments           risks of new state-level programs. But
with, for example, income-maintenance
and housing-allowance programs that             23 The Rose-Ackerman and Strumpf analyses,
have generated valuable information           incidentally, also produce a number of subtle and
about how programs work and the re-           more surprising results. Strumpf finds, for exam-
                                              ple, that a state with a higher expected return
sponse of participants to various values      from experimentation can have a lower propensity
of the key parameters. We don’t neces-        to experiment.
1134      Journal of Economic Literature Vol. XXXVII (September 1999)

under the new welfare reform mea-            recognized. It manifests itself clearly on
sures, matching aid has been replaced        both sides of the Atlantic. We see it in
by block grants. This in itself serves to    Europe under the nomenclature of the
reduce incentives for experimentation.       “principle of subsidiarity,” where it is
There are some conflicting incentives        explicitly enshrined in the Maastrict
here. On the one hand, the new legis-        Treaty as a fundamental principle for
lation gives the states broader scope for    European union. In the U.S., it often
experimentation, but it places the full      appears more informally as an aversion
cost of any new measures on the state        to the “one size fits all” approach.
with no sharing from the center. The            Somewhat paradoxically, however,
net outcome on the amount of                 this view is the subject of a widespread
experimentation is thus a priori unclear.    and fundamental challenge both at the
   More generally, we need a lot more        theoretical and policy levels. The
work on the implications of fiscal de-       source of this challenge is the claim
centralization for both the amount and       that interjurisdictional competition
kinds of policy experimentation and in-      among decentralized levels of govern-
novation. As I have suggested, there are     ment introduces serious allocative dis-
some clear and important cases where         tortions. In their eagerness to promote
innovation and experimentation at state      economic development with the crea-
and local levels have led to new policy      tion of new jobs (so the argument goes),
measures that have had broad national        state and local officials tend to hold
application. But it is much less clear how   down tax rates and, consequently, out-
we are to understand this experience in      puts of public services so as to reduce
terms of the overall effectiveness of a      the costs for existing and prospective
federal system in policy innovation.         business enterprise. This results in a
                                             “race to the bottom” with suboptimal
   6. Interjurisdictional Competition        outputs of public services.24
     and Environmental Federalism:              This argument has a substantial his-
      A Challenge to the Basic View          tory. Some thirty years ago, for exam-
   The preceding sections have set forth     ple, George Break (1967) made the case
an economic conception of a federal          for the detrimental effects of interjuris-
system. It is one in which the central       dictional competition:
government plays the major role in                The trouble is that state and local govern-
macroeconomic stabilization policies,          ments have been engaged for some time in an
takes the lead in redistributive mea-          increasingly active competition among them-
sures for support for the poor, and pro-       selves for new business . . . In such an envi-
vides a set of national public goods. De-      ronment government officials do not lightly
                                               propose increases in their own tax rates that
centralized levels of government focus         go much beyond those prevailing in nearby
their efforts on providing public goods        states or in any area with similar natural at-
whose consumption is limited primarily         tractions for industry . . . Active tax competi-
to their own constituencies. In this way,      tion, in short, tends to produce either a gen-
they can adapt outputs of such services        erally low level of state-local tax effort or a
                                               state-local tax structure with strong regres-
to the particular tastes, costs, and other     sive elements. (Break 1967, pp. 23–24).
circumstances that characterize their
own jurisdictions.
                                               24 Competition may also take place between dif-
   The general idea of decentralizing
                                             ferent levels of government. On such “vertical
the provision of public services to the      competition” (as well as horizontal competition),
jurisdictions of concern has been widely     see Albert Breton (1998).
                        Oates: An Essay on Fiscal Federalism                                1135

Fear of losing local business and jobs        vided basic support for the centraliza-
thus leads to suboptimal levels of state      tion of environmental management in
and local public goods. Such competition      the United States.
can involve regulatory as well as purely         What I want to stress here is the fun-
fiscal policies. John Cumberland (1979,       damental character of this challenge to
1981) has extended the Break argument         the basic model of fiscal federalism.
to encompass the setting of standards for     The claim is that the decentralized pro-
local environmental quality. In the Break     vision of public services is basically
spirit, Cumberland contends that state        flawed; in the words of one recent
and local governments engage in “de-          U.S. observer, we need centralization
structive interregional competition.” In      in order to “Save the States from
order to attract new business and create      Themselves” (Peter Enrich 1996). 25
jobs, public officials compete by reduc-         But is this claim in fact true? This
ing local environmental standards to          turns out to be a very complicated ques-
lower the costs of pollution control for      tion both in theoretical and empirical
firms that locate within their borders. In    terms. There is now a substantial
this instance, interjurisdictional competi-   theoretical literature that addresses this
tion leads to excessive environmental         issue. In one set of papers, my col-
degradation. The implication of the           league Robert Schwab and I have devel-
Cumberland view is that national stan-        oped a series of models that explore the
dards for environmental quality are           conditions under which horizontal com-
needed to prevent the excessive levels of     petition among governments is effi-
pollution forthcoming under state and         ciency-enhancing (Oates and Schwab
local standard setting.                       1988, 1991, 1996). It turns out that it is
   More recently, Alice Rivlin (1992)         straightforward to develop an analogue
has echoed these views in her “rethink-       to perfect competition in the private
ing of U.S. federalism.” Although advo-       sector. In such a setting, governments
cating an extensive devolution of pub-        compete with one another for a mobile
lic-sector responsibilities to state and      capital stock that both generates in-
local government, Rivlin sees it as al-       come for local residents and provides a
most axiomatic that competition among         tax base for them—and such competi-
the states results in inadequate levels of    tion leads local officials to adopt effi-
public services. Her remedy is a system       cient levels of outputs of public goods
of shared taxes under which the reve-         and tax rates. In these models, the in-
nues from a new national value-added          visible hand works in much the same
tax would be shared among the states.         way as in the private sector to channel
This, she argues, would free the states       policy decisions in individual jurisdic-
so that they would not have “to worry so      tions into an efficient outcome from a
much about losing businesses to neigh-        national perspective.
boring states with lower tax rates”              These models, moreover, are quite
(p. 142).                                     rich in terms of the variety of policy in-
   This line of argument has proved           struments. Public officials provide not
quite powerful in the policy arena.
There are strong forces for the “har-           25 There is, incidentally, a very extensive, inter-
monization” of fiscal and environmental       esting, and lively debate on this matter among le-
measures in Europe that draw heavily          gal scholars. Recent issues of the law journals are
                                              full of papers on interjurisdictional competition
on this proposition. Likewise, the case       and its consequences. See, for example, Richard
for the “race to the bottom” has pro-         Revesz (1992) and Daniel Esty (1996).
1136         Journal of Economic Literature Vol. XXXVII (September 1999)

only outputs for local residents, but                    kind of baseline from which one can in-
public inputs that enhance the produc-                   troduce a range of quite plausible and
tivity of locally employed capital, and                  realistic modifications that can be the
environmental regulations that impose                    source of allocative distortions. A large
costs on local business and improve lo-                  number of papers explore outcomes
cal environmental quality. They finance                  either where jurisdictions are suffi-
these public outputs with a set of taxes                 ciently large to have some influence
on local residents and capital. And                      over the price of capital or where local
there is no race to the bottom here. In-                 governments are restricted in their ac-
stead, jurisdictions find it in their own                cess to policy instruments and must, for
interest to charge benefit taxes that                    example, tax business and household
lead to efficient decisions in both the                  capital at the same rate. Many of these
public and private sectors. 26                           papers employ game-theoretic ap-
   The problem is that these models                      proaches in which there is strategic in-
make some strong assumptions. Let me                     teraction among the jurisdictions
note three of them here: jurisdictions                   (Wildasin 1988). In such settings, we
behave as price-takers in national or in-                find that outcomes can easily occur that
ternational capital markets; public offi-                involve suboptimal levels of public
cials seek in their decisions to maximize                outputs. 27
the welfare of their constituencies; and                    The theoretical literature thus gener-
these officials have access to the                       ates some diverse findings on this issue.
needed fiscal and regulatory policy in-                  There seem to be some basic efficiency-
struments to carry out their programs                    enhancing aspects of interjurisdictional
efficiently. It is not hard to show (or                  competition, but there are clearly a
surprising to find) that violations of any               range of “imperfections” that can be the
of these conditions can lead to distorted                source of allocative distortions. The real
outcomes. Suppose, for example, that                     issue here is the magnitude of these dis-
local policy makers are Niskanen-type                    tortions. Are we dealing with minor de-
agents that seek to maximize, not the                    viations from efficient outcomes—or
well-being of their constituencies, but                  does such competition produce major
rather the size of the local public                      welfare losses? The pure theory can’t
budget. It is then straightforward to                    help us much in answering this ques-
show that they will set excessively lax                  tion. Moreover, some of the terminol-
environmental standards in order to en-                  ogy is not very helpful. In particular,
courage a larger inflow of capital so as                 the description of interjurisdictional
to enlarge the local tax base (Oates and                 competition as involving a “race to the
Schwab 1988).                                            bottom” seems quite misleading. Such
   The Oates-Schwab models provide a                     a descriptive image may well be an
                                                         effective rhetorical device: it conjures
   26 I should emphasize here that all public out-
                                                         up a vision of one jurisdiction cutting
puts (including environmental quality) are entirely      its tax rates and lowering its environ-
local in these models; there are no spillover effects    mental standards, only to be outdone
into other jurisdictions. The analysis, incidentally,    by a neighboring jurisdiction, in a pro-
extends not only to fiscal instruments, but regula-
tory ones as well (such as environmental stan-           cess that leads to a downward spiral to
dards). The analysis of “regulatory federalism”          the “bottom” (suggesting a very bad
is, in principle, analogous to that of fiscal federal-
ism. The same general principles concerning
decentralization apply to fiscal and regulatory            27 See John Wilson (1996) for an excellent
instruments.                                             survey of this literature.
                        Oates: An Essay on Fiscal Federalism                      1137

outcome indeed). However, the models            7. Fiscal Federalism: Expanding the
that generate these results are nothing                Scope of the Analysis
of the sort. They are often game-theo-
                                                 The normative framework for most of
retic models that produce Nash equilib-
                                              the literature in fiscal federalism (and
ria with suboptimal public outputs as
                                              for my treatment in this essay as well)
the outcome. What matters here is the
                                              consists of the traditional principles of
extent of the suboptimality. And the
                                              welfare economics. From this perspec-
race-to-the-bottom terminology tends
                                              tive, institutions are evaluated in terms
to obscure this issue.
                                              of their impact on efficiency in resource
   Unfortunately, we do not have many
                                              allocation and the distribution of in-
empirical studies to bring to bear on
                                              come. However, the choice of a system
this matter. There is a substantial de-
                                              of governance involves other values as
scriptive literature addressing economic
                                              well: the extent of political participa-
competition among state and local gov-
                                              tion, the protection of individual rights,
ernments in the U.S., with some inter-
                                              and the development of various civic
esting findings (Timothy Bartik 1991).
                                              virtues. Political theorists throughout
But this body of work really does not
                                              the ages have explored the ways in
shed much light on the normative ques-
                                              which different political systems ad-
tion of whether such competition is ef-
                                              dress these various objectives of the
ficiency-enhancing or not (Paul Courant
                                              polity. In addition, the vertical struc-
1994). In an interesting study that is of
                                              ture of government may have important
relevance, Anne Case, James Hines, and
                                              implications for the way in which the
Harvey Rosen (1993) find evidence of
                                              public sector functions and its impact
strategic interaction in state-level fiscal
                                              on the operation of a system of markets.
policies. Using a similar methodology,
                                              In this section, I want to explore some
Jan Brueckner (1998) finds empirical
                                              of the new (and older) literature that
support for policy interdependence in
                                              addresses some broader implications of
the adoption of growth-control mea-
                                              fiscal federalism.
sures by local governments in Califor-
nia. But at this juncture, I think it is      7.1 Economic and Political Objectives
fair to say that the jury is still out on       in a Federal System
this matter. The welfare implications of
interjurisdictional competition remain           The first issue involves extending the
the subject of a lively ongoing debate        conceptual horizon to encompass addi-
with a real need for further empirical        tional political objectives. What might
work to supplement the large theo-            this add to our more narrowly focused
retical literature. In my own view, the       economic view of fiscal federalism? In-
existing work is not sufficient to make a     man and Rubinfeld, in one strand of
compelling case for the abandonment of        their important new work on fiscal fed-
(or basic amendment to) the principle         eralism, have (and are) exploring this
of fiscal decentralization. The case re-      issue in an attempt to redefine and
mains strong, it seems to me, for leav-       extend the analytical framework to en-
ing “local matters in local hands.”           compass some of these additional politi-
Moreover, as we shall see shortly, there      cal and constitutional dimensions of
is another literature that takes a very       public-sector structure.
different (and unambiguously positive)           The approach of Inman and Rubinfeld
view of the role of interjurisdictional       (1997a,b,c) incorporates explicitly cer-
competition.                                  tain political goals into a more extended
1138       Journal of Economic Literature Vol. XXXVII (September 1999)

objective function. In such a setting, we      teresting that the Court has seen fit to
find ourselves examining tradeoffs be-         set aside, in certain instances, the pre-
tween such goals as economic efficiency        sumed economic consequences of cer-
and political participation. In one such       tain state regulations in favor of decen-
illustration, they present a “federalism       tralized political choices, so long as they
frontier” in which (over the relevant          “were decided by an open, participatory
range) increased political participation       political process, as evidenced by state
comes at the expense of economic               legislative involvement” (1997a, p. 1252).
efficiency (1997a, p. 1230).                      It seems unlikely that we can ever
   The basic presumption here is that          hope to quantify such tradeoffs in a for-
more decentralized political systems are       mally satisfying way. But the Inman-Ru-
conducive to increased citizen impact          binfeld work does suggest that careful
on political outcomes and political par-       analysis can certainly help to clarify the
ticipation. The evidence on this issue,        nature of the tradeoffs involved in the
in truth, is somewhat mixed, but overall       vertical design of the political system
it suggests on balance “that both citizen      and allow economics to play a broader
influence and effort increase as the           role in the debate. It is interesting,
size of government declines” (1997a,           moreover, that the political objectives
p. 1215). The basic political objectives       seem, on the whole, to strengthen the
thus strengthen the case for increased         case for fiscal decentralization.
decentralization; they point to a system
that is more decentralized than one            7.2 Public-Sector Institutions:
chosen simply on the grounds of an               Market-Preserving Federalism
exercise in economic optimization.                An alternative approach to federalism,
   While this is suggestive at a general       related to the “new institutional econom-
level, it raises the more difficult ques-      ics,” sees political decentralization in
tion of how one addresses these trade-         terms of its capacity to sustain a pro-
offs in the actual design of fiscal institu-   ductive and growing market economy.
tions. How, for example, can we define         From this perspective, Barry Weingast
and measure in a meaningful way the            (1995), Ronald McKinnon (1997a), and
marginal rate of substitution between          their colleagues have explored the insti-
economic efficiency and political par-         tutional structure of a system that prom-
ticipation and incorporate this into the       ises to provide a stable framework for a
design of a political system? To ap-           market system (see also McKinnon and
proach this question in a substantive          Nechyba 1997 and Qian and Weingast
way requires the study of more specific        1997). Weingast’s point of departure is
issues. And here Inman and Rubinfeld           a “fundamental political dilemma of an
(1997a) provide a provocative beginning        economic system,” namely that “a gov-
with a careful study of “anti-trust state-     ernment strong enough to protect prop-
action doctrine.” This involves an intrigu-    erty rights and enforce contracts is also
ing series of Supreme Court decisions          strong enough to confiscate the wealth
in which state programs, that—had they         of its citizens” (1995, p. 1). 28
been designed and introduced by pro-              The attraction of federalism for
ducers themselves, would have consti-          Weingast is its potential for providing a
tuted a violation of anti-trust laws—were
                                                 28 However, as Martin McGuire and Mancur Ol-
upheld on the basis of state legislative
                                               son (1996) have shown, even a self-aggrandizing
sovereignty. Although the history of this      autocrat (if secure) has powerful incentives for
doctrine is a complicated one, it is in-       supporting an economically efficient system.
                        Oates: An Essay on Fiscal Federalism                               1139

political system that can support an effi-    capital projects over their useful life.
cient system of markets. In a provoca-        But they have no recourse to public
tive treatment, Weingast lays out a set       sources for funding this debt; they op-
of three conditions for a federal system      erate in private credit markets just like
that characterize what he calls “market-      private borrowers. These markets them-
preserving federalism.” These condi-          selves, through the determination of
tions require that (1) decentralized gov-     credit ratings and other forms of moni-
ernments have the primary regulatory          toring fiscal performance, create an en-
responsibility over the economy; (2) the      vironment in which the fiscal authori-
system constitutes a common market in         ties must behave in responsible ways. 29
which there are no barriers to trade;         These markets, by creating a hard
and (3) decentralized governments face        budget constraint in terms of debt fi-
“hard budget constraints.” By this last       nance, have imposed a very useful disci-
condition, Weingast means that lower-         pline on decentralized fiscal behavior. 30
level governments have neither the ca-           More generally, a hard budget con-
pacity to create money nor access to un-      straint implies that decentralized gov-
limited credit. And it implies further that   ernments must place a basic reliance on
the central government does not stand         their own sources of revenues. They
ready to bail them out in instances of        must not be overly dependent on trans-
fiscal distress.                              fers from above. I discussed in an ear-
   Weingast goes on to argue in histori-      lier section the potential role for inter-
cal terms that eighteenth century En-         governmental grants, but Weingast and
gland and the United States in the nine-      McKinnon (as well as others) remind us
teenth century were effectively such          of the important discipline that stems
systems of market-preserving federal-         from self-financing. It is especially im-
ism, and that this fostered in important      portant that intergovernmental grants
and fundamental ways the process of           not be expansible in the sense that re-
economic growth. It proved critical, ar-      cipients can turn to the grant system to
gues Weingast, to the industrial revolu-      bail them out of fiscal difficulties
tion in England and supported a system        (Wildasin 1998b). In particular, public
of “thriving markets” in the United States    authorities need to fund their own
throughout the nineteenth century.            expenditures at the margin. 31
   McKinnon (1997a) has explored in              The institutional perspective reminds
more detail the importance of Wein-           us that there is more to the design of a
gast’s last condition of a hard budget
constraint. Crucial to this view is the          29 James Poterba and Kim Rueben (1997), for

separation of monetary and fiscal pow-        example, have found that those states with tighter
                                              anti-deficit rules, and more restrictive limitations
ers. In a federal system, if the central      on the authority of the state legislature to issue
government controls the common cur-           debt, pay lower rates of interest on their bonds.
                                                 30 McKinnon (1997b) has gone on to argue that
rency, then lower-level governments
                                              much of the impetus for European Monetary
will be limited to fiscal instruments and     Union has as its source a collectively imposed
will not have access to the “soft” option     budgetary retrenchment. His interesting argument
of monetized debt. As McKinnon points         is that European decision makers, realizing that
                                              they cannot achieve fiscal stability with continued
out, state and local governments in the       access to monetary powers, are seeking through
United States engage in extensive debt        EMU to create the hard budget constraints that are
finance for capital projects. This makes      the prerequisite for responsible fiscal management.
                                                 31 This is subject to the qualification that
good economic sense in terms of               matching grants may be needed to internalize
spreading the payments for long-lived         interjurisdictional spillover benefits.
1140        Journal of Economic Literature Vol. XXXVII (September 1999)

federal fiscal system than just the allo-             The Brennan-Buchanan view suggests
cation of functions to the appropriate             the hypothesis that the overall size of
levels of government. In addition, we              the public sector “should be smaller, ce-
need sets of formal and informal institu-          teris paribus, the greater the extent to
tions that embody the rights sorts of in-          which taxes and expenditures are de-
centives for public decision makers (Ol-           centralized” (1980, p. 185). The evi-
son 1990). These rules or procedures               dence on this hypothesis is, however, at
must make the costs of public programs             best mixed. For example, I was unable
as fully visible as their benefits in ways         to find any systematic relationship be-
that make public officials accountable             tween public-sector size and the extent
for their decisions (Shah 1998).                   of fiscal decentralization (Oates 1985).
   The treatment of fiscal structure in            However, some later and more disag-
this section is not unrelated to Geoffrey          gregated studies have found some ten-
Brennan and James Buchanan’s (1980)                dencies of this kind (See Oates 1989 for
view of fiscal decentralization as a               a survey of this work.).
mechanism for controlling the size of                 More generally, there is not much
the public sector. Drawing by analogy              evidence on the relationship between
on the conventional theory of monopoly             fiscal decentralization and economic
in the private sector, they envision the           performance. But there is some. Jeff
government sector as a monolithic                  Huther and Anwar Shah (1996) at the
agent, a “Leviathan,” that seeks its own           World Bank have assembled a large and
aggrandizement through maximizing                  diverse set of indices for eighty nations.
the extraction of tax revenues from the            These indices encompass a wide variety
economy. From this perspective, the                of measures of economic and political
design of the constitution and associ-             structure and performance: quality of
ated institutions has as a major objec-            governance, political freedom, political
tive the placing of a set of constraints           stability, debt-to-GNP ratios, measures
that limits Leviathan’s access to tax and          of income, the degree of equality in the
other fiscal instruments. Fiscal decen-            distribution of income, and many more.
tralization can, in their view, play a             In examining the statistical associations
most important role in constraining                among these various indices, they find
public sector growth. Competition among            in nearly every case a statistically sig-
decentralized governments for mobile               nificant and positive correlation be-
economic units greatly limits the capac-           tween increased decentralization and
ity of Leviathan to channel resources              improved performance (either in politi-
into the public sector. As Brennan and             cal or economic terms). There are obvi-
Buchanan put it, competition among                 ous and important qualifications here.
governments in the context of the “in-             Such associations do not prove causa-
terjurisdictional mobility of persons in           tion. In particular, the degree of fiscal
pursuit of ‘fiscal gains’ can offer partial        decentralization is itself the outcome of
or possibly complete substitutes for ex-           a complex of political and economic
plicit fiscal constraints on the taxing            forces. Nonetheless, the initial results
power” (1980, p. 184).32                           are suggestive and invite further ex-
                                                   ploration. Elsewhere, Sang-Loh Kim
   32 In a more formal treatment of this matter,   (1995) in an intriguing econometric
Dennis Epple and Allan Zelenitz (1981) have        study making use of an international
shown that while competition among jurisdictions
can constrain government rent-seeking behavior,    panel data set, has estimated a Barro-
it cannot altogether eliminate it.                 type growth model. In addition to the
                        Oates: An Essay on Fiscal Federalism                       1141

usual explanatory variables, he included     that has no doubt occurred to the
a measure of fiscal decentralization         reader. In the earlier section on inter-
that, in most of his estimated equations,    jurisdictional competition, the central
has a significant and positive partial as-   concern was that such competition
sociation with the rate of economic          leads to too little in the way of public
growth. Kim’s findings thus support          outputs. There it was argued that com-
Shah’s contention that fiscal decentrali-    petition for new firms and jobs may lead
zation enhances economic perfor-             to public budgets that are too small,
mance—in this case, more rapid eco-          and to overly lax environmental stan-
nomic growth. In contrast, Heng-fu Zou       dards. In contrast, the thrust of this sec-
and his colleagues have found a nega-        tion has been on the beneficial effects
tive relationship between economic           of competition as a disciplining force
growth and fiscal decentralization in        that restrains the tendencies in the pub-
two studies, one examining a sample of       lic sector towards excessive spending
forty-six countries over the period          and other forms of fiscal misbehavior.
1970–89 (Davoodi and Zou 1998) and           One’s view of the role of intergovern-
the other a study of the growth of prov-     mental competition clearly depends
inces in China (Zhang and Zou 1998).         on how one views the operation of the
Much obviously remains to be done at         public sector more generally!
the empirical level in order to give us
a better sense of the relationship of fis-        8. Fiscal Decentralization and
cal decentralization to economic and                 Economic Development
political performance.
   There is also much more to do at the         When examining international cross-
conceptual level. While Weingast’s in-       sectional data on intergovernmental
itial forays into market-preserving fed-     structure, one is immediately struck by
eralism are certainly provocative, they      the sharp contrast in the extent of fiscal
raise at least as many questions as they     decentralization in the industrialized
answer. It is fair, I think, to charac-      and developing countries. In a study of
terize the analysis as fairly “loose” at     my own involving a group of forty-three
this stage. For example, are Weingast’s      countries (Oates 1985), the sample sta-
conditions for market-preserving feder-      tistics revealed an average share of cen-
alism to be regarded as necessary or         tral-government spending in total pub-
sufficient (or both) for an effective po-    lic expenditure of 65 percent in the
litical foundation for a private market      subsample of eighteen industrialized
economy? Jonathan Rodden and Susan           countries, as contrasted to 89 percent in
Rose-Ackerman (1997) have raised a           the subsample of twenty-five develop-
number of probing questions concern-         ing nations. In terms of total public
ing the Weingast analysis. There is          revenues, the central-government share
clearly much to chew on here. The next       for this same subsample of developing
step, it seems to me, is to attempt to       countries was over 90 percent!
formalize these relationships more ex-          Although there are real concerns with
plicitly so as to get a better sense of      the accuracy of some of these fiscal data
how different political and budgetary        (Richard Bird 1986), the general pre-
institutions influence the functioning of    sumption that the developing countries
a market system.                             are characterized by relatively high de-
   Finally, it is impossible to leave this   grees of fiscal centralization seems
section without noting an obvious irony      firmly grounded. And this, moreover, is
1142      Journal of Economic Literature Vol. XXXVII (September 1999)

not something new. Writing over forty         prove to be very helpful. If we look at
years ago, Alison Martin and W. Arthur        the United States, for example, we find
Lewis (1956) noted that “the weakness         that in the late nineteenth century the
of local government in relation to cen-       public sector was both very small and
tral government is one of the most strik-     highly decentralized. At the turn of the
ing phenomena of under-developed              century, the public sector accounted for
countries” (p. 231).                          only about 8 percent of GNP in the
   What are we to make of this? Some          U.S., while the central-government
observers attribute the poor economic         share of total public expenditure was
performance of many of the developing         around 30–35 percent. By 1955, the
countries in large measure to the failure     central-government share of public
of central planning and make a strong         spending had roughly doubled from
case for the devolution of fiscal respon-     one-third to two-thirds. 33 The fiscal
sibilities. But the issue is clearly more     records of other industrialized nations
complicated than this. In particular, the     like Great Britain reveal roughly similar
question arises as to whether fiscal de-      patterns.
centralization is a cause or a result of         The point is that the trend over this
economic development. Roy Bahl and            period of economic growth was not one
Johannes Linn (1992), for example, ar-        of increasing fiscal decentralization; it
gue that as economies grow and mature,        was just the reverse! It is worth noting,
economic gains from fiscal decentraliza-      however, that these centralizing tenden-
tion emerge. As they put it, “Decen-          cies seem to have played out around the
tralization more likely comes with the        middle of the century. For most of the
achievement of a higher stage of eco-         industrialized countries, fiscal centrali-
nomic development” (p. 391); the              zation ratios appear to have peaked in
“threshold level of economic develop-         the decade of the 1950’s, and since that
ment” at which fiscal decentralization        time, they have actually declined
becomes attractive “appears to be quite       slightly in most cases (Oates 1978;
high” (p. 393). From this perspective, it     Werner Pommerehne 1977). What typi-
is economic development that comes            cally seems to be taking place is a com-
first; fiscal decentralization then fol-      plicated process of intergovernmental
lows. But not all would agree. More           evolution. We see efforts at devolution
generally, it seems to me, we must re-        in a number of OECD countries accom-
gard intergovernmental structure as           panied, at the same time, by the emer-
part of a larger political and economic       gence of a new top layer of government
system that both influences and is de-        in the European Community.
termined by the interplay of a variety of        But all this may not have much rele-
political and economic forces. It may         vance for the developing nations. This
well be that fiscal decentralization itself   is because they have a very different
has a real contribution to make to im-        starting point for the growth process. As
proved economic and political perfor-         Diana Conyers (1990) stresses, “Most
mance at different stages of development.     less developed countries inherited rela-
   To gain further insight into this issue,   tively centralized systems of govern-
we might turn to the historical experi-       ments from their colonial powers, and
ence of the industrialized countries and      in the first years of independence there
examine the course of fiscal decentrali-        33 See John Wallis and Oates (1997) for a de-
zation through extended periods of eco-       scription and analysis of the evolution of American
nomic growth. This, in fact, does not         federalism in the twentieth century.
                        Oates: An Essay on Fiscal Federalism                              1143

was often a tendency to maintain—if          improved growth performance depends.34
not strengthen—central control and              The prescriptive literature on fiscal
centralized systems of planning, in or-      structure for the developing countries
der to encourage a sense of national unity   harks back directly to several of the
and reinforce the new government and         points made in the preceding sections.
its policies” (p. 16). Thus, many of these   In particular, there is a heavy emphasis
countries entered upon nationhood with       on reliance on own finance in order to
highly centralized government sectors;       create hard budget constraints. This can
they have not undergone anything like        have special relevance in the develop-
the process of public-sector evolution ex-   ing-country context, where decentral-
perienced in the industrialized countries.   ized governments often have very lim-
   The implication of all this is that the   ited access to their own major sources
potential of fiscal decentralization for     of tax and other revenues and are heav-
improving economic and political per-        ily dependent on transfers from above.
formance must be evaluated in terms of       In some instances, provincial or state
the specific circumstances that charac-      governments may even have access to
terize the current state of a developing     the public banking system to absorb
nation. There remains, in my view and        their debt issues. This predictably leads
that of some others (Shah 1994), a           to large budgetary deficits and both
strong case on traditional grounds for a     fiscal and monetary instability.
significant degree of decentralization in       This literature makes reference to
public-sector decision-making in the         the problem of “vertical imbalance,”
developing nations. This case, as we         meaning a disparity between different
have discussed, rests both on the poten-     levels of government in their expendi-
tial economic gains from adapting levels     ture commitments and their access to
of public outputs to specific regional or    revenues. Although the concept suffers
local conditions and on the political ap-    from certain ambiguities, it does focus
peal of increased participation in gover-    attention on the important issue of the
nance. The economic case has been            widespread inadequacy of revenue
made formally in purely static terms (as     sources at decentralized levels of gov-
noted earlier in the treatment of the        ernment. The often heavy reliance of
Decentralization Theorem), but it may        provincial, state, and local governments
well have some validity in a dynamic         on transfers from above undercuts in-
setting of economic growth. Develop-         centives for responsible fiscal decision-
ment policies that are sensitive to par-     making; fiscal decisions become out-
ticular regional or local needs for infra-   comes of politically driven negotiations
structure and even human capital are         between central and “local” authorities,
likely to be more effective in promoting     not the result of weighing benefits and
economic growth than are centrally de-       costs of prospective public programs.
termined policies that largely ignore           The case for establishing adequate
these geographical differences. There
exists, incidentally, no formal theory of       34 Some observers, like Remy Prud’homme

fiscal decentralization and economic         (1997), argue that the case for fiscal decentraliza-
                                             tion has been much exaggerated. Prud’homme
growth; it might be useful to set out        claims that many of the premises of the fiscal fed-
such a theory, for a framework that in-      eralism vision are typically not satisfied in the
corporates jurisdiction-specific invest-     developing-country setting; decentralized govern-
                                             ment bodies, he argues, are frequently unrespon-
ment programs might provide some in-         sive to the needs of their constituencies and
sights into the parameters on which          manifest widespread corruption.
1144      Journal of Economic Literature Vol. XXXVII (September 1999)

and effective tax systems at decentral-       through all these dimensions of fiscal
ized levels of government is one of the       reform is the crucial attention to fiscal
critical issues of fiscal federalism in the   decision-making institutions and proce-
developing world. And it is a truly chal-     dures themselves to introduce mecha-
lenging problem (Bahl and Linn 1992;          nisms that provide incentives for public
Bird 1992). The earlier section dealing       officials to act in the public interest; this
with the tax-assignment problem set           means largely, as Shah (1998) stresses,
forth some of the properties of “good”        establishing channels for account-
taxes at decentralized levels of govern-      ability. 35 In the interim, provincial and
ment. But provincial and local govern-        local governments cannot be left to fend
ments in developing countries often           entirely for themselves; depending on the
face serious obstacles to the use of          specific circumstances, there will often
these tax bases. The scope, for example,      be a need for significant transfers from
for using local property taxes is circum-     the center, especially to impoverished
scribed in many instances by the ab-          jurisdictions. But the general direction
sence of the requisite institutions for       of needed reform seems clear.
tax administration. As Bahl and Linn             The ongoing efforts to decentralize
(1992) point out, there is typically more     the public sectors of former socialist
potential for such taxes in urban than in     states encounter much the same set of
rural areas in most developing coun-          issues. But the problems are in some
tries. The obstacles are real, but there      ways even more complicated, inasmuch
are ongoing and extensive efforts to          as the process of decentralization is go-
build up the administrative capacity for      ing on alongside a process of privatiza-
more effective revenue systems.               tion; the complicated and sometimes
   Fiscal reform efforts in the develop-      chaotic transition from a command
ing world thus must focus on (1) Re-          economy to a market system does not
structuring systems of intergovernmen-        provide a stable environment within
tal grants, in some instances to reduce       which to restructure the public sector.
the extent of financing that they pro-        Nevertheless, a comprehensive process
vide to decentralized levels of govern-       of fiscal decentralization is underway in
ment, and, more generally, to remove          much of Central and Eastern Europe,
the perverse incentives that they often       and it involves the same issues of defin-
embody for fiscal behavior on the part        ing the fiscal responsibilities of the dif-
of recipients; (2) Redesigning revenue        ferent levels of government and intro-
systems so as to provide decentralized        ducing the fiscal instruments and
levels of government a much expanded          procedures needed both to support
access to own-revenues to finance their       emerging private markets and to deliver
budgets and thereby reduce their de-          needed public services (Bird, Ebel, and
pendence on transfers from above; and         Wallich 1995).
(3) Reviewing the use and restrictions
on debt finance to ensure that debt is-           9. Some Concluding Observations
sues are not a ready way to finance defi-
                                                The evolution of the vertical struc-
cits on the current account. All three of
                                              ture of the public sector continues in
these avenues of reform contribute in
important ways to the establishment of          35 See Govinda Rao (1998) for an illuminating

a hard budget constraint, but one that        treatment in the Indian context of the wide range
                                              of mechanisms (or “subterranean transfers” as he
permits decentralized levels of govern-       calls them) through which central government
ment to do their job. Finally, running        subsidizes the states.
                        Oates: An Essay on Fiscal Federalism                           1145

interesting and novel ways. As I noted       sector. Recent decades have seen the
earlier, the first half of the twentieth     creation of special districts to provide
century was characterized by a strong        particular public services and the for-
trend toward increased fiscal centraliza-    mation of metropolitan area govern-
tion. Indeed, some acute political ob-       ments to bring center cities and their
servers in the nineteenth century fore-      suburbs into a single jurisdiction (again
cast this trend. Tocqueville, writing in     for purposes of addressing specific
the first half of the nineteenth century,    needs such as transportation and hous-
predicted that “in the democratic ages       ing). It is especially striking to witness
which are opening upon us . . . cen-         in the European Community the moves
tralization will be the natural govern-      toward devolution in many member
ment” (1945, Vol. II, p. 313). And           countries, while, at the same time, the
nearer the end of the century, Lord          Community develops a set of supra-
Bryce reiterated this forecast (at least     national institutions for governance and
for the U.S.). After reviewing both the      economic management. Other coun-
“centrifugal” and “centripetal” forces at    tries, like South Africa and the former
work in American government, Bryce           socialist states, are struggling with their
concluded that while the centrifugal         own sets of pressing issues in their at-
forces were “likely, as far as we can see,   tempts to find effective mechanisms for
to prove transitory . . . the centripetal    political and fiscal decentralization.
forces are permanent and secular                While the existing literature in fiscal
forces, working from age to age” (1901,      federalism can provide some general
Vol. II, p. 844). Bryce then proceeded       guidance on these issues, my sense is
to forecast that “ . . . the importance of   that most of us working in the field feel
the States will decline as the majesty       more than a little uneasy when proffer-
and authority of the National govern-        ing advice on many of the decisions that
ment increase” (1901, Vol. II, p. 844).      must be made on vertical fiscal and po-
Later, Edward McWhinney (1965) went          litical structure. We have much to
on to generalize all this to what he         learn!
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