Autonomy in Subnational Income Taxes: Evolving Powers, Existing Practices in Seven Countries 9780773588097

Table of contents :
Cover
Title
Copyright
Contents
Subnational Tax Autonomy: Introduction and Summary of Evidence
1 Asymmetrical Federalism in Spain: The Challenges of Financing the Autonomous Communities
2 Fiscal Autonomy in Scotland
3 Asymmetrical Federalism: The Case of Belgium
4 The Deadlock of Federalism in Germany: Assessing Recent Reforms
5 Setting Personal Income Tax Rates: Evidence from Canada and Comparison with the United States of America, 2000–2010
6 Cantonal Tax Autonomy in Switzerland: History, Trends, and Challenges
Contributors

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Autonomy in Subnational Income Taxes

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Autonom y in Subnational Income Taxes Evolving Powers, Existing Practices in Seven Countries Edited by Violeta Ruiz Almendral and François Vaillancourt

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by McGill-Queen’s University Press Montreal & Kingston • London • Ithaca

© McGill-Queen’s University Press 2013 ISBN 978-0-7735-3879-5 (cloth) ISBN 978-0-7735-3880-1 (paper) Legal deposit second quarter 2013 Bibliothèque nationale du Québec Printed in Canada on acid-free paper that is 100% ancient forest free (100% post-consumer recycled), processed chlorine free McGill-Queen’s University Press acknowledges the support of the Canada Council for the Arts for our publishing program. We also acknowledge the financial support of the Government of Canada through the Canada Book Fund for our publishing activities.

Library and Archives Canada Cataloguing in Publication   Autonomy in subnational income taxes : evolving powers, existing practices in seven countries / edited by Violeta Ruiz Almendral and François Vaillancourt. Includes bibliographical references and index. ISBN 978-0-7735-3879-5 (bound). – ISBN 978-0-7735-3880-1 (pbk.)   1. Income tax. 2. Intergovernmental tax relations. 3. Intergovernmental fiscal relations. 4. Fiscal policy. I. Ruiz Almendral, Violeta II. Vaillancourt, François HJ4629.A98 2013  336.24  C2012-906667-2 Typeset by Jay Tee Graphics Ltd. in 10/13 Baskerville

Contents

Subnational Tax Autonomy: Introduction and Summary of Evidence 3 Violeta Rui z Almend ral and F ran ço is Vaillan co u rt 1 Asymmetrical Federalism in Spain: The Challenges of Financing the Autonomous Communities  13 Violeta Rui z Almend ral 2 Fiscal Autonomy in Scotland  44 Charli e J effery 3 Asymmetrical Federalism: The Case of Belgium  61 Magali Verd o n ck 4 The Deadlock of Federalism in Germany: Assessing Recent Reforms 80 Cha rles E. Blankart an d Erik R. Fasten 5 Setting Personal Income Tax Rates: Evidence from Canada and Comparison with the United States of America, 2000–2010 100 Françoi s Vai llanco u rt an d David G u imond 6 Cantonal Tax Autonomy in Switzerland: History, Trends, and Challenges 121 Fabri zi o Gi lardi, Dan iel Kü bler, an d Fabio Wasserfallen Contributors 141

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Autonomy in Subnational Income Taxes

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Subnational Tax Autonomy: Introduction and Summary of Evidence Violeta Ruiz Almendral and François Vaillancourt Most specialists in intergovernmental financial relations hold that subnational tax autonomy is the cornerstone of a viable system of fiscal federalism. Such autonomy, they argue, creates a (partial) relationship between what is spent in a jurisdiction and who pays for it. The principle they apply holds that, at least at the margin, spending by a constituent unit in a federal or quasi-federal country – whether asymmetric or not – should be paid for by revenues that are under the control of that unit. And control means that constituent political leaders have the power to vary what they collect upward or downward to match the preferences of their population in terms of public spending. If we focus on personal income taxation as an example of a subnational revenue source, a constituent unit could increase the revenue it derives from it by increasing the rates, broadening the tax base, or increasing collection efforts. Economists recommend that the tax base be the same across all constituent units in a country to minimize administrative and compliance costs as well as tax avoidance activities. Tax collection efforts are often not under the control of constituent units. If tax collection is under their control, increasing its intensity is a roundabout way of varying effective tax burdens for various taxpayers. It is not a clear statement by the political leadership of a ­constituent

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unit of the cost of providing additional public goods. Thus, subnational tax autonomy entails, for the most part, the power to set tax rates (in this case, on personal income). The sharing of the income tax field between the central and constituent units in federal and quasi-federal countries is of three broad kinds: 1 Full tax powers. Both levels of governments have the power to access a given tax field; they can define the base, set the rates, and collect the taxes themselves. In practice, they may choose to use the tax base already set by another level (usually the central one) and to have the tax collected on their behalf. But they must set their rate; otherwise it defaults to zero. There must be an explicit tax decision by constituent unit governments. 2 Optional tax powers. Both levels of governments have the power to access a given tax field; however, the subnational governments must use the tax base of the central government which collects the tax. If they do nothing, the central government rate is the default rate for their share of any shared tax. There is no need for an explicit tax decision by constituent unit governments. 3 No tax powers. One level of government sets the base and the rates and collects the tax. It is then shared between the two levels of government according to a formula that may or may not give some weight to where the tax was collected. In this case, there is no possibility of explicit tax decisions by constituent unit governments. The purpose of this book is to make available to readers interested in fiscal federalism, and in particular subnational taxation, the papers presented at a February 2010 conference in Madrid with subsequent updates for Belgium, Scotland, and Spain. The departure points of the conference were twofold: 1 There are important differences between constituent units of federal or quasi-federal states in oecd countries with respect



Introduction and Summary of Evidence 5

to both the taxation powers they hold and the use they make of such powers, if any. 2 A series of changes, proposed changes, or rejection of changes in relevant institutional arrangements in four such countries – Belgium, Germany, Spain, and the United Kingdom – has occurred over the last five years. It thus seemed of particular interest to examine two issues. First, why were changes giving more tax rate setting powers implemented (in Spain), agreed to (in the United Kingdom and Belgium), or set aside (in Germany)? Second, how are such powers used in federations where constituent units already possess them, namely, in Canada, Switzerland, and the United States? Examining how these powers are used will give us some inkling as to where the changes adopted or under consideration might lead. We thus cover the three types of arrangements described above: 1 Canada, Switzerland, and the United States belong to the first group, with their constituent units having always had to set a personal income tax rate to obtain revenue from it. 2 Belgium, Scotland, and Spain belong to the second group, with the central rate as the default rate until recently, but with changes now being implemented or having been agreed to. 3 Germany belongs to the third group, with a tax sharing formula and no changes currently being considered. The book comprises six papers organized according to the two issues raised above. The first group begins with a paper on Spain by Violeta Ruiz Almendral. This reflects the fact that Spain has actually made a key change that requires an important subset of its constituent units (which are called autonomous communities or acs) to set tax rates in 2011 and, in particular, to set their personal income tax rate. We then have a paper by Charlie Jeffrey on the case of the United Kingdom, and more specifically Scotland, where a proposal by a commission of

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inquiry endorsed by the Labour government in the fall of 2009 and by the ­Conservative/Liberal Democrat government elected in the spring of 2010,1 and soon to be enacted into law, would require Scotland to set a personal income tax rate. Then we turn to two papers, one by Magali Verdonck on Belgium that examines why Belgian regions had made little gain in obtaining autonomy with respect to the major taxes until October 2011 when a new political agreement gave them some autonomy (about 25 per cent of the pit tax base with the requirement to set a tax rate [tax on tax] and some limited freedom in doing so), and the other by Charles Blankart and Erik Fasten, who present the reasons why the Länder were not granted tax autonomy in the last reform of the German federal model. The second group of papers begins with a discussion by ­François Vaillancourt and David Guimond of the use of personal income tax autonomy by Canadian provinces and American states. Then this question is examined for Switzerland, in a paper by Fabrizio Gilardi, Daniel Kubler, and Fabio Wasserfallen. The first paper, by Violeta Ruiz Almendral presents, in brief, the legal framework that sets the tax powers of Spanish acs. It then traces the evolution of the tax powers of the typical constituent unit in Spain: the fifteen common-system acs. One table shows that these powers have increased both in terms of what the acs can do and in terms of the importance of revenues they obtain. The paper then reminds us of a key point, which is that from a tax perspective there are two kinds of constituent units in Spain: the fifteen common acs and the two foral communities which are still much more powerful, in terms of taxation powers. Thus, one interesting interpretation of the 2010 reform that gives more powers to common acs is that it could be one more step in the convergence of tax powers of common acs with those of the highly autonomous foral acs. Hence, while more powers may lead to more differences in the tax outcomes among the common acs, more powers also create a greater measure of legal similarity between the two classes of acs. The second paper, by Charlie Jeffery, begins by reminding us that while the United Kingdom is united, it is not a unitary state,



Introduction and Summary of Evidence 7

and that there are, de facto, four sets of fiscal arrangements covering England, Northern Ireland, Scotland, and Wales. Of particular interest here is the Scottish one, since both a recent commission report (The Caldman Report 2009) and a Scottish office policy paper (November 2009) propose more taxsetting powers for Scotland. The paper shows that all parties, be they pro (snp) or anti Scottish independence, favour more tax autonomy for Scotland. The snp does so on the grounds that it is a normal step toward independence and also a stepping stone to attain it. The Unionist parties (Conservative, Labour, and Social Democrat) favour greater tax autonomy because it will enhance the accountability of the Scottish Parliament to its electorate. Such autonomy also appeals to the English electorate, who know well that Scotland receives more public funding (per capita) than does England. Finally, Jeffery examines the factors that came into play after the British election of May 2010 and raises the interesting possibility of a trade-off between more autonomy in Edinburgh and less power in London.2 In the third paper, Magali Verdonck, examines why so few tax powers are exercised by Belgian regions, notwithstanding Flemish demands for such powers. She enumerates six reasons that hold in this case, but that probably also play a role in other countries. They are 1 the history of the country (inversion of rich/poor region ranking); 2 geography of the country (smallish and thus having greater potential tax-induced mobility); 3 institutional structure (asymmetry between united Flemish region/community and separate Brussels-Walloon/francophone groupings); 4 underfinancing of one region (Brussels) due to tax arrangements (pit on residence, non taxation of Eurocrats) making for unequal starting conditions; 5 the risks of a race to the bottom in tax rates; 6 the existence of non-tax instruments (public spending grants) available to reach a similar degree of political autonomy.

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Ruiz Almendral and Vaillancourt

These six items constitute a helpful checklist that can be applied to any other tax devolution situation. Finally, one should note that the personal income tax autonomy obtained by the regions in 2001, but exercised only by Flanders, is the result of a political trade-off: more cash transfers for the French community, more powers for Flanders. It was not a choice based on public finance considerations. The recent (October 2011) agreement may be seen as a second round of tax autonomy most likely to be used by Flanders and granted in exchange for more revenue for Brussels. The fourth paper, by Charles Blankart and Erik Fasten, begins with a history of the current German federation, highlighting the debates that surrounded its birth in 1948. It then points out the significant growth in the public debt at both the federal and Länder level. At the Länder level, this growth has been encouraged by soft budget constraints that result from central government policies of buying off the agreement of some Länder and from constitutional court decisions. Given this context, there appears to be a need for reform in intergovernmental financial arrangements. One possibility would be to make the Länder face harder budget constraints by requiring them to raise more revenues on their own. Germany has not chosen this path. In Federalism Reform I, concluded in 2006, it was agreed not to give Länder more tax powers, such as the power to set their personal income tax. Consequently, Federalism Reform II included a debt brake to prevent Länder from borrowing over the business cycle, thus strengthening their budget constraints, albeit by buying off five Länder and postponing implementation of the debt brake agreement. The implementation is set for 2016 for the central government and up to 2020 for the Länder. The fifth paper, by François Vaillancourt and David Guimond, is the first to examine the theme of the use of tax powers by constituent units in the field of personal income taxes. It presents evidence for Canada, where, in 2000, the provinces acquired more freedom in setting their tax rates, and for the United States, where full freedom was always available to the states. In the case of Canada, starting in 2000, provinces that had their personal



Introduction and Summary of Evidence 9

income tax collected by the federal government (nine of them; all but Quebec) were required to set their own tax brackets and tax rates, moving from a tax on tax (provincial tax as per cent of federal one) to a tax on income system. In 2008, we find variations: in the number of brackets used (from one for Alberta to five for British Columbia); in the step-up amount to the second bracket (from twenty-nine to thirty-nine thousand dollars); in the rates per bracket; and in provincial progressivity. The results of this variation in the statutory dimensions of provincial taxation are that the variation in the actual tax burden goes down as income goes up; that effective p ­ rogressivity does not vary much between provinces, being highest in the two distinct societies of Quebec (language) and British Columbia (climate); and that, for high-income individuals, the highest tax burden is found in Quebec and the lowest in Alberta. Comparing 2008 to 2000, one also finds that the variation between provinces increases with the passage of time. The last finding of change over time may be influenced by the relatively short time span. What does a system where full tax freedom was always in place look like? We can find an answer in the case of the United States of America by examining the situation there in 2008. We find: the non-use by seven American states of the personal income tax (pit), something that does not occur in any of the Canadian provinces; the use by eight states of a flat tax rate and by most states of the federal agi as a tax base; much greater variation in the number of brackets, from one to ten, with a higher average number than in Canada; and a greater variability in tax rates, either minimum, median, or maximum, with the coefficient of variation at least twice that of Canada for a similar set of rates. Thus, freedom in setting personal income tax rates can, in large countries, lead to major differences in tax policy by constituent units. The sixth paper, by Fabrizio Gilardi, Daniel Kubler, and Fabio Wasserfallen, examines the case of Switzerland. The authors show that tax autonomy at the cantonal level is a defining aspect of Swiss federalism and that even the recent tax harmonization law does not constrain the tax rate setting powers of

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cantons. They also show that there are important differences between cantons in the use or not of specific tax instruments and in personal income taxes. For example, the pit rate for an annual income of 200,000 chf varies from 4 to 12 per cent while progressivity also varies between cantons. The authors then examine how pit rates changed from 1990 to 2007. They find a decline for all four income categories, but this decline is much more pronounced for the lowest income than for the highest. Hence, if there is a race to the bottom, it benefits the lower income group and not the higher one, an unexpected result. Various factors explain this lack of a race to the bottom: the co-operative nature of Swiss federalism embodied in various mechanisms, the fact that it is not only taxes but public services that matter, the direct democracy mechanism that makes it hard to push through measures benefiting only a small group (the rich), and the fact that, following a tax cut, large cantons may lose more from the reduction of revenues from existing taxpayers than they gain from new taxpayers attracted by this tax cut. In addition, tax rate differences are capitalized in property values, making a move less appealing. What lesson can we draw from these various papers? First, geography, both physical and ethno-linguistic, matters. Because mobility is costlier, constituent units in large countries can more easily implement different pits than those in smaller countries. Constituent units that are different ethno-linguistically can more easily differ in terms of taxation than those that are not. Larger constituent units are less likely to cut rates since the gains from newly arrived taxpayers may not compensate the losses from existing ones. Second, history matters. Countries that have a tradition of tax freedom at the constituent unit level are unlikely to give it up, while countries that are without this tradition find it difficult to accept. Third, institutional (constitutional, legal, consensual) arrangements matter. If constituent units have a powerful voice at the



Introduction and Summary of Evidence 11

centre, they may feel less need for tax autonomy. If budget constraints on constituent units are weak, with frequent/generous central government bailouts, then again tax autonomy may seem less desirable. Fourth, economics matter. The greater the difference in tax potential or in natural endowments between constituent units, the stronger will be the demand for autonomy by the better-off and the rejection of it by the less well-off. This can be mitigated by equalization arrangements. Under the constraints listed above, the two logics of political autonomy and fiscal accountability can combine to produce change in the direction of more tax powers at the constituent unit level. Indeed, taking a long-term perspective, this seems to be the natural outcome one would expect to emerge in countries with well-functioning constituent units. A question that remains is: what tax powers should be increased for constituent units? In our opinion, these should be pit powers and not value added tax (vat) or corporate income taxation (cit) powers. cit powers are inappropriate for constituent units given the mobility of capital and the difficulties of establishing the tax base even at the national level (transfer pricing, thin capitalization, royalties, etc). vat powers are difficult to implement at the subnational level, although the Canadian experience shows that it is feasible. And while the American experience shows that retail sales taxes can be used successfully at that level, it is a unique North American system that is becoming a strictly American one not easily implemented elsewhere and with many failings. In Canada the retail sales taxes, at the provincial level, are being replaced by a vat (six of ten provinces as of 1 July 2010).3 pit powers are thus more appropriate since constituent units are usually responsible for providing people-oriented services (education, health, social services). These services are natural complements for a pit since they often have redistributive effects in kind, while the pit may be redistributive in cash.

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notes 1 As stated in the May 2010 Gracious Address. See http://www.bbc.co. uk/news/10149102. 2 Thus providing a partial answer to the vexing West Lothian question. 3 In August 2011, a referendum in British Columbia rejected the vattype harmonized sales tax (hst); the tax should thus revert to a sales tax on 1 April 2013.

1 Asymmetrical Federalism in Spain: The Challenges of Financing the Autonomous Communities Violeta Ruiz Almendral Introduction In January 2010, Spain instituted a new financing system for autonomous communities (acs).1 One of its most significant elements is the substantial increase in taxation powers for regional governments. There are also new balancing transfer systems that aim to equalize ac public revenues and guarantee the provision of “essential public services” – services related to education, health, and support for the elderly, etc. The cost of these transfers has considerably increased, especially in such acs as Madrid and Catalonia where immigration growth has been quantitatively relevant. The system was approved at a difficult economic juncture for Spain, with the country facing a current deficit of more than 10 per cent and a growing public debt. With the bursting of the housing bubble and the abrupt end of construction activity, unemployment has now hit 24 per cent, and there is no real hope for recovery for the next two or three years.2 The crisis has brought to the forefront the vast differences in income and indebtment among autonomous communities as well as the unpredictable impact of the economic crisis on their financing system. But as the song goes, the best is (probably) yet to come. On 2 September 2011, article 135 of the Spanish Constitution was

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reformed in order to include a debt and deficit ceiling. On 27 April 2012, a new Stability Law3 was approved, substantially limiting debt and deficit limits for all tiers of government. On 28 September, the European Union approved a new set of regulations (the so-called Six Pack 4), designed to make the ­Stability Pact substantially stricter. This paved the way for the approval of the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, also known as the “Fiscal Compact” of the “Fiscal Stability Treaty.” The treaty, which entered into force on 1 January 2013, significantly changes the Stability Pact. I will not deal with the specifics of these reforms,5 nor is it possible to fully assess their impact, and the impact they will have, on the Spanish fiscal federalism model. Before presenting the major changes in and challenges of the current financing system for acs, it is worth going over the main aspects of (fiscal) federalism in Spain, in order to understand how the recent changes might play out in the future.

How

federal

is Spain?

Spain might not be a federal country by name, but the level of decentralization of public expenditures and, to a lesser extent, of taxation powers, equals that of many formal or traditional federations. Unlike other European constitutions, such as the German, the Spanish Constitution of 1978 omits any reference to the form of the state. That is, it does not describe it as centralized, unitary, federal, or regional. After almost forty years of Franco’s highly centralized government, consensus on this matter was understandably hard to obtain (López Guerra 1996; Moreno 1999).6 It is generally agreed that one of the major challenges of the 1978 Constitution was to finally resolve the “regional question.” This challenge was met not by defining the new system but, rather, by establishing a procedural framework (a How to manual for federal states). The constitution establishes an “optional autonomy system” (the so-called “prin-



Asymmetrical Federalism in Spain 15

cipio dispositivo”). Certain groups of provinces (those having common historical, cultural, and economic characteristics), which already existed under Franco and were kept in the 1978 Constitution, had the right to decide whether they wanted to become acs (Section 143 of the Constitution). If they decided to do so, they would then have to choose which responsibilities they wanted to assume. In other words, this is autonomy “à la carte” or a “cheese platter” system (López Guerra 1998). The constitution does not, then, directly assign authority to acs, but affords them the possibility of taking authority over a group of responsibilities listed in the constitution (Sections 148 and 149), while reserving specific functions for the central government.7 From a legal perspective, acs assume their authority via a Statute of Autonomy (Estatuto de Autonomia), which acts as the supreme norm, or effective constitution, of each community. Statutes have a legally complicated double status: they are both the highest norm of a region and a government law, rendering them subject to the constitution (and to the Constitutional Court’s scrutiny). This double nature explains why a reform of a statute needs to be approved by both the central parliament and the autonomous community. In the case of “fast lane” communities (those that accessed this status earlier), there must also be a referendum in the community. Potentially, this system could have led to a fully asymmetrical federal system. In practice, an asymmetrical system was never considered desirable, and a set of political agreements and laws contributed to harmonize the levels of authority of acs. Today, all acs have a similar degree of responsibility, the main differences lying in the financing systems (foral vs. common system, as we will see). This constitutional process has given rise to a state that clearly falls into the category of “decentralized.” When we take a closer look at the broad scope of decentralization in Spain and at the authority gained by the acs over the past (almost) thirty years, we may conclude that Spain is – in practice if not in legal form – a federal country.8

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Table 1 Decentralization in Spain (public spending) (% share of total public expenditure)

Central government Social security1 Autonomous communities Municipalities

1982

1996

2009

53 32.5 3.6 10.6

37.5 29.2 22.3 11.6

20.9 29.9 35.6 13.6

1 Social Security is controlled by the central Government, but it is a separate entity from a budgetary perspective.

The Asymmetric Model(s) and the Need for Bilateral and Multilateral Agreements The most striking feature of the Spanish devolution process is arguably the speed at which it has developed (Colino 2008). Between 1978 and 1983, all of Spain’s regions engaged in this process, with the result that the whole country is presently divided into seventeen acs. The evolution of public expenditure clearly shows the speed of the devolution process. Table 1 shows that, in 1978, the central government was in charge of 89 per cent of public expenditure. Today, it manages about 50 per cent. Another important feature of this model of the state is its asymmetry. This asymmetry is both de facto and de jure (Watts 1999) and explains the key role played by political agreements, even today, when most asymmetries have been smoothed out. Today, all acs (except Basque Country and Navarra, which fall outside the scope of this paper) have similar levels of authority. This asymmetry explains why bilateral (between the centre and a single ac) and multilateral (the centre and all acs on an equal footing) agreements have played such an important role in the assignment of responsibilities. Bilateral agreements have been necessary in order to address the different autonomy a­ spirations of acs. Moreover, in the case of the Basque Country and Navarra, bilateral agreements were the only way to address the special status that they, as “historic Communities,” were granted by the 1978 Constitution.



Asymmetrical Federalism in Spain 17

The coexistence of multilateral and bilateral agreements has served to greatly unify the policy responsibilities of the acs, and gives weight to the acs’ views on the allocation of resources. However, the system has been widely criticized for its lack of transparency, since agreements are negotiated behind closed doors and the results are only partially made public. Another salient element of intergovernmental agreements is that they are made between the executive branches, which means that the Senate, originally designed to be a territorial chamber (along the lines of the German Bundesrat) plays a very small role in addressing acs’ issues, and almost no role at all in fiscal federalism. Why is this? Part of the explanation is that most senators are elected by universal suffrage, provinces being the voting districts, while only a minority (46 out of 253) are appointed by the parliaments of the acs. According to Section 69 of the Constitution, four senators per province are elected directly by citizens. Then, every ac may choose one senator, plus one more for every million inhabitants. Most importantly, the Senate has very limited powers over the passage of state laws and it has no veto rights. As much as they are criticized, political agreements on the allocation of resources have played, and still play, a very important role in guaranteeing to acs sufficient means for carrying out their responsibilities. That said, a reform of the Senate is probably necessary since it would be the best way to reinforce the agreements between centre and ac and to give all acs an equal or similar voice. Senate reform should aim to give that chamber sufficient authority to fully discuss legislation affecting acs, in a similar fashion to the German Bundesrat. Of course, even though the reform of the Senate has been much debated and there seems to be a consensus that it needs to take place (Ruiz Almendral 2004), it might never happen. One of the reasons is that some acs, especially Catalonia and the Basque region, prefer to maintain a bilateral relationship with the centre. Because of the Spanish electoral system, nationalist parties from these regions sit at the central parliament, which

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Violeta Ruiz Almendral

gives them substantial political power to broker agreements that serve their interests. A substantial reform of the Senate that would shift political debate on matters of interest to acs to that chamber would put those communities on an equal footing with the others. Together with political agreements, the rulings of the Constitutional Court have played, and still play, a significant role in the definition of authority in the Statutes of Autonomies. Given that the vast majority of the matters listed in the constitution are actually shared between the central government and the acs, it is not hard to imagine that this has been a source of permanent conflict between these two tiers of government. The court, as the only body competent to resolve such conflicts, has undertaken a very important task in the evolution of the Statutes of Autonomies (López Guerra 1998). Of course, this role has been reinforced by the “unfinished” nature of the different provisions regarding regional autonomy established in the constitution, and by a certain “didactic” tendency of the court in fully explaining and thus serving to clarify the rules governing the Statutes of Autonomies. Moreover, the court has often ruled in favour of the acs which, in the first years of the decentralized model, was almost revolutionary in a country with such a long tradition of centralization (López Guerra 1998).

The Two Financing Systems for Autonomous Communities: Common versus Foral One of the main features of the Spanish fiscal decentralization model is the radical asymmetry that exists between two groups of acs. On the one hand, the financing systems applicable to the two foral acs are known as Concierto (Basque Country) and Convenio (Navarra) systems. Both terms translate into English as “agreement.” The main characteristic of this system is a maximum level of taxation autonomy, which means that these two acs have powers to pass legislation, with only a few limitations,9 on the main taxes of the Spanish fiscal system. Because the central government is still responsible for the provision of some



Asymmetrical Federalism in Spain 19

public functions or services within the territory of these two acs, it is entitled to receive a certain sum of money from them, known as the cupo (quota). The result is that these acs do not share the full cost of their services, which also implies that their citizens enjoy higher per capita public spending than the rest of the country.10 On the other hand, under the so-called “common system,” which applies to the other fifteen acs, the acs have very limited taxation powers, and this results in greater financial dependence on the central government. Hence, most of the revenues of these acs are provided by the central government in the form of transfers. For the two acs within the cupo system, the revenues deriving from their own taxes represent 94 per cent of expenditure, while transfers from the centre account for less than 1 per cent in the case of the Basque Country, and less than 3 per cent in the case of Navarra. For the common-system acs, transfers still represent more than 60 per cent of their revenues. Within this category, ceded taxes, which in practice often operate as a mere transfer of funds (as most acs have exercised their powers in a very limited way) represent about 90 per cent of total ac taxation (Ruiz Almendral 2004). The question is, of course, how is it possible to maintain such different financial systems among subnational entities within the same country? The mere existence of such asymmetries has been, and still is, the cause of much political discussion. The constitution, in its first supplementary provisions, states that “the Constitution protects and respects the historical rights of the foral territories.” However, it is unclear whether this provision actually calls for totally different financing rules (Medina Guerrero 1991). It has also been argued that it is not feasible to maintain such asymmetry in the long term since this will have a negative impact on the efficiency of the system. It would lead to increasingly divergent tax systems (García-Milá and McGuire 2003). Whether the cupo system could be extended to the other acs has been the subject of much academic debate. There seems to

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Violeta Ruiz Almendral

be a consensus that it would not be economically sustainable, since it would entail the loss of the central government’s most important taxes, and their revenues (Castells 2000b; Monasterio Escudero and Zubiri Oria 2009). According to some analysts, if this system were to be applied to all common-system acs, all of them except the two poorest (Andalucía and Extremadura) would have larger revenues than they do under the current regime (Zubiri 2000b). Moreover, the current cupo system means that the Basque Country and Navarra do not fully cover the central government’s costs (both within the territory and as a pro rata share of other costs) relative to them. So such a system would not adequately fund the central government (GarcíaMilá and McGuire 2003). The cupo regime has created certain tensions with European Union (eu) law, since a miscalculation of the cupo, together with sometimes lower rates for corporate income taxes in the Basque Country, has been deemed by some to be to the benefit of Spain vis-à-vis other eu countries. So far, the question has not been finally resolved (Ruiz Almendral 2008b; Palao Taboada 2009).

Limited Powers of Common-System acs to Establish New Taxes and the System of “Ceded Taxes” Although the constitution (Sections 133 and 157) bestows taxation powers on the fifteen acs, the Special Law for the Financing of the Autonomous Communities, Law 8/1980 (Ley Orgánica de Financiación de las Comunidades Autónomas – hereafter, the lofca) imposes severe limits on acs’ capacity to create new taxes. The most important limitation is the prohibition of double taxation (Sections 6.2 and 6.3), which prevents ac taxes from being similar to taxes created by the central government and the municipalities. Since these two other orders of ­government have already established taxes on most of the possible sources of revenues, little tax room has been left for acs. The situation did not change when the acs were established.



Asymmetrical Federalism in Spain 21

Debates about the acs’ fiscal responsibility have become central in the relationship between the state and the acs (Piña Garrido 2010). There is a certain generalized agreement that the acs have fiscal responsibility “at the margin” (Heald and Geaughan 1996; Boadway 2001), as opposed to the equivalence of expenditure and own revenues, which is a healthy and sound fiscal objective. There is a widespread view that, in order to achieve a fundamental decentralization of powers, the subnational tiers of government must be able to raise revenues in addition to the central government transfers they receive. Furthermore, the transfer of at least some taxation powers to subnational tiers of government is essential in order to achieve a certain level of political autonomy. In 1997 there was a major change in the financing system of acs. Some taxes traditionally belonging to the centre, and including the personal income tax, were transformed into shared taxes (ceded taxes or impuestos cedidos). Subsequent reforms in 2002 and 2010 have increased acs’ powers over these taxes. The main goal of these reforms was to make acs more involved in the establishment of taxes and thus more directly accountable to their taxpayers for the monies they spend. These reforms consist of the sharing of some tax room that previously had been occupied solely by the centre. This has been done through a type of resource called a “ceded tax.” The term “ceded” is not quite accurate, since it was not the tax but rather its yield that was ceded to the acs. Thus, until 1997, ceded taxes were central government taxes whose yield was granted to acs according to the taxes paid within each ac’s territory. Due to powers delegated by the centre, acs had also taken on the responsibility for administering and collecting these taxes. Ceded taxes were, therefore, a kind of transfer by which some of the taxes “owned” and until 1997 regulated exclusively by the centre accrued to, and were administered by, the acs. They differ from transfers in that the acs may receive a “bonus” in some cases. Thus, if the actual yield of the tax is greater than forecasted by the central government, the ac receives the ­difference;

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if the yield is less, the ac receives the initially forecasted amount. However, an increase of the yield may or may not be a consequence of better tax administration. For example, it may be due to economic conditions (Monasterio Escudero and Zubiri Oria 2009). Therefore, this bonus only partially serves as an incentive for acs to administer ceded taxes more efficiently. On the other hand, the acs’ decision-making powers over these kinds of taxes were, previously, almost non-existent. As can be seen in tables 2.0, 2.1, and 2.2, the acs’ regulatory powers over ceded taxes have been increasing in scope, thus also increasing their actual tax room. acs may regulate certain aspects of the personal income tax, the wealth tax, the death and gift taxes, stamp duty, and gambling taxes. The use of these powers by acs is another story entirely. In fact, because acs do not actually use their powers, at least not extensively, I submit that ceded taxes work, in practice, as a type of transfer. Technically of course, in budgetary terms, they are classified as acs own taxes. But if the fact that the acs receive the revenue regardless of what they do is taken into account, the taxes can be viewed as a transfer, from a political point of view. Until 2009, acs were given the option to choose whether they wanted to exercise their regulatory powers. If an ac failed to choose or decided not to exercise such powers, there would be no consequences; the central government would continue to regulate every aspect of these taxes in that ac, so it would not lose any revenue by failing to legislate. If an ac were to choose to exercise its regulatory power, it could do so by enacting legislation which would then substitute for central government law in those areas where the ac has the authority to legislate. The way that this option was structured – and the fact that the central government still guarantees to acs lump-sum grants allocated on the basis of historical shares in its transfers, regardless of whether they exercise their powers or not – served to create a strong disincentive for acs to use their new taxation powers. ­Evidence of this disincentive is the fact that, since 1997, the acs have mainly used their powers to create new fiscal benefits (Ruiz Almendral 2002a; Piña Garrido 2010).



Asymmetrical Federalism in Spain 23

The evolution of ceded (shared) taxes This situation changed in 2010. Starting in 2011, the central government will no longer regulate the ceded part of the tax. Thus, “lazy” acs might lose their revenue if they fail to legislate. This was a central government initiative; no ac asked for this change. It is intended to reinforce fiscal responsibility, if only by forcing acs to exercise their powers. The reassignment of taxation powers resulting from shared taxes mechanisms constitutes the most important tax reform since the State of Autonomies became a reality. Under the new regime (new since 1997), common-system acs have substantially increased their taxation powers. Although the gap between the powers of the foral and c­ommon-system acs remains quite large, it has certainly been reduced by the reform. If the trend continues, the possibility that the two systems will converge should not be completely ruled out. Such convergence derives mainly from the common-system acs’ newly acquired taxation powers. Until 1997, only foral acs could pass legislation and control the main taxes of the system (such as the personal income and corporate income taxes). Since 1997, common-system acs have gradually gained access to most important tax bases (and rates), excluding corporate income taxes. Although the gap is still wide, considering that common-system acs can regulate only certain aspects of some of these taxes while foral acs can regulate most elements of the said taxes, the tendency is toward a degree of convergence. However, when we compare the powers of the common-system with the foral acs over the main taxes of the taxation system, it is clear that a profound asymmetry prevails.

The Role of Transfers: A System Still Largely Based on Need The financing of common-system acs is still largely based on need, not fiscal capacity. Thus, their enhanced tax room on

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Table 2.0 1997 share (%)

ac

Ceded tax

Administration

Personal income tax

 33

State

Wealth tax

100

acs

Death and gift taxes

100

acs

Taxes on transfers and official documents Gambling taxes

100

acs

100

acs

Legislative powers that acs may assume Tax rates (must have same number of tax brackets as the state tax) Tax credits, under certain conditions Tax rates (must have same ­number of tax brackets as the state tax) Minimum threshold Deductions (mainly for family ­circumstances) Tax rates Tax rates

Exemptions Taxable base Tax rates Tax credits Tax administration regulations

ceded taxes is not sufficiently taken into account. The common system establishes a set of revenue guarantees aimed to cover the potential risk that the exercise of taxation powers usually entails. Put simply, while revenues in the foral-system acs accrue to the acs on a strictly derivation basis, in the common system the central government guarantees minimum revenues on ceded taxes as well. Note that no constitutional provision actually calls for this, but acs have come to expect this guarantee, even after the increase in their options to obtain further revenues. The small proportion of own tax revenues in the financing of the common-system acs results in a substantial lack of fiscal responsibility. This situation derives both from the fact that these



Asymmetrical Federalism in Spain 25

Table 2.1 2002 share (%)

ac

Ceded Tax

Administration

Legislative powers that acs may assume

Personal income tax

 33

State

Tax rates (must have same ­number of tax brackets as the state tax) Tax credits, under certain conditions Tax rates Minimum threshold Tax credits Deductions (mainly, for family circumstances) Tax rates Deductions and tax credits Tax administration regulations Tax rates Tax credits Tax administration regulations

Wealth tax

100

acs

Death and gift taxes

100

acs

Taxes on transfers and official documents Gambling taxes

100

acs

100

acs

Value added tax Excise duties Tax on wine Tax on electricity Tax on vehicles Special tax on gas

 35

State

Exemptions Taxable base Tax rates Tax credits Tax administration regulations None

 40  40 100

State State State

None None None

100

acs

100

acs

Tax rates (under certain ­conditions and limits) Tax rates (under certain ­conditions and limits) Tax administration regulations

acs have limited taxation powers and from their insufficient use of the powers that they already have, and is barely consistent with the larger responsibility that the acs have in other areas: i.e., while to a large extent they decide health and education policy, they do not seem to have an interest in deciding taxation policy, which pays for everything else.

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Table 2.2 2010 share (%)

ac

Ceded Taxes

Administration

Legislative powers that acs must assume

Personal income tax

 50

State

Wealth tax (repealed in 2009) Death and gift taxes

100

acs

100

acs

Taxes on transfers and official documents Gambling taxes

100

acs

100

acs

Value added tax Excise duties Tax on wine Tax on electricity Tax on vehicles

 50

State

Tax rates (must have same ­number of tax brackets as the state tax) Tax credits, under certain conditions Personal deductions Tax rates Minimum threshold Tax credits Deductions (mainly, for family circumstances) Tax rates Deductions and tax credits Tax administration regulations Tax rates Tax credits Tax administration regulations Exemptions Taxable base Tax rates Tax credits Tax administration regulations None

 58  58 100

State State State

None None None

100

acs

Special tax on gas

100

acs

Tax rates (under certain ­conditions and limits) Tax rates (under certain ­conditions and limits) Tax administration regulations



Asymmetrical Federalism in Spain 27

Table 3 Comparison of legislative powers of common-system and foral acs Main taxes in Spain

Legislative powers that foral acs may assume

Personal income tax

Total regulation of the tax

Corporation income tax Tax on income of nonresidents

Total regulation of the tax Regulation of the tax only in the case of permanent establishment in the foral territory Total regulation of the tax

Wealth tax

Death and gift taxes

Total regulation of the tax

Taxes on transfers and official documents Gambling taxes

Total regulation of the tax

Value added tax Excise duties

None None

Total regulation of these taxes

Legislative powers that common-system acs must assume Tax rates (must have same number of tax brackets as the State tax) Tax credits, under certain conditions None None

Tax rates Minimum threshold Tax credits Deductions (mainly, for family circumstances) Tax rates Deductions and tax credits Tax administration r­ egulations Tax rates Tax credits Tax administration r­ egulations Exemptions Taxable base Tax rates Tax credits Tax administration r­ egulations None None

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When we consider the constitutional framework, there is no reason for this inconsistency. In accordance with the recognition of autonomy, or, stated more accurately, the recognition of the right to be autonomous, the Spanish Constitution grants acs “financial autonomy for the development and execution of their authority.” Apart from stating this principle of financial autonomy, the constitution establishes a list of resources that will constitute the acs’ income. This list includes almost all kinds of existing resources. Thus, acs may obtain revenues from ceded taxes; surtaxes on existing central government taxes; their own taxes; public debt; and transfers (Section 157.1). Furthermore, the constitution clearly recognizes and guarantees taxation powers to the acs (Section 133.2). However, they must abide by the rules established by the central government. In Section 157.3, the constitution allows the centre to approve a special law (ley orgánica) regulating both how the resources listed in section 157.1 will be distributed among acs and the limits on the exercise of their financial power on the resources (i.e., whether and to what extent they may create new taxes, etc.). This implies that the central government is given the power to both limit and control the financial autonomy of the acs, which is probably inconsistent with the recognition of the right to autonomy granted to the acs (Ruiz Almendral 2012, 2012a). Most relevant is the above-mentioned Special Law for the Financing of the Autonomous Communities (lofca). The limits established on the creation of new taxes by acs provide good examples of limits on how acs may use resources listed in article 157.1. Although it is not always clear whether acs have been deterred from creating new taxes by the limitations on establishing new taxes or by their unwillingness to withstand the political consequences of increasing the tax burden, the existence of such limits underlines the importance of intergovernmental transfers in Spain. When the level of tax autonomy is so low, the possibilities for acs to obtain own resources are scarce; hence the need for transfers from the centre. This situation also explains the substantial imbalance between the common-system acs’ spending autonomy – which has been strongly supported



Asymmetrical Federalism in Spain 29

by the Constitutional Court – and their limited power to raise their own revenues. Therefore, since the beginning of the State of Autonomies, transfers have played a far more important role than own taxes, resulting in the common-system acs’ financial dependence on the centre. For most of them, transfers still represent more than half of their revenues. Moreover, if we take into account that ceded taxes are closer to being a transfer than a tax revenue, this percentage can amount to as much as 80 per cent. The transfers received by the acs have traditionally been based on need. According to the lofca, the cost of the devolved powers would be calculated and a given amount would then be transferred to the acs. In reality, the cost was never calculated. It was, rather, negotiated in bilateral commissions (between the centre and each ac). The reason is that the accounting systems of the central government were inadequate for such calculations, so the real cost of the transferred services was never actually determined. The parties would meet behind closed doors and agree on a certain amount. This continuous negotiation was the subject of sharp criticism. Apart from the argument that it was undemocratic, from a financial perspective it was deemed to create inequalities since, eventually, those acs in a weaker bargaining position would receive less money to exercise the powers that fall within their scope of authority (LeónAlfonso 2007). The financial dependence of acs was not seen as a problem in the early years of devolution. At that time, citizens regarded acs with a certain distrust, and voters emphatically rejected some of the acs’ attempts to establish new taxes. As the acs gained more powers, however, their financial needs grew substantially, necessitating a greater expansion of the transfer system. Today, the financing system is entirely regulated in a state law for all fifteen common-system acs. In brief, the law prescribes that all acs shall receive an amount sufficient to finance their authority. If an ac decides to increase or decrease the tax burden of its ceded taxes, this change will be reflected in the total budget received from the centre, which will then vary

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accordingly. However, since acs still receive the revenue of ceded taxes even when they do not actually regulate any aspect of them, there is no mechanism to create incentives for acs to exercise their taxation powers. That is, the financial incentive for acs to use their powers over those ceded taxes that they control is weaker than the political incentive not to increase the tax burden on their citizens. In fact, a substantial amount of revenue is already guaranteed from ceded taxes they do not control. This explains why most have preferred to establish tax credits and tax benefits as opposed to increasing the tax burden. They have, so far, increased taxes in only a few cases – gambling taxes, capital transfers tax, and stamp duty. Spain could adopt a formula that takes into account common-­ system acs’ actual fiscal capacity by measuring their potential to obtain ­additional revenues and considering this when designing the transfer ­systems. Such a move would constitute an appropriate way to increase the common-system acs’ exercise of fiscal responsibility. The idea would be to establish a system similar to the Canadian “representative tax system.”

The Constitutional Court’s Ruling on the Statute of Catalonia and Its Possible Impact on Fiscal Federalism On 28 June 2010, the Spanish Constitutional Court ruled that part of the Catalonian Statute of Autonomy11 is unconstitutional.12 This has created significant political turmoil. While from a formal perspective Catalonia has the same powers as the other acs, it has traditionally played a leading role in the devolution process. Thus, many other communities (such as Andalusia and Valencia) had reformed their statutes partially following the Catalonian model. Their laws are also affected now.13 In a very long ruling (the longest in Spanish history, with almost a thousand pages), the court struck down 14 of the 113 articles that the People’s Party (pp) argued were unconstitutional, while reinterpreting a further 23.14



Asymmetrical Federalism in Spain 31

Fiscal federalism, normally a contested area, was barely touched by the court’s ruling. This is partly explained by the fact that the current financing model, which entered into force in January 2010 via a central government law, closely followed some of the provisions of the Catalonian statute. Thus that statute has once again paved the way for fiscal federalism reform in a way that has also benefited the other acs. In effect, the court has merely softened some sections of fiscal federalism, such as the obligation for the centre to invest in Catalonia and the obligation to transfer certain taxes, which are, according to the court, within the authority of the centre and cannot be unilaterally determined by communities. In this regard, the phrase “provided that they also make a similar fiscal effort” of section 206, par. 3, and the phrase “may include the legislative capacity to establish and regulate local government taxes” of section 218, par. 2, have been annulled (table 4). Of course, it must be borne in mind that the political consequences of the ruling are far greater than the legal problems. The underlying, and larger, issue that needs to be resolved now is how to accommodate the demands of some acs for greater autonomy with the current model of the Spanish state. This may be easier than the political rows suggest and may not require reforming the Constitution, which was designed with enough flexibility to accommodate a potentially asymmetric federal system.

The Reform of the Constitution on 27 September 2011 On 23 August 2011, President Zapatero announced before parliament a reform of the constitution intended to include a deficit limit. This came as a surprise to virtually everyone, but since the other large party (Partido popular) was in agreement, a formal proposal was presented before Congress on Friday, 26 August. According to the Spanish Constitution, because this article does not touch any of the main elements of the text (fun-

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Table 4 ARTICLE 206. Participation in Income from State Taxes and Leveling and Solidarity Mechanism 1.  The level of financial resources available to the Generalitat for funding of its services and powers shall be based on criteria of expenditure needs and shall take its taxation capacity, among other criteria, into account. To this end, the resources of the Generalitat are, among others, those deriving from its taxation revenues, increased or reduced in accordance with its participation in the leveling and solidarity mechanisms. 2. The Generalitat participates in the income deriving from ceded state taxes. The percentage of participation is established taking its services and powers into account. 3.  The financial resources available to the Generalitat may be adjusted to enable the state financing system to have sufficient resources to ensure leveling and solidarity with other autonomous communities, so that the education, health, and other essential social services of the welfare state provided by the different autonomous governments can achieve similar levels throughout the state, provided that they also make a similar fiscal effort. Similarly, where appropriate, the Generalitat receives resources from the leveling and solidarity mechanisms. The aforementioned levels shall be established by the state. 4.  The leveling and solidarity mechanisms shall be determined in accordance with the principle of transparency, and the results shall be evaluated every five years. 5.  The state shall guarantee that application of the leveling mechanisms shall in no case alter the position of Catalonia in the pre-leveling ranking of per capita earnings. 6.  In determining the expenditure needs referred to in Section 1, the population, adjusted for differential costs and demographic variables, and in particular by means of a correction factor based on the percentage of immigrants in the population, shall be taken into account, as a basic variable. Likewise, population density, the size of urban nuclei, and the socially excluded population shall also be taken into account. ARTICLE 218. Autonomy and Financial Powers 1.  Local governments have autonomy over their budget and the use and application of their resources, including their share of the budgets of other Public Administration bodies, which they may dispose of freely in the exercise of their powers. 2. The Generalitat has power in matters of local financing, within the framework established by the Constitution and the state regulations. This power may include the legislative capacity to establish and regulate local government taxes and includes the power to establish the criteria for distribution of shares of the budget of the Generalitat. 3.  The local governments can regulate their own finances within the framework of the law. This includes the authority to set the quota or rate



Asymmetrical Federalism in Spain 33

Table 4 continued of local taxes, and also rebates and exemptions, within the limits established by law. 4.  The local governments have the power, within the framework established by regulations governing the local taxation system, to manage and collect their taxes and implement inspections, without prejudice to their being able to delegate this function to the Generalitat and participate in the Taxation Agency of Catalonia. 5. The Generalitat is responsible for financial supervision of local governments, while respecting their autonomy as recognized by the Constitution.

damental rights, the Crown, the outline of the State of Autonomies)15 its reform may be undertaken by absolute majority of the Parliament and without referendum. On 2 September, barely two weeks after the first announcement, the article was modified. The current political debate is confusing and muddled, so it is probably too early to fully understand all the consequences. The new article 135 of the Constitution does several things. First, it refers to the principle of stability as regulated in the Treaty for the Functioning of the European Union (tfue), to which the article also refers. Section 135.1 establishes that “all public administrations will follow the principle of budget stability”; Section 135.2 that “The central government and the Autonomous Communities may not incur a structural deficit higher than that established by European Union. An Organic law [that is, a law that needs absolute majority for its approval] will establish the maximum structural deficit permitted to the central government and the autonomous communities. Local entities [mainly municipalities] must have totally balanced budgets.” The inclusion of the principle of stability is not a radical change or an innovation in our legal system, at least to the extent that the principle was already mentioned in the tfue, which is part of Spanish law. But the new article does ease the coordination between Spanish and European budgetary principles. It also makes it easier to impose these limits on ­subnational

34

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entities without the constant claim that this may limit their autonomy. Second, the reform also limits debt, not just the deficit. Thus, section 135.3 establishes that the total indebtedness may never be higher than that established in European law. Again, not a radical reform but good news that it is now enshrined in the constitution. Third, the reform has elements of flexibility. A first is that the numbers will be established in an organic law, which is easier to change than the Constitution. This Law was published on 27 April 2012 (The Ley Orgánica 2/2012, de 27 de abril, de Estabilidad Presupuestaria y Sostenibilidad Financiera). This law substantially enhances the coordination powers from the central government vis à vis autonomous communities. It also enshrines the 0.4 structural deficit limit (art. 11), albeit it will not enter into force until 1 January 2020. A second element of flexibility also follows closely the German constitutional reform. The new section 135.4 establishes that the deficit and debt limits may be infringed only in cases of “natural catastrophes, economic recession or situations of extraordinary emergency that are beyond the central governments’ control”: such circumstances will need to be assessed and the breach of the deficit/debt limits approved by an absolute majority of Congress. Fourth, the new section 135.5 establishes the minimum content that the future organic law is to contain. The law will need to develop the principle of stability as well as establish how acs and municipalities may participate in the process of distributing the deficit and debt threshold among the different entities. The law will then establish how the “pie” of total deficit and debt is distributed among the entities, as well as the method by which such limits will be calculated. Finally, the law will need to establish the possible sanctions to be applied to those entities that do not comply with the limits. Fifth, the new section 135.6 is directed to acs that must adopt the pertinent legislation, or modify existing legislation, in order to comply with the new article 135.



Asymmetrical Federalism in Spain 35

At this stage, and without knowing what the organic law will actually look like, the following reflections can be made. First and foremost, the article is a substantial change from the old article 135,16 which merely established the obligation to always repay the interest and capital of the state’s public debt, a matter that was then, and still is, completely outside the democratic debate since that section has not been modified. Even if both the government and ­Parliament “forgot” to include the necessary credits to repay the ­public debt in the budgetary document, they would still be automatically included. It is remarkable, in my view, that article 136 has not been amended. This article refers to the Auditing Court (Tribunal de Cuentas), a totally independent body, accountable only before parliament, that is charged “with auditing the State’s accounts and financial management, as well as those of the public sector” (136.1).17 Second, from a political perspective, the decision has been harshly criticized because it seems to have been dictated by ­Germany. Indeed, opposition leader Mr Mariano Rajoy p ­ roposed a similar measure in 2010 which was rejected by the ruling party without further discussion. Third, it could be argued that the content of the new article is not so new when one takes into account that the stability principle already exists in the tfeu and that the “internal stability pact” already establishes the deficit limits for all public entities. However, even if the final text of the organic law does not differ greatly from the existing laws, there is a fundamental difference in the degree of importance that the principle acquires. Fourth, a classical argument employed by those who oppose the stability principle has been that it runs counter to the principle of equity in the distribution of public moneys, as established by article 31.2 of the Spanish Constitution (2. Public expenditure shall make an equitable allocation of public resources, and its programming and execution shall comply with criteria of efficiency and economy).18 Another is that the reform does not necessarily diminish public spending, but that the taxing capacity must be raised. Spain currently has substantially lower tax

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pressure than most other countries in the euro-area, even less pressure if the fact that the welfare state has been extensively implemented (with free and universal health care and education, for example) is taken into account.

The Challenges Ahead The decentralization process in Spain has been remarkably swift and, generally speaking, quite successful. Authority has been devolved to acs in an orderly fashion and this new tier of government has been well accepted by citizens. Nonetheless, far too many issues remain unresolved, among them the following: 1 While political agreements are a necessary part of Spain’s cooperative federal model, the Senate should also play a role. But unless there is a substantial reform of the institution, this will not be ­possible. Senate reform is now more necessary than ever since only an adequate representative chamber can guarantee that acs will have a say in the eu policies that affect them. 2 As important as the opinions of the Constitutional Court may have been in the clarification of the devolution process, most of the conflicts should now be discussed and resolved in Parliament, thus decreasing what has been known as a “judicialization” of the State of Autonomies. 3 The level of fiscal responsibility is insufficient. Despite the significant reallocation of taxation powers, the system is still largely based on need assessment by the central government and the allocation of funds according to those needs. The level of need has never been actually assessed, but rather estimated and negotiated. Today, the basic formula of the system guarantees funds to acs regardless of their fiscal responsibility, regardless of whether they decide to establish new taxes or increase tax pressure in order to obtain more funds, and regardless of whether they control their indebtedness and deficits.



Asymmetrical Federalism in Spain 37

4 The financing system does not sufficiently take into account the eu stability pact constraints. Although Spain has adopted a kind of “internal stability pact” (Ruiz Almendral, 2008), the sanctions are not credible enough and acs are able to run large deficits while reducing their tax burdens. The financing of acs seems to have been designed without taking into account the European context. The new Article 135 should change this, but it is too early to draw conclusions. 5 While the financing of the regions is at the forefront of the political agenda in Spain, the financing of municipalities is not. These entities, which are responsible for more than a fifth of public spending, have been aptly labelled the “Cinderellas” of the decentralization process because they are underfinanced, politically under-represented, and also in need of deficit curbing. Only by taking into account all financing problems in Spain as a whole can these problems be solved.

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notes 1 The system was established by two laws: Ley Orgánica 3/2009, de 18 de diciembre, de reforma de la lofca; Ley 22/2009, de 18 de diciembre, por la que se regula el sistema de financiación de las Comunidades Autónomas de régimen común y Ciudades con Estatuto de Autonomía y se modifican determinadas normas tributarias. 2 See the latest report (first semester of 2012) from the Ministry of Finance at http://serviciosweb.meh.es/apps/dgpe/textos/sie/ siepub.pdf, accessed 11 May 2012. 3 The Ley Orgánica 2/2012, de 27 de abril, de Estabilidad Presupuestaria y Sostenibilidad Financiera 4 See http://ec.europa.eu/economy_finance/economic_governance/ index_en.htm (accessed 16 November 2011). 5 I have dealt with these issues in Ruiz Almendral 2012 and 2012a. 6 The closest precedent for decentralization in Spain was established by the Constitution of 1931 – the Second Spanish Republic – and lasted only eight years. This model was intentionally not followed; its tragic ending in Civil War did not make this advisable. For more than a century, until the Second Republic, Spain had been a centralized state, a situation that created many political tensions (López Guerra, 1996; Moreno, 1999). 7 For example, the state is in charge of “regulating the basic conditions to ensure the equality of all Spaniards in the exercise of their rights and the fulfillment of their obligations” (Section 149.1.1a), and is assigned exclusive authority for “coordination of the economy” (Section 149.1.13a). 8 The term “federation” is not uncontroversial. For some it is necessary that the decentralization of powers derive directly from the constitution in order to categorize a country as federal (Beer 1997); for others only those countries where subnational governments actually exercise their powers may fall into the said category (Bird 1994). It is so difficult to find two similar federations that the term must be used with care (Watts 1994). 9 Such limitations are established in the laws regulating the convenio and concierto, and basically refer to the need to maintain a certain level of harmonization with the state’s tax system. They are, however, established in quite broad terms which, for example, allow the Basque Country to establish corporation tax credits that differ broadly from those of the state. See Ruiz Almendral (2003); Ruiz Almendral (2004); and Monasterio Escudero and Zubiri Oria (2009).



Asymmetrical Federalism in Spain 39

10 See Ruiz Almendral (2008b). 11 The norm is available in English, not so the ruling. http://www. parlament-cat.net/porteso/estatut/estatut_angles_100506.pdf 12 Note that the decision to strike down a Statute of Autonomy is unprecedented in Spanish democracy, but then so are the rest of the elements surrounding it: a court deciding with only ten out of its twelve members, since one had died and another (Pablo Perez Tremps) was recused; and one of the worst political rows in recent history. The court was divided and had been unable to agree on a ruling in the past five years. Finally, last June the much expected ruling was approved by a majority of 6 to 4. 13 But the legal consequences do not end in Catalonia, since other statutes have followed the same structure and used similar definitions of what shared power means. This is the case for Valencia, Aragón, Illes Baleares, Andalucía, Castilla y León, Extremadura, and Castilla La-Mancha (these last two reforms are still pending). The Valencian and Andalusian statutes are by far the most similar to the Catalonian, and they will need to be reformed, since legally the effects of the ruling go beyond the Statute of Catalonia and are extended to any similar statutes. It is particularly remarkable how in all the other cases the statutes were approved thanks to political pacts entered into by the two main parties: the Socialist (psoe) and the People’s Party (pp). In particular, in the case of Andalucía, the pp endorsed a number of provisions that were an exact copy of the Catalan statute, and that the same party (on a national level) had deemed to be unconstitutional. 14 As interesting as the list of articles annulled are the areas that were declared valid, since some of them were also largely contested. Among others, the duty to know the Catalan language (sections 34 and 50.5) was merely softened by adding that it shall not imply a prohibition against using the Spanish language or an obligation to use Catalan. 15 This reform will follow article 167 of the Spanish Constitution: Section 167 1 Bills on constitutional amendments must be approved by a majority of three-fifths of members of each House. If there is no agreement between the Houses, an effort to reach it shall be made by setting up a Joint Committee of an equal number of Members of Congress and Senators which shall submit a text to be voted on by the Congress and the Senate. 2 If approval is not obtained by means of the procedure outlined in the foregoing subsection, and provided that the text has been

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passed by the overall majority of the members of the Senate, the Congress may pass the amendment by a two-thirds vote in favour. 3 Once the amendment has been passed by the Cortes Generales, it shall be submitted to ratification by referendum, if so requested by one tenth of the members of either House within fifteen days after its passage. 16 Former Section 135 1 The Government must be authorized by law in order to issue Public Debt bonds or to contract loans. 2 Loans to meet payment on the interest and capital of the State’s Public Debt shall always be deemed to be included in budget expenditure and may not be subject to amendment or modification as long as they conform to the terms of issue. 17 Section 136 1 The Auditing Court is the supreme body charged with auditing the state’s accounts and financial management, as well as those of the public sector. It shall be directly accountable to the Cortes Generales and shall discharge its duties by delegation of the same when examining and verifying the General State Accounts. 2 The State Accounts and those of the State’s public sector shall be submitted to the Auditing Court and shall be audited by the latter. The Auditing Court, without prejudice to its own jurisdiction, shall send an annual report to the Cortes Generales informing them, where applicable, of any infringements that may, in its ­opinion, have been committed, or any liabilities that may have been incurred. 3 Members of the Auditing Court shall enjoy the same independence and fixity of tenure and shall be subject to the same incompatibilities as judges. 4 An organic act shall make provision for membership, organization, and duties of the Auditing Court. 18 Many Spanish commentators have made this point – that the stability notion both limits public spending and makes its distribution less equitable; among others, Aliaga Agulló (2003), 655 and Martínez Giner (2002), 471. I have maintained the opposite view: Ruiz Almendral (2008),153–62.



Asymmetrical Federalism in Spain 41

References Aliaga Agulló, E. “El proceso de asignación de los recursos públicos en la futura Ley General Presupuestaria.” Revista Española de Derecho Financiero, no. 120 (2003): 653–80. Beer, Samuel. 1997. “A Political Scientist’s View of Fiscal Federalism.” In The Political Economy of Fiscal Federalism, edited by Wallace Oates, 21–46. Toronto: Lexington Books. Bird, Richard. 1994. “A comparative perspective on federal finance.” In The Future of Fiscal Federalism, edited by K.G. Banting, D.M. Brown, and Thomas Courchene, 293–398. Kingston: School of Policy Studies. Boadway, Robin. 2001. “Inter-Governmental Fiscal Relations: The Facilitator of Fiscal Decentralization,” Constitutional Political Economy 12, no. 2: 93–121. Castells Oliveres, Antoni. 2000b. “Autonomía y solidaridad en el sistema de financiación autonómica.” Papeles de Economía Española, no. 83: 37–59. Colino, César. 2008. “The Spanish model of devolution and regional governance: evolution, motivations and effects on policy making.” Policy & Politics 36, no. 4: 573–86. García-Milá, Teresa, and T.J. McGuire. 2003. “Fiscal Decentralization in Spain: An Asymmetric Transition to Democracy.” In Subsidiarity and Solidarity: The Role of Intergovernmental Fiscal Relations in Maintaining an Effective State in Diverse Countries, edited by R. Bird. Washington: World Bank, forthcoming. Heald, David, and Neal Geaughan. 1996. “Financing a Scottish Parliament.” In The State and the Nations, edited by Stephen Tindale, 167–83. London: Institute for Public Policy Research. León-Alfonso, Sandra. 2007. The Political Economy of Fiscal Decentralization. Bringing Politics to the Study of Intergovernmental Transfers. Spain, Instituto d’Estudis Autonòmics. Lopez Guerra, Luis. 1996. “Regions and Nationalities in Spain: The Autonomous Communities.” In The Regions – Factors of Integration or Disintegration in Europe? edited by Gisela Färber and Murray Forsyth, 144–55. Baden-Baden: Nomos Verlagsgesellschaft.

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– 1998. “The Spanish Constitutional Court and Regional Autonomies in Spain.” In Federalism and Regionalism in Europe, edited by Antonio D’Atena, 257–62. Napoli: Editoriale Scientifica. Martínez Giner, L.A. “El principio de justicia en materia de gasto público y la estabilidad presupuestaria.” Revista Española de Derecho Financiero, no. 115 (2002): 471–92. Medina Guerrero, Manuel. 1991. Los regímenes financieros forales en la Constitución de 1978. Oñati: Instituto Vasco de Administración Pública. Monasterio Escudero, Carlos, and Ignacio Zubiri Oria. 2009. Dos ensayos sobre financiación autonómica. Madrid: Fundación de las Cajas de Ahorro. Moreno, Luis. 1999. “Asymmetry in Spain: Federalism in the ­Making?” In Accommodating Diversity: Asymmetry in Federal States, edited by ­Robert Agranoff, 149–68. Baden-Baden: Nomos Verlagsgesellschaft. Palao Taboada, Carlos. 2009. “State Aid and Autonomous Regions: The ecj’s Ruling in the Basque Country Case.” Bulletin for International Taxation, May/June 2009: 225–35. Piña Garrido, Lilo. 2010. “El nuevo sistema de financiacion de las ccaa: autonomia, espacios fiscales propios y competencias normativas.” 1 y 2, Crónica Tributaria, 2010. Ruiz Almendral, Violeta. 2002. “Fiscal Federalism in Spain: The Assignment of Taxation Powers to the Autonomous Communities.” International Bureau of Fiscal Documentation. European Taxation 42, no. 11 (November): 467–75. – 2003. “The Asymmetric Distribution of Taxation Powers in the Spanish State of Autonomies: The Common System and the Foral Tax Regimes.” Regional and Federal Studies 13, no. 4 (Winter 2003): 41–66. – 2004. Impuestos Cedidos y Corresponsabilidad Fiscal. Valencia, ­Tirant lo blanc – 2008. Estabilidad presupuestaria y gasto público en España. Pamplona: La Ley-Wolters Kluwer. – 2008b. “¿Vuelta a la casilla de salida? El concierto económico vasco a la luz del Ordenamiento comunitario.” Revista Española de Derecho Europeo, no. 28 (2008): 499–528.



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– 2012. “Estabilidad Presupuestaria y Reforma Constitucional.” Revista Europea de Derecho Europeo (Civitas), n. 41 (2012): 33-112. – 2012a. “Sharing Taxes and Sharing the Deficit in Spanish Fiscal Federalism.” eJournal of Tax Research (Australia) 10, no.1 (2012): 88–125. Watts, Ronald. 1994. “The Value of Comparative Perspectives.” In The Future of Fiscal Federalism, edited by K.G Banting, D.M. Brown, and Thomas Courchene. Kingston: School of Policy Studies. – 1999. “The Theoretical and Practical Implications of Asymmetrical Federalism.” In Accommodating Diversity: Asymmetry in Federal States, edited by Robert Agranoff, 24–42. Baden-Baden: Nomos Verlagsgesellschaft.

2 Fiscal Autonomy in Scotland CHARLIE JEFFERY Asymmetry in the United Kingdom The way in which United Kingdom’s component parts – England, Northern Ireland, Scotland, and Wales – are governed is unusually asymmetrical. Northern Ireland, Scotland, and Wales have had devolution since 1999 – that is, directly elected representative institutions with significant policy responsibilities (though for substantial periods since 1999 the devolved institutions in Northern Ireland were “suspended”). The package and scope of policy responsibilities that each has differs. Scotland and Northern Ireland have generally similar though not identical packages of policy responsibilities, extending across many fields of domestic policy. Wales has policy responsibilities in most, but not all, of the same areas, but has had less scope in exercising them. Scotland and Northern Ireland from the outset had full legislative powers in their fields of responsibility and have exercised those powers, as a rule, autonomously of the uk Parliament. Until 2011 the National Assembly for Wales had “secondary” legislative powers, whose scope was specified within individual uk Acts of Parliament. However, the possibility to widen the range of that scope for action, up to and including full “primary” legislative powers, was introduced in a second Welsh devolution act in 2006. A near two-thirds majority in a referendum held in Wales in March 2011 endorsed a move to full legislative powers, bringing Wales more closely into line with Scotland and Northern Ireland.



Fiscal Autonomy in Scotland 45

Alongside differences in powers, the devolved institutions are also structured differently. The Scottish Parliament and National Assembly for Wales operate with a conventional governmentopposition divide, while the Northern Ireland government is a proportional or “involuntary” coalition. In the Northern Ireland Assembly, both the Irish nationalist and British unionist parties are allocated ministerial positions according to the d’Hondt formula.1 The proportional government that results is one of a range of mechanisms designed to institutionalize co-operation across Northern Ireland’s divided communities in a broadly consociational government form (Tonge 2005). One of the few areas where the devolved institutions have common arrangements is in the way they are funded. These arrangements are set out below. This paper argues that this area of commonality is likely to diffuse into different sets of territorial financial arrangements, attuned to the particular circumstances of each part of the uk. This has been the wider pattern since the introduction of devolution: the emergence and consolidation of disconnected, even centrifugal territorial dynamics. These disconnections also apply to England. Though England lacks its own devolved institutions, it too has a distinctive form of territorial government. It is governed directly by uk central government institutions, which combine uk-wide with England-only roles. England has diverged from Scotland, Wales, and Northern Ireland both by default (in the sense of not having its own representative institutions) and by design (as uk governments have introduced policies in England that follow different priorities from those outside of England).

The uk’s Territorial Financial Arrangements The uk’s territorial financial arrangements are unique. The level of public spending on programs in England is decided by the uk Parliament and financed from general uk taxation. Spending and financing decisions that have an impact only on England are made on the same basis as spending and revenue-­raising on programs with a uk-wide reach. uk Parliament decisions on

46 Charlie Jeffery

spending in England are also one of the main determinants of the funding of the devolved institutions. The other determinant is history. This mix of England and history is explained below, using the example of the Scottish Parliament, though the arrangements for Wales and Northern Ireland are essentially the same. The bulk of Scottish revenues are allocated by a uk government block grant. This grant has two components: a baseline and an annual increment. The baseline was derived initially from the total amount of annual spending that was allocated to Scotland-specific policy programs by the late 1970s. (Scotland had distinctive policy arrangements, often known as administrative devolution, long before devolution, as, to varying extents, did Northern Ireland and Wales.) From 1979 that spending total was established as a baseline subject to annual incremental change. Annual increments were – and remain – determined by what has become known as the “Barnett Formula,” named after the then deputy finance minister, Joel, now Lord, Barnett. Increments are calculated by totalling any changes in uk Parliament spending decisions on programs in England which are comparable to programs dealt with through Scotland-specific spending (that is, those that now fall under the responsibility of the Scottish Parliament), and applying a population factor. Scotland currently has 10.08 per cent of the population of England, so the Scottish Parliament gets 10.08 per cent of any changes (up or down) in spending on comparable programs in England. Any one year’s change is added to or, as has been the case since 2011–2012, subtracted from the baseline taken forward into the next year, which then becomes the new baseline subject to further incremental change. In 2007–2008 the combination of baseline and increment allocated almost £27 billion to the Scottish Parliament. A further £4 billion was generated by local taxation decisions (on residential and business property) that fall under the responsibility of the Scottish Parliament. In addition, the Scottish Parliament has at its disposal the so-called “tartan tax,” the possibility of varying



Fiscal Autonomy in Scotland 47

uk standard rate personal income tax by ±3 per cent. Though strongly endorsed in the 1997 referendum that led to the establishment of the Scottish Parliament, no Scottish government has yet used its tartan tax powers. Its probable yield would have been a maximum of around £1 billion in 2009 (csd 2009). There are no equivalents to the tartan tax in Wales and Northern Ireland. The result is (also in the absence hitherto of significant borrowing powers) that the great bulk of the revenue available to the Scottish Parliament are allocated to it by the uk government and are not the consequence of devolved decision-making. The uk government does not attach strings to this allocation. The Scottish Parliament has almost complete spending discretion (the only significant exception being “additionality” contributions to European Union structural funding programs which are hypothecated within the uk government grant to particular spending purposes). This almost complete spending discretion has an additional nuance. For historical reasons (mainly a perceived need to counter the growth of Scottish nationalism), the baseline grant in Scotland supports per capita public spending in Scotland that is higher than per capita spending in England. In 2007–2008, per capita spending in Scotland was at 118 per cent of the uk average. Wales and Northern Ireland also had spending premiums (at 111 and 122 per cent respectively). England’s per capita spending by contrast was at 97 per cent of the uk average. This territorial pattern of public spending does not reflect differential spending needs in any direct way, beyond population weighting. Official uk Treasury needs assessments in both 1979 and 1993 suggested that Scotland received funding substantially higher than its “needs” suggested. More recent attempts to assess relative need across the uk concur (Independent Commission on Funding and Finance for Wales 2009a; House of Lords 2009). Scotland (and Northern Ireland) appears consistently to have been overfunded relative to need, and Wales, at least according to the more recent assessments, appears to be underfunded relative to need.

48 Charlie Jeffery

Territorial Finance Challenged It is not surprising that this system of territorial finance is under challenge. The mix of (large) uk grants and unfettered devolved spending does not produce clear lines of accountability to the taxpayer. And the absence of a clear relationship between needs and spending levels appears questionable on fairness grounds. Though these issues have long been subject of scholarly debate (e.g., Bell and Christie 2001; Heald 2002), they were for a long time ignored in political debate. This was in part a matter of inertia: the Barnett arrangements were a proven mechanism. And, in part, it was a matter of expediency. Maintaining Barnett was easier than opening up a potentially divisive discussion among putative winners and losers about the territorial distribution of funding. However, three factors had emerged by the late 2000s which in different ways challenged the status quo. The first was the gradual accumulation of territorial policy differences, especially in Scotland, that appeared to deliver more generous public services to Scots as compared to the English (for example, state-funded long-term care for the elderly, free university tuition, the phased abolition of medical prescription charging). In English political debate (both Conservative and Labour) the apparent connection between higher per capita funding in Scotland and more generous public policies was becoming increasingly controversial. Second, the election of a secessionist Scottish National Party minority government in Scotland in 2007 and its re-election with an unprecedented single party majority in 2011 added additional spice to sensitivities over the territorial distribution of funding. And third, the emerging financial crisis at the turn of the decade raised new questions about the sustainability and fairness of the Barnett arrangements. What is striking is how the challenges that have emerged as a result of this combination of issues have been partial and territory-specific rather than focused on the system as a whole. Two uk parliamentary enquiries have recommended the introduction of a uk-wide system of needs-based fiscal equalization, including a House of Lords special committee formed at the



Fiscal Autonomy in Scotland 49

behest of Lord Barnett (House of Commons 2009; House of Lords 2009). Nonetheless, it is debatable that these had a genuinely pan-uk vision. Though not expressed directly, their recommendations were addressed primarily at heading off English resentments about higher per capita spending outside England and especially in Scotland. “Fairness” has also been the issue in Wales. A Commission on Funding and Finance in Wales established in 2008 focused on the relative underfunding of the National Assembly in relation to the level of need in Wales. The commission estimated that Wales requires a spending premium of 114 per cent of the uk per capita average. The commission has suggested both that this premium might be delivered through a systematic uk-wide approach to needs assessment, with consequent adjustments (downward) for Scotland and Northern Ireland (Independent Commission on Funding and Finance for Wales 2009b), and that it might be delivered through a simpler, Wales-only solution; for every £1 of spending by the uk government in fields equivalent to those devolved to the National Assembly, Wales should no longer receive a population share, but rather a needs weighting of £1.14 (Independent Commission on Funding and Finance for Wales 2009a). The Labour minority government elected in Wales in 2011 appears set to pursue the debate about “fair funding.” Meanwhile the uk government has promised to establish a new Welsh funding commission, modelled on the earlier Scottish Calman Commission (see below), though by October 2011 neither the remit nor the timing of the Welsh commission were clear. The devolution finance debate has been muted in Northern Ireland, though there continue to be ad hoc adjustments to Northern Ireland-specific spending that emerge as sidepayments to help overcome the periodic disputes between the Irish-nationalist and British-unionist parties in the Northern Ireland Assembly. There has been a (rather low-key) debate on devolving decision-making on corporation tax to the assembly to enable it to compete with the lower corporation tax rate levied across its land border with the Republic of Ireland. The

50 Charlie Jeffery

Conservative-Liberal Democrat government elected in 2010 has agreed to consider Northern Irish corporation tax devolution.

Fiscal Autonomy in Scotland The debate in Scotland has been anything but muted and very different. Its focus has been not on relative need or extracting side payments, but rather on fiscal autonomy. There have been two variants of this debate. One has focused on fiscal autonomy as a means of rendering the spending decisions of the Scottish Parliament more accountable; the other has been about maximizing the powers of the Parliament en route to full Scottish independence. Fiscal Autonomy and Accountability The accountability argument has been the preserve of the main unionist parties in Scotland – Labour, the Conservatives, and the Liberal Democrats. It was a central theme in a special commission on devolution finance established by the Liberal Democrats that reported in 2006 (Steel Commission 2006). Voices close to the Conservatives in Scotland have argued for a substantial level of own resources for the Parliament, through assigned revenues from uk taxes and additional tax powers (Reform Scotland 2008), and greater fiscal autonomy has been a key feature in the campaign of Murdo Fraser, one of the candidates for the leadership of the Conservative Party in Scotland, in that party’s leadership contest in autumn 2011. Similarly, key figures in the Labour Party in Scotland – notably its former leader Wendy Alexander – have pushed in a similar direction. The motives have varied. The Liberal Democrats’ Steel Commission highlighted the potential for taxation powers as levers for economic management and for changing environmental behaviour (Steel Commission 2006). Alexander (2007) noted the potential for a larger measure of fiscal autonomy in Scotland to help head off English resentment about Scottish public spending – which could cause a reduction in the Scottish block grant. On the whole, the central theme has



Fiscal Autonomy in Scotland 51

been the fiscal disciplining of what Alexander called the “pocket money parliament,” funded generously and without strings by an indulgent “parent” at Westminster. There has been considerable discussion about the comparative softness of budget constraints in Scotland since devolution. Until recently there has been a period of strong growth in uk public spending and, through the Barnett formula, the funding available to the Scottish Parliament. On that basis, the Scottish Parliament has been able to introduce a number of high-cost policies not replicated elsewhere in the uk – such as publicly funded long-term care for the elderly and the abolition of all university tuition fees for Scottish-domiciled students. In other areas, some policies have been interpreted as corporatist deals (e.g., boosting teachers’ pay above the level received by teachers in England, though without an obvious linkage to measures of improved performance) or as benefits of the “pork barrel” (e.g., the funding and improvement of transport links in particular parts of Scotland). Some significant level of decision-making responsibility for raising the revenues that support spending would harden the budget constraint by creating a direct accountability to the taxpayer-voter in Scotland. That, in theory, would impose stricter discipline on spending, and even – especially in Conservative thinking – limit the size of the state in Scotland. This argument about fiscal accountability and discipline has been put more strongly by unionist voices, especially in the Labour Party, since 2007, when the Scottish National Party (snp) replaced Labour in government. One outcome was the Commission on Scottish Devolution, established in April 2008, inter alia, to “improve the financial accountability of the Scottish Parliament” while continuing to “secure the position of Scotland within the United Kingdom” (csd 2009). The commission’s recommendations are discussed below. Fiscal Autonomy En Route to Independence The other strand in Scotland’s fiscal autonomy debate is associated primarily with the snp. Its core belief is that Scotland

52 Charlie Jeffery

is a national community with distinctive interests, identity, and needs and, for these reasons, should have self-government, including decision-making on taxation and borrowing. There are both gradualist and maximalist variants of this belief. Those variants are reflected in a debate on the definition of “full” fiscal autonomy either as something conceivable within the uk, or as a defining feature of an independent Scotland. This nationalist strand to the fiscal autonomy debate has also developed rapidly in the period since the snp came into government in 2007. On the way it has received support from some academic economists, although on economic rather than political grounds (Hallward and MacDonald 2009). The nationalist strand is discussed below.

The Commission on Scottish Devolution The Commission on Scottish Devolution (csd), chaired by Sir Kenneth Calman, was set up by a decision of the Scottish Parliament (with the support of Labour, the Conservatives, and the Liberal Democrats and against the opposition of the snp) and supported by the Labour uk government and the Conservatives and Liberal Democrats at Westminster. This unusual cross-party and cross-border body sat from April 2008 and reported in June 2009 (csd 2009). Its recommendations fell in three main areas: 1 a number of minor adjustments to the Scottish Parliament’s policy responsibilities; 2 a strengthening of the institutional relations between the Scottish and uk governments; and 3 a significant extension of the Scottish Parliament’s fiscal autonomy. Its recommendations were by far the most radical in the latter area. They proposed full devolution of tax powers in a number of fields with modest tax yields: aggregates levy, landfill tax, air passenger duty, and stamp duty land tax.



Fiscal Autonomy in Scotland 53

Table 1 Recommendations of the Commission on Scottish Devolution Estimated tax receipts in Scotland (2006-07) from the recommendations on

£ million

Income tax Aggregates levy Landfill tax Stamp duty land tax Air passenger duty Local business taxes (non-domestic rates) Local property tax (Council Tax) Total devolved tax revenues % Total devolved budget

4,650    50    75   555    94 1,884 1,812 9,120    35%

Source : csd (2009).

More significant was the csd’s recommendation on income tax. The csd held the view that the tartan tax had never been used because there was no penalty for not using it; the Scottish Parliament’s block grant remained at the same level in the absence of an active tartan tax decision. The csd instead proposed that Parliament should be required to take a tax decision. The mechanism it proposed was one recommended to it by the Canadian public finance specialist François Vaillancourt (csd 2009), which was to set a “default” rate of income tax in Scotland at ten percentage points less than in the rest of the uk (with the reduction applying at all income tax bands, currently 20, 40, and 50 per cent). The block grant would be commensurately reduced. It would then be a decision for the Scottish Parliament whether to replicate the uk rate or set income tax below or above it. This decision would be subject to considerable public debate and would therefore require the Parliament actively to account for that decision. The commission did not recommend any scope for progressivity (or regressivity) across the three tax bands; the Scottish Parliament could decide to levy tax, for example, at 18, 38, and 48 per cent, but not at 15, 40, and 55 per cent. Together with existing powers on local taxation, the csd estimated that these changes would leave the Parliament ­responsible for raising around 35 per cent of its expenditures (see table 1),

54 Charlie Jeffery

around two-and-a-half times the current level. Finally, the csd recommended a modest extension of the scope for the Parliament to borrow, both to even out short-term revenue fluctuations and to enhance its capital budget through additional borrowing facilities with the uk Treasury (csd 2009). The csd’s recommendations on finance were almost all endorsed in a uk Government White Paper published in November 2009 (Scotland Office 2009). The only exception was the removal of air passenger duty from the list of devolved tax powers. Its recommendations were also supported by the Liberal Democrats, though what it proposed was nearer to the minimum acceptable to them (and rather less than the Steel Commission had proposed in 2006). The Conservatives at Westminster were broadly supportive but unwilling to endorse the recommendations on finance, though they did commit to revisiting the issue were they to win the UK election in 2010. In the end, following the formation of a Conservative-Liberal Democrat coalition following that election in May 2010, a Scotland Bill2 was introduced to the uk Parliament in November 2010 (and considered also by the Scottish Parliament both before and after the Scottish election in May 2011). This bill took forward most of the White Paper’s recommendations, including the main provisions on income tax (though now with the aggregates levy removed from the list of Scottish taxes, and the level of borrowing available through the uk Treasury extended beyond that foreseen either by the Calman Commission or in the White Paper). The bill is expected to be enacted late in 2011.

The National Conversation The snp’s policies on the constitutional status of Scotland in general, and its fiscal arrangements in particular, continue to evolve. Shortly after taking office in 2007 the snp published a White Paper, Choosing Scotland’s Future (Scottish Executive 2007). This set out two broad options – more devolution within the uk or Scottish independence – and launched a consultation process, the “National Conversation” to explore views on those



Fiscal Autonomy in Scotland 55

options. The 2007 White Paper said relatively little about fiscal autonomy, though it did later produce papers on both borrowing powers and fiscal autonomy as part of the National Conversation (also submitting these as evidence to the csd) (Scottish Government 2009a; 2009b). These papers reflected a more general nuancing of the Scottish government’s position, which dismissed others’ approaches to expanded devolution – such as the csd’s thinking – as insufficient. Instead, the Scottish government developed a terminology of “devolution-max” as a feasible and desirable option, alongside its goal of independence. This maximalist position was also reflected in its positions on fiscal autonomy, which went significantly further than the csd. For example, its paper on borrowing argued for scope to borrow for purposes of counter-cyclical economic management, not just to even out revenue fluctuations and enhance capital spending, and to borrow on the capital markets rather than accessing (and requiring the approval of) the uk Treasury (Scottish Government 2009b). Similarly, the National Conversation paper on Fiscal Autonomy for Scotland, while insisting that independence is the preferred option, also makes a case “short of independence” for the advantages of “devolution max.” “Devolution max” would make the Scottish Parliament “responsible for raising, collecting and administering all (or the vast majority of) revenues in Scotland and the vast majority of spending for Scotland” (Scottish Government 2009a). Any uk government services delivered in Scotland would be compensated by a payment from Edinburgh to London. The model is broadly that of the Basque Country, and the paper recognizes – as in the Basque Country – that fiscal autonomy “max” would be hedged by eu rules, agreements on a “degree of harmonization” reached with the uk government, and the wide role of the uk government in regulating the uk economy. The option of devolution max – now re-branded as “full devolution” – was taken forward in the Scottish government White Paper Your Scotland, Your Voice published in 2009 (a few days after the uk government’s White Paper on the csd recommen-

56 Charlie Jeffery

dations). The White Paper (Scottish Government 2009c) also set out the intention to propose a bill to the Scottish Parliament to hold a referendum on a number of constitutional options, including the status quo, independence, and “full devolution.” In the end, that bill was not introduced to the Parliament as planned, since the snp recognized it could not pass that bill given its minority status. When it unexpectedly won an absolute majority in the 2011 Scottish election, the snp reiterated its intention to hold a referendum, but not until the second half of the parliamentary term, in 2014 or 2015. Emboldened by its majority, the snp also pushed for changes to the Scotland Bill, including the devolution of corporation tax (taking the Northern Irish debate as a lever for extracting corporation tax devolution in Scotland) and excise duty (on alcohol and tobacco sales), greater borrowing powers, and devolution of control of revenues from the Crown Estate (lands held by the sovereign). It has also criticized the Calman proposals on income tax, seeing these as too narrow a tax base for the Parliament with too little clarity about how the reduction in the Scottish block grant would be calculated. Excursus: Energy and Autonomy The snp’s commitment to fiscal autonomy requires further comment. It might at first seem a significant risk to move away from a situation where Scotland is resourced by the uk taxpayer to spend 115 per cent of the uk average to one of extensive or full reliance on resources generated in Scotland. That risk is mitigated by Scotland’s energy resources. Exceptionally within the uk, the Scottish government produces annual estimates of both expenditures and revenues in Scotland (including spending by both the uk and Scottish governments in Scotland and all revenues territorially attributable to Scotland). Though necessarily estimates – no data are collected on territorial revenues, and in some fields there are no precise data on spending by territory – these figures are generally regarded as credible. These estimates now include revenues from North Sea oil and gas extrac-



Fiscal Autonomy in Scotland 57

Table 2 Government expenditures and revenues in Scotland Current budget balance Excluding North Sea revenue Including North Sea revenue

2003–04 %gdp

2004–05 %gdp

2005–06 %gdp

2006–07 %gdp

2007–08 %gdp

–7.9

–7.1

–6.8

–6.1

–6.3

–3.5

–2.3

 0.8

0.9

0.2

Source : Scottish Government (2009d).

tion, most of which is extracted from Scottish waters, and none of which is currently attributed to Scotland. Table 2 shows that excluding oil and gas revenues Scotland has a persistent and large current account public sector deficit. However, if oil and gas is included, the deficit is much reduced. If oil and gas prices were as high as they were in the mid-2000s, the deficit would be eliminated altogether. Clearly, this is a temporary situation. “Peak oil” in the North Sea has been reached and revenues can be predicted to decline in the coming decades. On the other hand, Scotland – by virtue of its physical environment – is set to become a major producer of renewable energy from wind, wave, and tidal sources. The snp’s interest in controlling revenues from the Crown Estate – which includes almost all the Scottish foreshore – is significant in this context, as are the very ambitious targets and incentives on renewable energy production it has set. It is, in other words, likely that energy revenues generated in Scotland will remain high, even as oil holdings diminish, limiting the risk of a move away from a uk block grant toward a reliance on own resources.

What Happens Next? The timing and scope of any move in Scotland toward greater fiscal autonomy remains unclear. The uk government appears committed to the Scotland Bill more or less in the form­

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presented to the uk Parliament in November 2010. The Scottish government clearly sees the Scotland Bill as insufficient, though it may in the end decide to “bank” the additional fiscal powers proposed while continuing to work toward greater fiscal autonomy. Amid this political uncertainty, though, some of the parameters surrounding future developments are quite clear. In particular, there now exists, across the political spectrum, agreement that there should be some degree of additional fiscal autonomy in Scotland. The csd established a benchmark, which is likely to be the starting point for future thinking among the unionist parties. The motivation for advocating fiscal autonomy (and the scope of autonomy envisaged) is very different from that of the snp, but the direction of change, away from the status quo, is clear. Moreover, what the debates on territorial financial arrangements around the uk have shown is that for each region the fiscal contingencies are self-contained and territory-specific. The Welsh focus on need, Northern Ireland’s focus on side-­payments and corporation tax competition, and the Scottish debate on fiscal autonomy are each responses to particular territorial circumstances and do not appear easily amenable to a uk-wide approach to reform. It is likely that new forms of asymmetry will continue to be introduced on a case by case basis, through discrete sets of interactions between the different devolved governments and the uk, compounding the centrifugalist tendency that has been the defining feature of the first dozen years of devolution. notes 1 For a full explanation see http://www.niassembly.gov.uk/io/ summary/d%27hondt.htm. 2 The progress of the Scotland Bill can be followed at http://services. parliament.uk/bills/2010-11/scotland.html.



Fiscal Autonomy in Scotland 59

References Alexander, Wendy. 2007. A New Agenda for Scotland, speech given at the University of Edinburgh, Friday, 30 November 2007. http://www.wendyalexander.co.uk/wp-content/uploads/2008/11/ wendy-cc-speech-301107.pdf. Bell, D., and A. Christie. 2001. “Finance – The Barnett Formula: Nobody’s Child.” In The State of the Nations 2001: The Second Year of Devolution in the United Kingdom, edited by A. Trench, 135–52. Thorverton: Imprint Academic. csd (Commission on Scottish Devolution). 2009. Serving Scotland Better: Scotland and the United Kingdom in the 21st Century. Edinburgh: Commission on Scottish Devolution. Hallward, Paul, and Ronald MacDonald. 2009. The Political Economy of Financing Scottish Government. Cheltenham: Edward Elgar. Heald, D., ed. 2002. “Fiscal Autonomy under Devolution.” Special Issue of Scottish Affairs, no. 41: 5–26. House of Commons, Justice Committee. 2009. Devolution: A Decade On, HC 529–I. London: The Stationary Office. House of Lords, Select Committee on the Barnett Formula. 2009. The Barnett Formula, hl Paper 139, London: The Stationary Office. Independent Commission on Funding and Finance for Wales. 2009a. Working Paper: Replacing Barnett with a Needs-Based Formula. Cardiff: Independent Commission on Funding and Finance for Wales. – 2009b. Funding Devolved Government in Wales: Barnett and Beyond. Cardiff: Independent Commission on Funding and Finance for Wales. Reform Scotland. 2008. Fiscal Powers. Edinburgh: Reform Scotland. Scotland Office. 2009. Scotland’s Future in the United Kingdom, Cm 7738, London: The Stationery Office. Scottish Executive. 2007. Choosing Scotland’s Future. A National Conversation, Edinburgh: Scottish Executive. Scottish Government. 2009a. Fiscal Autonomy in Scotland. The Case for Change and Options for Reform. Edinburgh: The Scottish Government.

60 Charlie Jeffery – 2009b. Borrowing Powers. Information to be Shared with the Calman Commission. Edinburgh: The Scottish Government. – 2009c. Your Scotland, Your Voice. A National Conversation. Edinburgh: The Scottish Government. – 2009d. Government Expenditure and Revenue in Scotland 2007-2008. Edinburgh: The Scottish Government. Steel Commission. 2006. Moving to Federalism. A New Settlement for Scotland. Edinburgh: Scottish Liberal Democrats. Tonge, J. 2005. The New Northern Irish Politics? Basingstoke: Palgrave Macmillan.

3 Asymmetrical Federalism: The Case of Belgium Magali Verdonck Introduction In spite of pressing demands from the Flemish Region, Belgian reforms aimed at increasing tax autonomy are systematically postponed. The Brussels and the Walloon regions are mainly responsible for blocking this reform, and their reluctance finds its origin in six factors described in this paper: 1 2 3 4 5 6

the history of the country, the specific geographical context, the institutional structure of the country, the underfinancing of the Brussels-Capital Region, the risks of a race to the bottom in tax rates, and the belief that existing fiscal or non-fiscal means are available to reach a sufficient degree of political autonomy.

In order to place these factors in context, the next section outlines the main characteristics of Belgium’s fiscal structure.

The Evolution of Tax Autonomy in Belgium Belgium is characterized by two sets of constituent units: the regions and the communities. The federation is divided into three regions – Flemish, Walloon, and Brussels-Capital – for

62 Magali Verdonck

decentralized tasks linked to territory (housing, transportation, agriculture, city planning, etc.) and three communities – Flemish, French, and German-speaking – for decentralized tasks linked to people (education, health care, etc.). The responsibilities of these subnational units are implemented over clearly identified and overlapping territories.1 In particular, the Flemish and French communities both have responsibilities within the territory of the Brussels Region. The communities are financed exclusively through federal grants and enjoy no tax autonomy. An increase in the communities’ tax autonomy is not an option since the inhabitants of the Brussels Region do not have a subnationality that would indicate to which community they would pay the community tax. The regions, on the contrary, enjoy significant tax powers. In 2006, regional taxes financed about 35 per cent of the Walloon budget, 43 per cent of the Flemish regional budget, and 53 per cent of the Brussels-Capital budget. Federal grants completed the regional budgets. The present degree of tax autonomy has been reached in two steps, a first in 1990 and a second in 2002 (table 1). Today, the remaining purely federal taxes are the corporate tax, the value added tax, customs tariffs and excises, and various registration duties mainly related to federal responsibilities. The personal income tax is federal, but a positive or negative piggyback tax can be used by the regions. The Flemish Region has exercised this option through a lump-sum reduction of 125 € in 2008 for taxpayers with incomes below 22 250 €, of 200 € in 2009 for taxpayers with incomes below 23 000 €, and of 200 € (in 2010) for all taxpayers. In order to avoid the harmful impact that a region would sustain should unhealthy tax competition arise, various measures have been put forward. For the pit piggy-back tax, regional autonomy margins are set such that the sum of regional tax reductions or increases does not exceed 6.75 per cent of the federal pit revenue raised in each region. Furthermore, the regions are not authorized to reduce the tax’s progressivity.

Table 1 The evolution of regional tax autonomy in Belgium 1990–2010 Type of tax

Before 1990

Level of responsibility

Federal

1990–2001 Regional

Tax on gambling and betting Tax on automatic amusement machines Tax on drinking establishments Inheritance tax Real estate tax Registration fees on property transfer for payment

I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E

I, B, R, E I, B, R, E I, B, R, E I, R, E I, R, E 41,5% of I

Piggy-back tax on the federal personal income tax (pit) Duties on gifts Mortgage registration fees Road fund tax on automobiles Vehicle registration fees Eurovignette Radio-tv fee Personal income tax Corporate tax Value added tax Customs tariffs and excises Various other registration duties

I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E

I, R*, E*

I = tax income, B = base, R = rate, E = exemptions * Tax autonomy is limited

Federal

B B 58,6% of I, B, R, E B I, B, R, E I, B, R, E I, B*, R*, E* I, B*, R*, E* I, B*, R*, E* I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E

From 2002 Regional

Federal

I, B, R, E I, B, R, E I, B, R, E I, B*, R, E I, B, R, E I, B, R, E I, R*, E* I, B*, R, E I, B, R, E I, B*, R*, E* I, B*, R*, E* I, B*, R*, E* I, B, R, E

B

I, B, R, E I, B, R, E I, B, R, E I, B, R, E I, B, R, E

64 Magali Verdonck

Inheritance taxes and duties on gifts rely on fairly mobile tax bases and the amounts in question are quite substantial. In order to limit the competition that could arise in order to attract these substantial amounts, constraints have been introduced on the definition of the criterion of location. The region that benefits from inheritance taxes (and duties on gifts) is the one in which the deceased person (the donor) is legally registered and, if the deceased person (the donor) lived in several places during the five years preceding the death (or gift), the region in which the individual was legally registered for the longest time during this period will benefit from the tax. For the road fund tax on automobiles, vehicle registration fees, and the Eurovignette (road tax for trucks), the regions are obliged to conclude a co-operation agreement covering the cases where the tax is paid by a corporation, an autonomous government-owned enterprise, or a non-profit association engaged in leasing activities. The co-operation agreement centres on the definition of the tax base, the tax rates, and exemptions.

Resistance to Greater Tax Autonomy The History of the Country In order to understand the reluctance of French-speaking Belgians to allow greater tax autonomy to the regions, a historical perspective is required. The reason for the reluctance is essentially psychological, but cannot be ignored. Until 1963, gdp per capita was higher in the Walloon Region than in the Flemish Region. Since then, Flanders has outstripped Wallonia and the gap is ever increasing, as shown in graphs 1 and 2. Today, one can feel a subtle but real resistance to the idea that the Flemish Region, now one of the richest regions of Europe, might cut the regional ­solidarity link, since Wallonia supported Flanders when Walloon industry was booming. The historical perspective also explains the Flemish demands for increased autonomy. The Flemish population keeps an eye on historical trends as well, and has observed that since the



The Case of Belgium 65

Graph 1 Regional gdp per capita 1955–1997 (in thousand bef)

Source : Cassiers and Durré (2000).

Graph 2 Regional gdp per capita 1997–2008 (in euro)

Source : Institut des comptes nationaux and author.

i­ntroduction of a fiscal equalization mechanism in 1990, the need for fiscal equalization has steadily increased. Based on the distribution of income tax revenues per capita across the regions, the equalization transfers have been in favour of the Walloon Region since 1990 and of the Walloon and Brussels regions since 1997, partially at the cost of the Flemish Region (graph 3).

66 Magali Verdonck Graph 3 Regional income tax revenue per capita 1990–2005 (Belgian Average = 100)

Source  : Dussart 2007.

This ­situation has been translated by some Flemish politicians into the slogan “a Flemish household annually finances the equivalent of a new car for each Walloon household.” The observed financial disparities have led to repeated criticisms of French-speaking decision makers by their Flemish counterparts. The former are irritated by these attacks and regret that the Flemish view does not take into account objective financial constraints, especially with respect to the financial problems of the Brussels Region (see more on this issue below). Unfortunately, evidence of embezzlement and corruption at the local level in the Walloon Region has recently (in 2005 and 2006) provided additional ammunition to Flemish critics. The Size of the Country The status quo in regional tax autonomy in Belgium is also due to the relatively small size of the Belgian territory and of its capital region in particular. Table 2 compares the size of Belgium and its capital region with a range of other federations. The respective populations of the Flemish, Brussels, and Walloon regions are approximately of 6.5 million, 1 million, and



The Case of Belgium 67

Table 2 Relative size of a selection of federal countries and their capital states Federal country Belgium Germany Switzerland Spain Canada

Size of country (km2)

Size of capital state (km2)

30 528 357 046 41 285 504 782 9 984 670

161 891 5 958 8 030 1 076 395

Source : www.atlasgeo.net and cities’ web sites.

3.5 million. The Brussels Region is enclosed within the Flemish Region and distant by a few kilometres from the Walloon Region. The metropolitan area extends largely outside the Brussels Region’s borders. The Brussels Region population is less than half of the population of the metropolitan area, estimated at 2.9 million (Gayda 2009), and half of the people working in Brussels live in other regions (Lambert et al. 1999). This geographical situation leads to a potentially high degree of mobility for workers, inhabitants, and enterprises. The risks of a race to the bottom in tax rates seems, therefore, higher than in other federal countries. This geographical fact also engenders a high level of interdependency in economic activities and exacerbates the fears of inconsistency in economic and fiscal policies that might result from increased regional tax autonomy. The Institutional Structure of the Country An important institutional feature may also play a role in the stagnation of regional tax autonomy. The Flemish Region was absorbed by the Flemish Community2 in 1989 and this absorption or fusion has two consequences. First, while the level of tax autonomy is considered sufficient by the Brussels and Walloon regions, it seems quite low when expressed in percentage of own tax revenues in the merged Flemish budget (19.7 per cent) since the community side is

68 Magali Verdonck

completely financed through federal grants. Also, compared to decentralized units in other federal countries, the tax autonomy of the Flemish Region/Community is ­relatively low. The volatility of tax revenues, a source of concern for the two other regions, is less of a risk for the Flemish Region/Community. Second, the fusion enables the Flemish Region/Community to make financial transfers from the “community” side to the “region” side. And this is especially easy following the latest institutional reform in 2001. At that time, the French Community had significant financial needs, and the financing law covering the regions and communities was modified in order to help the French Community. The Flemish Community benefited proportionally from the increase in financial resources although it had no urgent need for it. The money could be equally for community responsibilities as for regional tasks. This could partly explain the better performance of the Flemish Region/Community – reflected in, for example, lower tax rates, higher educational performance (according to the pisa evaluation), and zero debt before the financial crisis. The asymmetry created by the Flemish institutional fusion explains why, on the one hand, the Flemish Region/Community is seeking greater tax autonomy and why, on the other hand, the two other regions fear increased competition with the betterendowed region. The Underfinancing of the Brussels Region The financial situation of the Brussels Region is characterized by relatively little tax revenue and relatively high costs of public services per inhabitant. The details of the following analysis are available in Verdonck et al. (2010). The Brussels-Capital Region accounts for 10 per cent of the Belgian population but nearly 19 per cent (Institut des Comptes Nationaux 2010) of national gdp. However, one result of the financing law and the allocation of taxes between regional and federal governments is that the economic activity in the Brussels Region produces comparatively little tax revenue for the region



The Case of Belgium 69

itself. The value added tax, the corporate tax, and the income tax are federal taxes. The main federal grant to the regions (the personal income tax grant) is proportional to the share of federal tax income revenues levied in the regions. But the personal income tax is residence-based, and half of the people working in Brussels reside in another region. Furthermore, by the terms of international treaties, many tax exemptions apply to international institutions and their employees. Being the capital of Europe, the Brussels Region houses many of these institutions. The loss of revenue resulting from these exemptions is only very partially compensated by the federal government. Another explanation for the relatively reduced financial means in the capital region, compared to other Belgian cities and other capital regions in the world, is the absence of financial equalization between its municipalities and the city-region’s hinterland. Such an equalization scheme is organized at the regional level in Belgium and Brussels’ region is composed mainly of poorer urban municipalities. On the expenditure side, the Brussels Region and its municipalities support the costs incurred by the economic and international activity taking place on their territory, without any contribution from the users who do not live in the region. Examples of these costs are public transport,3 roads, police, fire service, hospitals, and street-cleaning. Second, Brussels has lower-income inhabitants. The region has experienced an urban flight of the middle class during the last two decades. And as the capital and economic centre, it has attracted poor migrants. As a consequence, along with reduced income tax revenues, the cost of local social aid is relatively high. The proportion of inhabitants benefiting from social aid is nearly twice as high in Brussels as in the other large Belgian cities (Verdonck et al. 2010, 44). Finally, the Capital Region faces higher per capita public costs compared to other regions because of its bilingual status and its smaller resident population (but the obligation to serve a much larger commuting population). This small size causes higher

70 Magali Verdonck

costs per capita because fixed costs resulting from the political structure (a parliament and a regional administration) need to be shared by a smaller population. Note that in Germany the existence of such a financial handicap is taken into account and leads to special grants to the “little Länder,” but the Brussels Region does not benefit from such a system. The loss of revenues and the overexpenditures described above lead to a financial need of 720 million euros (Verdonck et al. 2010). This figure is to be compared to the size of the regional budget: 2.5 billion euros. Given this situation, if higher tax autonomy were allocated to the regional level, Brussels would not be on a level playing field with the other regions and the advantages of tax autonomy would be cancelled out by the costs of tax competition. The ongoing urban flight of the middle class would probably be exacerbated as would its impact on the decrease in tax revenues, increase in public expenditures, and increase in Brussels’ unemployment rate, already three times higher than in the Flemish Region and nearly twice as high as in the Walloon Region.4 Note that the Flemish Region proposes5 to cover a part of the needs of the Brussels Region in exchange for some power over Brussels’ public management. The Brussels Region is opposed to such a solution since its needs are essentially exogenous and not the result of ­inefficient management. Furthermore, between 1980 and 1989,6 the capital has been unofficially, but in effect, co-managed by the Flemish and the Walloon regions and experience has shown that their investments have tended to be in favour of commuters (larger roads for instance) rather than the inhabitants. The Risks of a Race to the Bottom in Tax Rates Regional tax changes since 2002 have been analysed by ­Verdonck (2009) in order to assess the costs and benefits of tax autonomy in Belgium. Part of the analysis has focused on the presence of a race to the bottom in tax rates. The conclusions are summarized here.



The Case of Belgium 71

G l o b a l A n a l y s i s   Some degree of race to the bottom is observed in the 2002–2009 period. This is especially the case for taxes on mobile tax bases (inheritance tax and duties on gifts) and taxes on immobile tax bases but paid by companies (real estate tax). No reduction of intraregional redistribution has been observed, however. This suggests that the regions have not adopted an aggressive tax competition strategy. The existing limits to tax autonomy seem to be efficient. R e g i o n a l A n a l y s i s  The Flemish Region is often the firstmover. It never needs to compensate a reduction in tax burden by an increase in tax rates elsewhere, and it can apply exemptions to large categories of taxpayers while the two other regions, when they mimic Flemish tax rules, must limit the budgetary impact by introducing conditions to exemptions or reductions. The Brussels Region is sometimes the first-mover and, at times, goes farther in tax burden reduction, especially when the tax rule change is adopted in support of housing policy. The Walloon Region is also the first-mover in some cases and has adopted the most generous conditions for succession or gifts of businesses. The proactive and creative behaviour of the Flemish Region, contrasting with the largely defensive7 behaviour of the two other regions, reflects the Flemish Region’s strong budgetary situation, as well as a regional fiscal data base that Brussels and Wallonia do not possess. A n a l y s i s b y T a x  The inheritance tax and the duties on gifts are often used less to adapt fiscal policy to local conditions and preferences and more to achieve a partial or complete race to the bottom. This is not surprising since these taxes are not directly related to regional responsibilities. They have an essentially redistributive function and the economic literature recommends assigning this function to the central (or federal/ national) level of government. Duties on gifts have led to a full mimicking and race to the bottom, while the inheritance tax has led to partial mimicking.

72 Magali Verdonck

We attribute this difference to the fact that the same rules apply to both taxes in order to prevent harmful tax competition. However, because gifts are more foreseeable than death, these rules are less effective in the case of duties on gifts. No rule exists to prevent harmful tax competition with respect to the real estate tax, probably because the immobility of the tax base meant that politicians did not see this tax as problematic. However, we see that a phenomenon of race to the bottom may take place when the taxpayers are legal entities rather than individuals. The same is true for the registration fee on property transfer for payment. In this case, there is some measure of race to the bottom, even though the tax base is immobile. The experience of recent years shows that the risks of race to the bottom are not absent and that the main winner of the tax competition is the Flemish Region. Bearing in mind that the remaining federal taxes are the personal income tax, the corporate tax, and the value added tax, all having quite mobile tax bases (at least in their upper brackets), the Brussels and Walloon regions are far from enthusiastic about a future increase in tax autonomy. Two forms of tax competition can exist: the competition to attract tax bases, on the one hand, and “yardstick competition,” on the other; in the latter case tax bases do not necessarily move but decision makers could suffer because the comparison with neighbouring entities reveals potential inefficiencies in the management of public funds. Since the mobility of enterprises, inhabitants, and workers between Flanders and Wallonia is low, in part because of the language barrier, the risk of competition for tax bases could be quite limited between the two regions. The risk is, however, much higher between the bilingual Brussels Region and its hinterland (in the other regions). Yardstick competition could a priori enhance better public management in the different regions and especially in the Brussels Region, whose inhabitants more often cross the regional borders than do the inhabitants of Wallonia or F ­landers. ­However, for yardstick competition to have a positive effect on



The Case of Belgium 73

public management efficiency, there must be fair financing of the three regions, taking into account the existence of significant external factors related to the large number of interregional commuters. Whatever the motivation (tax base attraction or yardstick com­petition), any risk of a race to the bottom as a result of tax competition would be particularly dangerous in the present situation of Belgian public finances. The current financial crisis is putting Belgium’s fiscal sustainability to the test. Recent projections by the Federal Planning Bureau (Bureau Federal du Plan 2009, 104ff) estimate that by 2015, the budget balance of the aggregate public entities will be 5 per cent of gdp lower than the objective of equilibrium of the stability pact. Efforts to reach the equilibrium and to create the necessary surplus to cover the cost of an aging population are incompatible with tax competition that would have the effect of reducing the regions’ tax revenues. Of course, such a reduction in tax revenues could theoretically be compensated by a reduction in expenditures. However, if the latter were possible, it would be preferable to use the revenues saved to finance an aging fund and not to pay for a race to the bottom in tax rates.

The Availability of Existing Fiscal and Non-fiscal Means to Increase Tax Autonomy Table 1 shows that the remaining federal taxes are few. Among them, there are few candidates for further tax decentralization. The value added tax and the excises concern extremely mobile tax bases (at the small Belgian scale). Customs tariffs are determined at the European level. We therefore examine only the possibility of decentralizing the personal income tax and the corporate tax (Decoster, Valenduc, and Verdonck 2009). We do not go into detail on the various registration duties since they require extensive explanation and represent a very small share of tax revenues.

74 Magali Verdonck

Personal Income Tax Regarding the personal income tax (pit), a first option would be to increase the margins of regional autonomy through the pit piggy-back tax. However, the effective use of the existing margins since 1990 does not seem to indicate that these margins are too small; they have been used only very partially. A second option for larger regional tax autonomy as regards the pit would be to transfer the full responsibility to the regions, or to remove the restrictive conditions on the progressivity of the piggy-back tax rates. Such an option has been explicitly proposed by the Flemish parliament.8 In the absence of a horizontal equalization mechanism between regions,9 this would be contrary to the theoretical recommendation of a centralized redistribution policy and could lead to a race to the bottom in tax rates given that high-income taxpayers can be particularly mobile. This is especially true in the Brussels-Capital Region. A third option is to transfer the fiscal incentives related to regional responsibilities (pit, reduction for mortgage expenditures or energy saving investments, for instance). There is no major objection to this option because nothing justifies the sharing of fiscal responsibilities in these exclusively regional (or subnational) domains.10 Such a transfer could be the starting point for an evolution of regional tax autonomy. Corporate Income Tax A touchy issue in the current debate about increasing tax autonomy is the partial decentralization of the corporate income tax. The Flemish Parliament is asking for the option of allowing for regionally financed reductions in the federal corporate income tax11 in order to create incentives for employment and investment. Such a measure raises a major technical problem. A partial decentralization of the corporate income tax, with the location criteria based on the company’s headquarters, is much too dangerous in terms of tax competition. Even the



The Case of Belgium 75

a­ dvocates of such a measure recognize this fact (Haelterman 2007). For enterprises having multiregional activities, it is therefore necessary to split the tax base between operating units located in different regions. Such a distribution needs to be based on – preferably a combination of – criteria that cannot be easily manipulated. The best candidates are criteria such as fixed assets, turnover, or wages. A regional reduction in the federal corporate income tax would then be equivalent to a grant based on the criteria used for the interregional distribution of the tax base. As a consequence, if the tax base is shared on the basis of wages paid in the different regions, the regional reduction of the corporate income tax would have the effect of an employment grant. But the regions are already responsible for employment grants. If the tax base is shared on the basis of fixed assets, a reduction of the corporate income tax would have the effect of an investment aid. Again, it is the regions that are currently responsible for investment aids. One may then conclude that since a (partial) decentralization of the corporate income tax requires a split of the tax base using criteria such as fixed assets or personnel expenditures, it offers no effective new autonomy to the regions, while it intensifies the risks of tax competition because the visibility of tax differences would increase, as would administrative costs.

Conclusion This paper puts forward six factors to explain why regional tax autonomy in Belgium has not increased since 2001. Nearly all these factors prevailed before the 2001 institutional reform. Why, then, did tax autonomy increase at that time while it has not continued to increase today? First, in 2001 the French Community had urgent financial needs and was forced to accept some Flemish demands as part of a compromise. Today, that situation does not exist. At present, the Brussels-Capital Region is the most fragile decentralized entity from a fiscal point of view. However, a refinancing

76 Magali Verdonck

combined with higher regional tax autonomy is seen as counterproductive for Brussels. Second, the taxes that could be decentralized today are of a very different kind from those decentralized in 2001. The corporate tax and the personal income tax are annual taxes and are very visible. Differences in tax rates and tax regulations for corporate and income taxes would be more evident than those for regional taxes since the most important of the latter are paid only a few times in a lifetime (inheritance tax, registration fee on property transfer, duties on gifts). Moving to taxpayer-friendly regions becomes much more interesting when the taxpayers “experience” the difference yearly. Furthermore, enterprises are known to be more mobile than other tax bases. Third, in the wake of the global financial crisis and in anticipation of the first effects of a soon-to-retire baby-boom generation, the budgetary situation of Belgium, as a whole, is much more problematic in 2011 than it was in 2001.

Addendum We note that on 11 October 2011 an agreement was reached on the sixth institutional reform. It has yet to be adopted by the Parliament. One chapter of the text12 is dedicated to the increase in tax autonomy for the regions. The main idea is that the most important federal grant to the regions is withdrawn while the federal income tax is reduced by an equivalent amount, leaving tax room (about 25 per cent) for the regions that they can use through a piggy-back tax expressed as a percentage of the federal tax. Regions may differentiate tax rates across tax brackets, but their autonomy is limited in order to prevent tax competition. The progressivity of the federal income tax may not be reduced by the regional piggy-back tax except if the advantage of the reduction in progressivity does not exceed 1 000 euro per year and per taxpayer. Also, in order to put the regions on a more level playing field, the Brussels-Capital Region is granted an additional yearly financing of 461 million euro by 2015, the majority to be paid by



The Case of Belgium 77

the federal government and about 10 per cent by the neighbouring regions.

notes 1 Maps in appendix show the territories of these six units. 2 For the sake of clarity, we call this decentralized unit the “Flemish Region/Community.” 3 The fees paid by the users of public transport cover only one-third of operational costs. The remaining two-thirds, as well as all the investments costs, are supported by the Brussels Region only (États financiers, stib, 2009). 4 www.statbel.fgov.be 5 Voorstel van resolutie, Stuk 1340 (1998–1999) – Nr. 1, Vlaams parlement. 6 During those years, the Flemish and Walloon regions were already effectively created while the status of the Brussels Region still had to be fixed. In the meantime, the Capital Region was under the control of the central government, composed at 90 per cent of Flemish and Walloons representatives. 7 The defensive strategy is sometimes explicitly mentioned in the preambles of regional tax laws. 8 Voorstel van resolutie, Stuk 1340 (1998–1999) – Nr. 1, Vlaams parlement. 9 Such a mechanism is rejected by the Flemish Region/Community. 10 The analysis in Verdonck (2009) has shown that when intimately related to regional conditions and preferences, tax-mimicking was less present. 11 Voorstel van resolutie, Stuk 1340 (1998–1999) – Nr. 1, Vlaams parlement. 12 http://www.lachambre.be/kvvcr/pdf_sections/home/FRtexte%20 dirrupo.pdf.

References Bureau Federal du Plan. 2009. Perspectives économiques 2009–2014. Cassiers, I., and A. Durre. 2000. “Les tendances longues en graphiques.” Reflets et perspectives de la vie économique 39 (2000/01): 156.

78 Magali Verdonck Decoster, A., C. Valenduc, and M. Verdonck. 2009. “L’autonomie ­fiscale des régions en Belgique : évaluation et perspectives.” Bulletin de Documentation, 69ème année, no. 4, 4ème trimestre. Bruxelles : spf Finances. Dussart, L. 2007. “Dégradation de la ‘clé ipp’ pour la Wallonie: Tentative d’interprétation au regard de l’évolution et de la composition du revenu imposable à l’impôt des personnes physiques.” Discussion Papers, no. 0704. Institut Wallon de l’Évaluation, de la Prospective et de la Statistique. Gayda, S. 2009. Application du logiciel tranus au cas de Bruxelles. Bruxelles: Bureau d’études Stratec. Haelterman, A. 2007. Regionalisering van de venootschapsbelasting: haalbaarheid, compliance issues en eu aanvaardbaarheid. Ministerie van de Vlaamse Gemeenschap, Steunput Fiscaliteit en Begroting. Institut des Comptes Nationaux. 2008. Comptes régionaux 1997–2006. Banque Nationale de Belgique. Institut des Comptes Nationaux. 2010. Comptes régionaux 1999–2008. Banque Nationale de Belgique. Lambert, J.-P., H. Tulkens, et al. 1999. “Les modes alternatifs de financement de Bruxelles,” recherche réalisée pour le compte de M. Rufin grijp, Ministre de la Recherche scientifique de la Région de Bruxelles‑Capitale. Société des Transports Intercommunaux de Bruxelles (stib). 2009. États financiers. Verdonck, M. 2009. “Evaluating the decentralization of tax powers: Lessons from the Belgian Regions.” Unpublished paper. Verdonck, M., S. Ector, and M. Taymans. 2010. Étude pour un juste financement de la Région de Bruxelles-Capitale, recherche réalisée pour le compte de M. J.-L. Vanraes, Ministre des Finances et du Budget de la Région de Bruxelles‑Capitale.



The Case of Belgium 79

Appendix The Regions

The Communities

The Flemish Region

The Flemish Community

The Walloon Region

The French Community

The Brussels-Capital Region

The German-speaking Community

Source : http://www.belgium.be/fr/la_belgique/pouvoirs_publics/la_belgique_­ federale/Carte.

4 The Deadlock of Federalism in Germany: Assessing Recent Reforms Charles B. Blankart and Erik R. Fasten Introduction Federalism increases individual well-being (Frey and Stutzer 2000). Many scholars and, recently, politicians, have begun to appreciate the efficiency borne by decentralized local government tasks (Blankart 2007). Especially in Europe, but also in many other industrialized and developing countries, devolution tendencies have increased over the last decades. Responsibilities and tax-raising powers have been transferred from the central to the subnational governments in order, inter alia, to promote efficiency and transparency in the public sector. Remarkably, it is not only multi-tier systems that are subject to devolution. The same is true for centralized states, such as the uk, which has increased local fiscal autonomy. On average, oecd (Organization for Economic Co-operation and Development) countries increased their own local revenues by 8.1 from 21.9 per cent to 30.0 per cent of consolidated general government revenues (excluding social security) between 1970 and 2001. Since then, seventeen out of twenty-two countries have increased their degrees of decentralization (Stegarescu 2005). During the same period, local expenditures increased from 24.9 to 31.2 per cent of consolidated general government expenditures. However, not all countries have federal structures and



The Deadlock of Federalism in Germany 81

some federal states have tended to move responsibilities toward the central government level in recent decades. Hence, the question arises: how to design the institutional setting to deliver the optimal policy outcome? And why do some federal states not fully use the advantages of a federal system? We focus on the case of Germany. We explain, first, the historical developments that led to the status quo of intertwined federal structures within Germany and show the major problems resulting therefrom. Second, we present recent political attempts to reform the federal system, which were intended to clarify responsibilities between government levels and re-establish sound public finances. However, the clear aim of the reforms was diluted by the political process and only minor reforms were enacted. Aside from the reduction of the number of laws which require approval by both chambers of parliament, the Bundestag (lower house) and the Bundesrat (upper house), a debt brake on the federal as well as on the constituent unit (or Länder) level was enacted. Third, we sketch upcoming economic challenges and possible reform options, which could be implemented in the current institutional context, in order to establish a sustainable and flexible federal system. Finally, we draw our conclusions.

Historical Evolution of Federal Structures in Germany Federal structures have a long-standing tradition in Germany. During the Kaiserreich of 1871, the state was organized following the autonomy principle: a few tasks, such as military, railway, customs, post, and social security had been assigned to the Reich and all the rest remained with the states. On the revenue side, the Reich had legislative competence for excise taxes, and revenues were shared between the Reich and the states. Legislative and revenue responsibility for personal and corporate income taxes remained with the states

82 Blankart and Fasten Figure 1 Institutional Congruency vs. Incongruency in Germany

Source : Blankart (2011)

and the municipalities. Responsibilities were clear and public goods were provided depending on the needs of the people in the specific states. Sudden changes in local needs could be addressed almost instantly, which meant that politicians could be expected to “sensibly” spend tax payers’ money, and institutional congruency prevailed (Figure 1, left). In the aftermath of the First World War and the foundation of the Weimar Republic, the federal system changed significantly. Fiscal autonomy of states was no longer secured, institutional incongruency was introduced and a structure based on a system of vertical administration prevailed. Decisions on tax rates and tax bases were now taken at the federal level and revenues were shared among all three government tiers. States could not react flexibly by lowering or increasing tax revenues to account for state-specific phenomena but had to rely on federal decisions. The motives of tax payers, decision makers, and beneficiaries no longer coincided (Figure 1, right). This fiscal regime was terminated with the end of the Second World War. Three years of an occupation regime followed in Germany. First steps toward a new constitution were taken on



The Deadlock of Federalism in Germany 83

1 July 1948 when the Western allies asked the prime ministers of the Länder to prepare a draft of a new constitution. The prime ministers’ aim was to establish a decentralized government with fiscal autonomy for the Länder supplemented by a fiscal equalization scheme. A formal federal constitutional assembly, the Parliamentary Council, was convoked on 1 September 1948. Its task was to create a federal German state (in the West) in which power would be divided between the federation, the “Bund,” and the states – the “Länder.” As more “centralistically minded” politicians gained influence, the council soon put aside the draft elaborated by the prime ministers. Some politicians were eager to obtain mandates in the new federal government and hence tried to shift the maximum amount of political power toward that level. This process was supervised by the governors of Western allies who held veto power over the final draft of the constitution. The governors’ main objective was the dispersion of political power in order to mitigate the reappearance of a German central power. Therefore, they favoured a decentralized federal governmental system over a unitary state. Given these diverging views, it was easy to predict that the council and the allies would soon run into conflicts. The majority of the council wanted a powerful central government that could allocate assignments to subnational entities while maintaining a full range of responsibilities. The allies favoured a decentralized organizing system, where tasks would be assigned according to the subsidiarity principle, mainly from the Länder to the federation. In the final negotiations the members of the Parliamentary Council and the allies had to find a compromise and agreed on a system of concurrent legislation between the federation and the Länder. A system of mixed obligations and responsibilities was born (Blankart 2007). The legislative authority for personal and corporate income taxation was negotiated within the concurrent legislation. In principle, the Länder were in charge of these taxes, but the federal government could easily assume these responsibilities when the “similarity of living ­standards”

84 Blankart and Fasten

was in danger or the unity of the economic system had to be fostered. The collection of these taxes remained with the Länder, even though the tax revenues generated within a particular territory did not fully remain there. If a Land could not extract enough resources in its own territories, the Länder were mandated to set up a horizontal financial equalization scheme. The notion of co-operative federalism was emphasized. The financial reform of 1969 fostered mixed responsibilities between government levels. As a result, today the legislative responsibility for the tax system lies mostly with the federal level, but the Länder have to agree in the Bundesrat (upper house of parliament). The Länder still lack the fiscal autonomy to raise additional revenues or cut these taxes. On the expenditure side, various federal laws assign tasks to the Länder governments which need to be executed independent of the available fiscal space in the Länder. In practice, Länder are able to increase their room to manoeuver only by running budget deficits and in turn piling up public debt. In theory, when there are political failures to promote fiscal discipline, federal systems can be expected to have higher debt levels than unitary states, since all influences lead to an increasing budget. These influences include “fiscal illusion” on the part of politicians (Buchanan and Wagner 1977), political business cycles (Nordhaus 1975), and fragmented governments (Alesina and Drazen 1991). Decentralized countries are therefore particularly susceptible to overspending. Subnational governments are likely to put their own interests and those of their constituents before those of the larger entity; hence a common “pool problem” arises (Rodden 2006). Additionally, a co-operation problem might evolve, which refers to the game played by the multiple subnational and national political actors (Braun and Tommasi 2004). If spillovers between jurisdictions are not internalized, local governments might seek a free ride at the expense of other jurisdictions ­(Musgrave 1959). Moreover, redistribution of income and macroeconomic stabilization polices might be hindered, since coordination is required.



The Deadlock of Federalism in Germany 85

If subnational governments are not solely responsible for their debt and therefore do not face hard budget constraints, the accumulation of debt increases ceteris paribus in federal rather than in unitary states.1 Thus, on the one hand, formal policy coordination and an institutional design that defines interactions between state levels in a multi-tier federal country are the main factors affecting politicians’ willingness to accumulate debt and expectations about the hardness of budget constraints (Rodden 2004). On the other hand, a well-designed federal system based on institutional congruency and self-responsibility could work properly and foster economic efficiency, equity, and economic growth. It is true that the German constitution contains a budget constraint, but it is also perceived as being too soft. The “golden rule” allows federal and state deficit spending up to the amount of public investment spending.2 In addition, the constitutional budget principles, enacted in 1969, require German federal and state budgets to be in line with the requirements of macroeconomic conditions – such as stable prices, high levels of employment, steady state external balances, and sound economic growth. As one consequence of the institutional design, federal and state public debt levels have increased steadily since the 1970s (Chart 1). That the debt of municipalities, in contrast, remained rather low should not be taken too literally since the municipalities rely heavily on off-budget and short-term cash credits that are not counted in the official figures. An additional structural push on federal and state public debt was exerted by German reunification in 1990, when “blooming and prospering landscapes” were promised, to be created by public expenditures in eastern Germany. Since the German Länder lacked the revenue sources to sustain their spending goals, predictably, their situation became increasingly unsustainable. The first two candidates for financial rescue were the Länder Bremen and Saarland. They became practically insolvent in 1992. In order to overcome their fiscal distress and to survive, they sued the federal government in a

86 Blankart and Fasten Chart 1 Debt levels of government levels in Germany 1970–2008 (in billion€)

Source : Destatis 2009

Note: Before 1991 debt levels are only for West Germany.

constitutional trial to obtain additional funds. The court in 1992 decided that the federation had to bail out the Länder and consequently both Länder received substantial federal assistance funds. But since no structural reforms were enacted, the fiscal positions of the two Länder did not substantially improve. What was thought to be a short-term assistance measure became a long-term structural subsidy for the regions, and the politicians in the respective Länder did not make any attempts to reduce the expenditure ratios to enhance their fiscal positions.

Recent Attempts at Federal Reform The need to change relationships within the German federal system became obvious over the last decades, especially after the Land of Berlin followed Bremen and Saarland and sued the federation to provide bailout measures.



The Deadlock of Federalism in Germany 87

This time, in 2006, the court decided differently. First, it ruled that Berlin’s fiscal capacity was still sufficient to provide required public services and that additional federal funds would be available only as last resort. Second, the court concluded that revisions of the federal system were required in order to prevent the Länder from experiencing repeated financial crises and therefore shifted the problem back to the political level. In addition to national discussions on debt sustainability, the provisions of the Stability and Growth Pact, adopted in 1997 at the European level, dominated German public spending discussions in the subsequent years; it was stricter than the national constitutional golden rule, although the pact itself could not prevent substantial deficits in some eu countries and was relaxed in 2005 under pressure from France and Germany, which were running “excessive deficits” during that time. In addition, the council of ministers did not apply sanctions and therefore the pact could not be perceived as a hard budget constraint. As a result, the reform deadlock between the two chambers of parliament, and the increasing debt levels, led to a consensus among politicians from different parties that constitutional amendments were required. A two-stage procedure was followed. The first stage (Föderalismusreform I) was enacted under the “grand coalition” (Christian Democrat/Social Democrat). It focused mainly on an efficient allocation of powers to both chambers. The second stage (Föderalismusreform II) was intended to concentrate on the sustainability of public deficits and the potential autonomy of the different orders of government. Federalism Reform I In October 2003 an initiative to reform the federal legislative procedure was launched. The deadlock between parliament’s two chambers would have to be broken in order to increase the federal system’s ability to act. In December 2004, the negotiations failed. There was no consensus among political parties or among representatives of the two chambers. One year later, in

88 Blankart and Fasten

March 2005, the negotiations were revived. In June 2006 the Bundestag agreed on a reform proposal and in July of that year the Bundesrat also agreed. Focal points of the reform were the realignment of powers between the federation and the Länder. The proportion of legislation which required the approval of both chambers was significantly reduced from about 60 per cent to about 35 to 40 per cent. Nevertheless, since no individual taxation powers on substantial taxes (either on the tax base or on the tax rate) were transferred to the Länder, the deadlock could not be fully broken. The Länder, however, gained exclusive legislative rights in specific policy areas such as the penal system, the press, assembly rights, and shop closing times. Furthermore, the Länder gained the power to determine the working conditions and the remuneration of their civil servants and to set property acquisition taxes. In return, the federation received exclusive powers in the fight against terrorism and a reduction in the number of laws that need to be approved by the Bundesrat. Moreover, there was a determination on the distribution of costs arising from sanctions resulting from noncompliance with the European Stability and Growth Pact. The federation has to pay 65 per cent, while the Länder share the remaining 35 per cent.3 The distribution of costs is thereby independent of the actions that brought about the sanctions. In summary, the direction of the reform was correct. The imbalances of the German federal system were reduced, but the extent of the reform was clearly insufficient. Länder still do not have adequate taxing powers to adjust their budgets according to the needs of their citizens. Shared responsibilities prevail in various legislative procedures which hinder efficient legislation and reduce the likelihood of political reforms. Federalism Reform II As a consequence of the high debt levels at all government levels, a consensus evolved among all political parties that the fiscal



The Deadlock of Federalism in Germany 89

constitution required further improvements. The “soft budget constraint” in the German constitution had not provided for sound public finances. As a result, discussions led to the implementation of a fiscal rule which would constitute a “hard budget constraint.” Initially, the agenda for the commission that was installed to prepare the reform included the goal of further increasing the autonomy of the Länder governments by allowing them to levy additional taxes on substantial tax bases, such as personal income and corporate income tax. However, it became obvious relatively soon that there would not be widespread support for a fiscal federal system based on competition. The system of cooperative federalism would have to prevail. In May 2009, the Bundestag agreed to a constitutional amendment, followed by the Bundesrat in June 2009. The main innovation was the establishment of a “debt brake” at both the federal and the Länder levels (Foeko II 2009). In line with the European Stability and Growth Pact, the German debt brake demands that the budget be “close to balance” in normal times. The framework differentiates between a structural and a cyclical component. The federal government’s structural deficit is limited to 0.35 per cent of gdp, while the Länder are not allowed to accumulate any deficits over the business cycle. Hence, the debt stock would diminish to sustainable levels if economic growth were sufficiently high and politicians followed the structural rule. In addition to the structural component, both the federation and the Länder are allowed to accumulate deficits depending on their economic conditions. Automatic stabilizers should fully function and thereby reduce adverse fiscal effects over the business cycle. In a downswing, the budget balance might be negative and in an upswing it is required to be positive to symmetrically account for the accumulated deficits. The deviations from “normal” conditions are determined by a “productions-function” approach. Furthermore, a “control account” is created for the federal government, which should function as a collective memory and hence should increase intertemporal

90 Blankart and Fasten

transparency of the budget process. If the actual deficit exceeds the permitted values in a budget cycle, the difference is credited to the control account, which should not exceed 1.5 per cent of gdp and should be reduced if the value exceeds 1 per cent of gdp in accordance with economic conditions. In the case of natural disasters or extraordinary circumstances exceptions from the rule might be undertaken, with the approval of the majority of the Bundestag. But since there is no clear definition of either term, there might be room for creativity to circumvent the rule. Along with the rule, there is a stability board which is intended to supervise the budget process of the federal as well as the Länder governments. The stability board consists of the finance ministers of the Länder and the federation; it audits the budget process. The decisions of the board are to be made public to increase transparency. Furthermore, the board will advise distressed entities, including suggesting restructuring measures. However, there are no sanctions or other ways for the board to intervene in the budget process. How did the rule pass both houses of parliament, despite the fact that deficit spending has been highly popular in recent years? The commission used two innovative mechanisms. First, the reform implementation was shifted into the future. The federal government has to issue a budget in compliance with the new debt brake first in 2016 and the Länder might use an additional four years (up to 2020) to consolidate their budgets. Thereafter, they are required to adhere to the debt brake. Second, the poorest Länder received additional funds to implement a successful consolidation strategy. Between 2011 and 2019, annual financial assistance of 800 million Euros is provided for five Länder: Bremen (€300 million), Saarland (€260 million), Berlin (€80 million), Lower Saxony (€80 million) and Schleswig-Holstein (€80 million), which adds up to 7.2 billion Euros over the entire period. The extra funds are conditional on the implementation of successful consolidation measures to reach the goal of implementing the debt brake in 2020.



The Deadlock of Federalism in Germany 91

As a result of these measures the federal government and the “rich” Länder were able to buy the agreement while the implementation was eased. We must bear in mind that the politicians who agreed are not likely to be the ones who will have to live by the rule. The coalition of reform and competition opponents agreed to the solution since the additional funds were sufficiently high. What are the main obstacles to a reform of the German federal system that features competition between Länder and allows local politicians more freedom to provide goods and services that are required by their citizens? Two main factors are involved: first, the general opponents of competition between jurisdictions, who fear a fiscal race to the bottom and an underprovision of public services and second, the intergovernmental transfer system which reduces the willingness to break up the current federal system. Several different types of transfers coexist in Germany. The federal government provides support for subnational governments and installs spending programs for the Länder. And there is a horizontal fiscal equalization scheme between the Länder designed to reduce revenue discrepancies. The scheme ensures that the capacities of Länder governments shall be similar and not limited by own tax revenues. In principle, increasing (or decreasing) tax revenues in each Land, lowers (or raises) the funds they receive from the equalization scheme and, more important, requires Länder with above average tax revenues to contribute to the equalization scheme. Thus, the fiscal equalization payments of the contributing Länder can be perceived as a tax on tax revenues. The higher their tax revenues, the higher their contributions to the poor Länder. This effect would be even more pronounced under tax autonomy of the Länder. A Land that increased its tax rates to improve its public services would automatically become liable to contribute a part of its additional revenues to the intergovernmental transfer scheme (be it through a reduction in transfers it would receive or through increased contributions). The Länder, therefore, have only minor incentives to increase their own

92 Blankart and Fasten Table 1 Assignments of the horizontal fiscal equalization scheme in 2009 (in 1,000 €) and number of votes in the Bundesrat Land North RhineWestphalia Bavaria BadenWürttemberg Lower Saxony Hesse

Contributions (–) / grants (+)

Votes

Land

Contributions (–) / grants (+)

Votes

–60,841

6

Thuringia

502,306

4

–3,370,047

6

Brandenburg

506,213

4

–1,508,177

6

456,788

3

113,766

6

MecklenburgWestern Pomerania Saarland

93,369

3

–1,918,929

5

Berlin

2,893,363

4

Saxony

921,283

4

Hamburg

–48,728

3

RhinelandPalatinate Saxony-Anhalt

295,341

4

Bremen

433,540

3

519,553

4

SchleswigHolstein Total

171,199

4

±6,906,722

69

Source : Blankart 2011 and bmf 2010

­revenues since the net effect is rather small. On the other hand, reducing tax revenues autonomously might induce additional transfers from the intergovernmental transfer system, which would be opposed by the actual contributors. Table 1 shows the individual contributions (-) or grants (+) of the horizontal fiscal equalization scheme for each Land and the number of votes in the Bundesrat. On the one hand, beneficiaries of funds through the fiscal equalization scheme have forty-three votes in the Bundesrat, which is close to two-thirds of the overall votes. This means that the majority of Länder gain from the system and have little incentive to establish a new system that would give them more autonomy. On the other hand, the contributors to the system are unlikely to allow poor Länder that receive financial support to lower their tax rates on substantial taxes, such as personal or corporate



The Deadlock of Federalism in Germany 93

income taxes. They fear subsidized competition among jurisdictions and adverse effects for their own Länder. In order to solve the deadlock, all participants must agree to base fiscal equalization on a Land’s resources4 instead of its tax revenues. However, since the existing fiscal transfer scheme lasts until 2019, any attempt to introduce greater tax autonomy for the Länder earlier would be in vain. It remains to be seen if the political parties will be able to tackle this major change to the German fiscal constitution by 2019.

Upcoming Challenges and Avenues for Reform In the medium term, an aging population and low birth rate will lead to substantial public financing problems in Germany. Recent projections by the federal statistical office in Germany estimate that the population will decrease from the current 82.4 million to somewhere between 69 to 74 million in 2050 (Destatis 2006). In addition, the proportion of elderly citizens will increase (Figure 2). Recent reforms of the social welfare system will not mitigate the substantial financing challenges in the health, pension, and other social security systems. The most recent reforms of the pension scheme, which introduced a gradual increase of the age of retirement to 67 years, will not be sufficient to tackle the financing gap. Furthermore, the health care system has been under reform since the current financing gap is estimated to raise as high as 2.5 times the current gdp. The recent attempts to reduce health care costs and increase competition in the market failed to achieve their aim. As a result, public finances in Germany face significant contingent liabilities. In addition, the fiscal costs of the recent economic and financial crisis will still be very high in coming years. The European Commission estimates fiscal deficits to be 3.4, 5.0, and 4.6 per cent of gdp in 2009, 2010, and 2011, respectively (European Commission 2009). Furthermore, it is uncertain if the German economy will return to its former growth path or if the output

94 Blankart and Fasten Figure 2 Population aging in Germany

Source : Destatis 2006

Note: The projections assume a constant birth rate and a migration balance of 100,000 people per year.

will be reduced in the long run. If the latter, policy reforms are even more urgent. The tremendous challenges in the upcoming years demand a flexible institutional environment which can react in a timely fashion to variations in economic conditions. Therefore, it is necessary to further increase elected representatives’ margin of manoeuvre and to shape institutions to allow for smooth policy implementation. The deadlock within the federal system has to be broken and clear responsibilities have to be installed. A system based on the subsidiary principle allows for the decentralized distribution of information (Hayek 1945) and the



The Deadlock of Federalism in Germany 95

Table 2 Institutional interrelation and the ability to reform Ruling coalition interests equal interests of Länder representatives Yes Party or party coalition builds majority in both chambers of parliament

Yes

Capability to reform is high

No

Potential deadlock between coalition and opposition

No Potential deadlock within party/ coalition Potential deadlock within party/ coalition and between coalition and opposition

Source : authors

heterogeneity of preferences within Germany (Tiebout 1956). It would enable efficiency of policy making and sound public finances would result. Tsebelis (2002) argues that the institutional setting and especially the number of players who have a veto are key factors that determine the chances of changing the political status quo. If the number of veto players increases or the cohesiveness decreases, political “stagnation” will increase and reform projects will likely not be enacted. The recent “federalism reform I” was intended to reduce the negotiation costs to political actors, but still about 35 to 40 per cent of German laws have to pass both chambers, the Bundestag and the Bundesrat. The interactions between the national and the subnational government level and between parties within the German federal system are illustrated in Table 2. On the one hand, the equality of majorities in both chambers is of importance since it allows the passage of new legislation with the agreement of the ruling coalition. If majorities in the two chambers diverge, a “conciliation committee” has to be installed which seeks to reach a consensus between the chambers. If no agreement is found, the reform project is rejected.

96 Blankart and Fasten

On the other hand, diverging interests between the federation and the Länder can emerge which might be independent of the political affiliation of the actors. The potential to block reform projects increases in Table 2 toward the lower right corner. An example from the recent policy debate, in which there was a failure to further reduce institutional incongruencies, underlines the shortcomings of the federalism reform solutions (Figure 1). After the federal elections of autumn 2009, the governing coalition of Christian Democrats and the Liberal Party tried to put their election pledges into practice. They announced tax cuts. They sought to reduce the value added tax for specific businesses, especially for the hotel industry.5 However, the Länder noticed that their budgets would be affected by this reform proposal. They feared lower revenues, with the same amount of mandatory expenditures, since they were still tied to the decisions of the federal government and did not have their own taxing rights. As a consequence, the prime ministers of several Länder, independent of their political affiliation, decided to oppose the plan and block the reform in the Bundesrat. In the final negotiations, the prime ministers gave up their resistance and agreed to the proposal, but it is clear that in coming years the capability to reform will be restricted and that recent federalism reforms have not broken the federal deadlock. Therefore, the question arises: what has to be undertaken to reform the German federal system? How is it possible to break the current rigidities? In principle, the approach that was pursued in the recent federalism reform might be reapplied. First, the implementation of the reform can be shifted into the future. Politicians will not bind their own hands, but those of their successors. Furthermore, there could be an option-based model: each Land could choose between either staying in the current system or opting out. Opting out would lead to additional autonomy; Länder could, for example, receive the right to levy additional taxes on personal or corporate income taxes. Opting out would also lead to increased obligations since Länder would no longer be able



The Deadlock of Federalism in Germany 97

to rely on federal government subsidies in case of distress or the fiscal equalization scheme. Such reform would release the potential of federal structures. Länder could become laboratories for new institutions and innovative policy decisions. They could learn from each other and could provide services which are in line with local requirements. The financial equalization scheme in Germany requires amendments no later than 2019, when the current additional subsidies for the eastern Länder will expire. Therefore, now is the right time to reform the entire financial equalization scheme and allow for more flexibility and institutional congruency.

Conclusion Germany faces tremendous economic challenges in the coming years. High public debt levels for all levels of government, population aging, financing gaps in the social security system – to name just a few – require further policy reforms. The current federal system lacks clear responsibilities for decision makers and is characterized by a reform deadlock. The latest reforms of the federal system were steps in the right direction, but did not significantly reduce the potential to block further reform attempts. The number of laws that require concurrent legislation between the federal government and the Länder has been decreased, but is still relatively high. In addition, the enacted debt brake might assist in reducing debt levels on the federal and the Länder level, but it is unclear if the governments will follow the rule. We propose to further reform the federal system by allowing each Land to opt out of the current system of intertwined responsibilities in order to decide autonomously on the provision of public services. If that were to happen, the advantages of a federal system could be fully realized and overall prosperity increased. Germany should adopt an option-based model in order to separate the time of decision from the time of implementation

98 Blankart and Fasten

which would ease the decision-making process. In summary, further reform steps are urgently required to implement a federal system in Germany that is capable of reacting to upcoming challenges and promotes institutional as well as political innovation. notes 1 In contrast, deficits in unitary states might also mount due to logrolling of representatives of subnational governments on the federal level. They seek to maximize distribution of funds in favour of their local clientele and also face a common pool problem. 2 One of the major shortcomings of the golden rule is the imprecise definition of investment spending, which has allowed finance ministers to constantly broaden their budgets. The differentiation between “consumptive spending” and “investment spending” as well as the determination of the depreciation rates is difficult in practice. 3 The Länder contribute to the fine according to their population (35 per cent) as a solidarity component and according to their own indebtedness (65 per cent). A Land that is not indebted, therefore, contributes only to the solidarity component. 4 E.g., on the gdp per capita. 5 Furthermore, the tax exemptions for dependent children were increased and crisis-related losses for corporations can more easily be deducted from the tax bill.

References Alesina, A., and A. Drazen. 1991. “Why are Stabilizations Delayed?” The American Economic Review 81, no. 5: 1170–88. Blankart, C.B. 2007. Föderalismus in Deutschland und in Europa. BadenBaden: Nomos. – 2011. Öffentliche Finanzen in der Demokratie. Munich: Vahlen. bmf. 2010. Der Finanzausgleich unter den Ländern für die Zeit vom 01.01.2009 – 31.12.2009, bmf/ V A 4. Buchanan, J., and R. Wagner. 1977. Democracy in Deficit: The Political Legacy of Lord Keynes. New York: Academic Press.



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Destatis. 2006. Bevölkerung Deutschlands bis 2050 - Übersicht der Ergebnisse der 11. koordinierten Bevölkerungsvorausberechnung – Varianten und zusätzliche Modellrechnungen, Statistisches Bundesamt, Wiesbaden. Destatis. 2009. Finanzen und Steuern, Fachserie 14 Reihe 5. European Commission. 2009. European Economic Forecast. Autumn 2009, dg Economic and Financial Affairs. Foeko II. 2009. Beschlüsse der Kommission von Bundestag und Bundesrat zur Modernisierung der Bund-Länder-Finanzbeziehungen, Kommissionsdrucksache 174 vom 5. März 2009. Hayek, F.A. 1945. “The Use of Knowledge in Society.” The American Economic Review 35, no. 4: 519–30. Musgrave, R. 1959. The Theory of Public Finance, McGraw-Hill: New York. Nordhaus, W.D. 1975. “The Political Business Cycle.” The Review of Economic Studies 42, no. 2: 169–90. Rodden, J. 2004. “Achieving fiscal discipline in federations: Germany and the emu.” Paper presented at Fiscal Policy in emu: New Issues and Challenges. Workshop organized by the European Commission, Brussels, 12 November 2004. – 2006. Hamilton’s Paradox: The Promise and Peril of Fiscal Federalism. Cambridge: Cambridge University Press. Stegarescu, D. 2005. “Public Sector Decentralisation: Measurement Concepts and Recent International Trends.” Fiscal Studies 26, no. 3: 301–33. Tiebout, C.M. 1956. “A pure theory of local expenditures.” The Journal of Political Economy 64, no. 5: 416–24. Tsebelis, G. 2002. Veto Players: How Political Institutions Work. Princeton: Princeton University Press and Russell Sage Foundation.

5 Setting Personal Income Tax Rates: Evidence from Canada and Comparison with the United States of America, 2000–2010 François Vaillancourt and David Guimond Introduction This paper examines the policies for setting tax rates adopted by the Canadian provinces following a change in the institutional arrangements in 2000. The behaviour of the states of the United States provides a point of comparison. This subject is of interest given the recent changes in policy in Belgium with respect to regions, in Spain with respect to non-foral autonomous communities, and in the United Kingdom with respect to Scotland. The paper begins by recalling the evolution of tax autonomy in Canada, drawing on Ruiz Almendral and Vaillancourt (2006). It then turns to a quantitative description of tax rates in Canada and the usa for the 2000–2008 period. Finally, it examines the reasons for the provincial choices made.

The Evolution of pit Tax Autonomy in Canada, 1947–2000 Canadian provinces1 can levy the same direct and indirect taxes as the federal government, except for custom duties and excise duties, and they have chosen to exercise their taxation powers



Evidence from Canada 101

in all major fields. In 2010 all provinces levy both personal (pit) and corporate (cit) income taxes at various rates and nine levy sales taxes using a mix of value added tax (vat) and retail sales taxes. Finally, some provinces levy payroll taxes and capital taxes on corporations. In all cases, they are completely free in setting the base, rates, and collection mechanisms. There are no tax harmonization laws setting tax parameters. The only constraint is that if they wish to see the cit, hst (one type of Canadian vat), or pit collected by the federal government free of charge, they must use the federal tax base/taxable income. This in practice serves as a harmonization measure. The occupation of the tax fields was not always structured in this way. Before the Second World War, provinces and the federal government both occupied the pit and cit fields. During the war, the provinces “rented out” the pit, cit, and succession duties2 fields to the federal government. Hence, in 1946 they occupied none of these fields except the sales tax one. The occupation of the pit tax field by the federal government after the Second World War was formalized in the Dominion3Provincial Tax Rental Agreement Act (Smith 1998). Briefly, provinces that signed the tax rental agreement that covered the 1947–1952 period received, in exchange, the most beneficial combination of per capita payment, Wartime Tax Agreements payments, and statutory subsidies. All provinces except Ontario and Quebec signed this agreement (Newfoundland signed it in 1949, when it joined Canada).4 Provinces that decided to impose a pit would see their taxable residents receive a credit of 5 per cent for such tax against the federal pit (Bird and ­Vaillancourt 2006. In 1950, Ontario adopted a law creating a personal income tax equal to 5 per cent of the federal tax (the amount of the federal credit) but the federal government refused to collect it and the Ontario Income Tax Act was not proclaimed. It was only in 1954, during the second tax rental agreement (1952–1957), that Quebec recreated its own pit (Lachance and Vaillancourt 2001). Arguments used to justify this action were that “the constitution concedes to provinces priority in the field of taxation”

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and that “it would be unjust and prejudicial to the province to deprive itself of a source of revenue to which it had a prior right and that was necessary to meet the needs resulting from the vigorous strides it had taken” (Smith 1998, 57). The Quebec tax on personal income was a progressive tax with rates between 2.3 and 12 per cent (progressivity similar to that of the federal pit). Quebec asked Ottawa to make it deductible, but the federal credit was only 5 per cent. This tax higher than the credit offered by Ottawa for non-signatory provinces could be seen as (partial) double taxation. “To accommodate Québec’s pit structure without causing taxpayers much excessive taxation, losing too much revenue or wrecking the tax rental system” (Smith 1998, 58), the federal government decided to change from a credit of 5 to an abatement of 10 per cent for provincial pits, as of 1955. Under this system, the provinces were offered three possibilities (Smith 1998): 1 to rent out their tax fields; 2 to impose and collect these taxes themselves; or 3 to impose them, but have them collected by the federal government. In the latter case, a province would have to levy taxes at the standard rates and keep its definitions of taxable income identical to those in the federal law. Quebec chose the second alternative. In 1962, the Tax Rental Agreement was replaced by a Tax Collection Agreement and the abatement by a reduction of federal taxes, the creation of tax room, thus requiring provinces to set their own tax rates as a percentage of the federal tax rate. The federal government would collect those taxes free of charge if the provinces used the same base (definition of income, deductions, exemptions, etc.) as the federal government and set their taxes in the form of “tax on tax (tot),” thus using the same progressivity as the federal pit. At that time, provinces were offered the opportunity to replace part of federal transfers for social spending with a greater occupancy of the pit tax field; only Quebec, which had asked for this arrangement, adopted it in 1965.



Evidence from Canada 103

In 1972, the federal government modified its pit, widening the base and reducing its tax rates, leading to an increase in the provincial pit tot rates, and in 1977 it reduced, for a last time, its pit rates as part of a modification of transfers to provinces that saw major cost-sharing transfers transformed into block grants made up of both cash payments and the revenue from provincial pit increases. Table 1 presents the occupancy of the pit field in Canada, Quebec, and Rest of Canada (roc) from 1947 to 2000. It is only following the 1972 and 1977 changes that provinces other than Quebec begin to show some initiatives with respect to the design of the tax system in the pit field. Chart 1 presents information on the timing of the introduction of the three most common tax measures as follows. 1 The most common and first introduced measures are surtaxes. These are calculated as a percentage of the provincial pit. They vary both across provinces at a point in time and for a province over time. Table 3 in Ruiz Almendral and ­Vaillancourt (2006) illustrates the second point for Ontario. 2 The second most common measure is investment tax credits for various types of investments. These are usually for investments in shares of businesses (equity or stock savings plans) active in the relevant province but can be for specialized types of activities such as livestock (Saskatchewan). 3 The third most common measure is credits for older individuals (65+). These aim at reducing the pit paid by poor older individuals. Other measures were also used. Let us note the temporary home heating tax credit introduced in Ontario for 1981, 1982, and 1983 in response to high oil prices; the income-linked child care expenses (children less than 7) tax credit introduced in 1997 in Ontario; the learning tax credit introduced in 1997 in Manitoba and aimed at reducing the cost of tuition; the incomelinked mortgage tax credit in 1980 and 1981 in Saskatchewan; the family employment tax credit introduced in Alberta in 1997.

Table 1 Personal income tax (pit) revenues in Canada selected years 1947–2000, $ and share of PIT and of GDP Total pit

% Federal

% Federal

% Federal

% gdp Federal

($millions)

of pit

in Quebec

roc

Total pit

pit

Provincial pit

1947a 1952

660 1,225

100 100

100 100

100 100

 5.4  5.5

5.4 5.5

0.0 0.0

1954

1,309

   98.1

n/a

100

 5.6

5.5

0.1

1957

1,676

   97.6

n/a

100

 5.6

5.4

0.1

1962

2,378

   84.9

   83.5

   87.0

 6.2

5.3

0.9

1967

5,112

   71.4

   55.9

   75.8

 7.3

5.2

2.1

1972

11,385

   69.3

   50.7

   75.8

10.3

7.2

3.2

1977

23,656

   60.4

   40.6

   69.0

10.7

6.5

4.2

1982

43,932

   58.6

   38.1

   66.8

11.6

6.8

4.8

1987

70,333

   59.3

   41.4

   66.0

12.6

7.5

5.1

1992

101,226

   58.7

   43.0

   64.1

14.5

8.5

6.0

1997

120,956

   60.6

   47.8

   64.5

13.8

8.4

5.4

2000

143,514

   62.4

   48.4

   65.4

13.6

8.5

5.1

Source : Bird and Vaillancourt (2006).

Note: roc is Rest of Canada without Quebec.



Evidence from Canada 105

Chart 1 Rate of introduction of specific tax measures in provincial pit by Canadian provinces: 1972–1999

Source : Ruiz Almendral and Vaillancourt (2006).

The taxation activity of Canadian provinces in the pit field shows the importance of incentives. An adequate link between transfers and tax points encourages subnational governments (sngs) to use their powers. But at least as important is the fact that such entities view their powers as theirs. As shown in chart 1, when provinces re-enter the pit field, they do not immediately use their powers to establish taxes but, rather, to introduce all types of tax credits. With time, however, sngs realize that the political burden of increasing fiscal pressure may be offset by the potential benefits (i.e., revenues, fiscal policy) of exercising their powers. Furthermore, the Canadian case also shows the importance of pit, which explains the many attempts to introduce a minimum level of harmonization in this tax, at least with reference to the definition of the tax base.

The Provincial pits in Canada since 2000 The federal government modified the pit rules in 1999. Starting in 2000, provinces were required to set their own tax brackets and tax rates, moving from a “tax on tax” system to a tax on income system.5 We begin by examining the Canadian situation

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Vaillancourt and Guimond

in 2008, the last year for which we have all the data required.6 We then present evidence for the American states for the same year to see how a federal country where subnational pit was never ceded to the central government compares. Finally, we examine the choices made by the provinces for four years: 1999, the year just before the change; 2000, the first year of change; 2004, the mid-point year; and 2008.

Provincial pits in Canada in 2008 One can characterize a pit system either by its formal or statutory attributes, or by its outcomes. The formal attributes are the number of steps in the tax schedules, the boundaries of such steps, and the tax rates associated with each step. One outcome is the income tax payable at a given income level. We first present the statutory aspects of provincial pits in Canada for 2008 in tables 2 and 3. In those two tables as well as table 4, we first present information for the nine provinces that use the Canada Revenue Agency to collect their pit, including the relevant mean, standard deviation, and coefficient of variation. We then add information on Quebec and the federal government for comparison purposes. Table 2 shows that: 1 eight of the nine roc provinces use from three to five brackets for pit in 2008. Alberta has only one; 2 the minimum income for the first step up (second bracket) varies from $29,591 to $39,136. No provinces use the federal step up income, with all except Saskatchewan below it; 3 the coefficient of variation (cv) for the first step up is smaller than the other two cvs. The province with the step up values closest to those of the federal government is, surprisingly, Quebec. Turning to table 3, which presents the statutory rates, we find that



Evidence from Canada 107

Table 2 Floor for Brackets in provincial pits, Canada, 2008 2008-Income tax brackets lower non zero amount of each bracket $

2nd bracket

Newfoundland Prince Edward Island Nova Scotia New Brunswick Ontario Manitoba Saskatchewan British Columbia

30216 31985 29591 34837 36021 30545 39136 35017

Statistics for 9 provinces Mean Standard deviation cv

33419 3365 0.101

71643 16870 0.235

Quebec Federal

37501 37886

75001 75770

3rd bracket 60430 63970 59181 69674 72042 66001 111815 70034

4th bracket

5th bracket

93001 113274

80407

97637

95561 16582 0.174 123185

Source : the authors. cv Coefficient of variation = standard deviation/mean

Notes: The first bracket has by definition zero as the minimum amount of taxable income. Alberta is excluded since it uses a flat rate and thus no brackets.

1 the rate for the lowest bracket varies from 6.05 to 11 per cent; this last rate for Saskatchewan is very close to that of its neighbouring province Alberta which uses a flat rate; 2 progressivity varies from province to province. Saskatchewan has the lowest progressivity of non flat tax provinces and British Columbia the highest. What is the result of these tax structures? Table 4 presents information on outcomes using information on the effective tax burden for a single individual. It shows that:

Table 3 Rates per bracket and progressivity measure, provincial pits Canada, 2008 2008-Marginal tax rate (%) rate per bracket Newfoundland Prince Edward Island Nova Scotia New Brunswick Ontario Manitoba Saskatchewan Alberta British Columbia* Statistics for nine provinces Mean Standard deviation cv Quebec Federal

1 8.2 9.8 8.79 10.12 6.05 10.9 11 10 5.06 8.88 2.10 0.237 16 15

2

3

4

Highest rate

Progressivity: highest/ lowest rate

13.3 13.8 14.95 15.48 9.15 12.75 13 10 7.7

16 16.7 16.67 16.8 11.16 17.4 15 10 10.5

n.a. 17.5 17.95 n.a. n.a. n.a. 10 12.29

16 16.7 17.5 17.95 11.16 17.4 15 10 14.7

1.95 1.70 1.99 1.77 1.84 1.60 1.36 1.00 2.9*

12.24 2.68 0.219

14.47 3.02 0.209

14.44 3.92 0.271

15.16 2.83 0.187

1.63

20 22

24 26

n.a. 29

Source : the authors. cv Coefficient of variation = standard deviation/mean

Notes* the rate for the fifth bracket in British Columbia is 14.7%; n.a: not applicable as no such rate (only three brackets)

1.50 1.96

Table 4 Provincial pit paid, four income levels and progressivity measures, Canada 2008 pit

paid by income level $

25000

50000

75000

200000

200 000 tax burden/ 25 000 tax burden

200 000 tax burden/mean at that level

25 000 tax burden / mean at that level

Newfoundland Prince Edward Island Nova Scotia New Brunswick Ontario Manitoba Saskatchewan Alberta British Columbia*

3242 3483

10606 10939

17925 18274

74598 77531

23.0 22.3

101.1% 105.1%

101.7% 109.3%

3322 3464 3132 3622 3097 2670 2659

11074 11088 9710 10977 10334 9452 8664

18650 18588 16027 18113 17334 15852 14604

78153 77299 74384 76607 71871 64726 68737

23.5 22.3 23.7 21.2 23.2 24.2 25.9

105.9% 104.8% 100.8% 103.8% 97.4% 87.7% 93.2%

104.2% 108.7% 98.2% 113.6% 97.1% 83.8% 83.4%

Statistics for 9 provinces Mean Standard deviation cv

3188 341.32 0.107

10316 860.44 0.083

17263 1434.23 0.083

73767 4550.44 0.062

23.1 1.3 0.6

x x x

x x x

Quebec Federal

3174 1935

11554 6344

19228 10744

80143 46618

25.2 24.1

108.6% x

99.6% x

Source: the authors. cv Coefficient of variation = standard deviation/mean

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Vaillancourt and Guimond

1 the variation in the tax burden goes down as income goes up, indicating perhaps greater concern for tax competition and tax-induced mobility as income goes up; 2 effective progressivity measured by the ratio 200 000 tax burden 25 000 tax burden does not vary much, being highest in the two distinct (non tax) societies of Quebec (language) and British Columbia (climate);7 3 for high-income individuals, the highest tax burden is found in Quebec and the lowest in Alberta, while for low income individuals, Manitoba has the highest and Alberta the lowest tax burden.

State pits in the usa, 2008 How does the situation in Canada compare to that of the United States? Table 5 provides information on states’ pit brackets and table 6 on tax rates. These tables show that American states decide whether or not to levy a pit and if they do, the states set the steps, rates, credits, and so forth. We present evidence on their choices in table 5. One should note: 1 The use by forty-three states of a pit with forty-one levying it on a broad base and two (New Hampshire and Tennessee) only on interest and dividend income (Cordes and Juffras 2012); 2 the non-use by seven American states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) of the pit; 3 the wide use by the forty-one broad base states of federal agi (Cordes and Juffras 2012); only five start off using their own definition of income. This last point is noteworthy given, as discussed above, that there has never been federal collection of state pits in the usa; 4 the use by eight states of a flat tax rate on a broad income base, the variation in the number of brackets from one to ten and in the bracket limits;

Table 5 State personal income tax brackets – number and cut-offs for lowest and highest, 2008, United States No. of Brackets State Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts

 3 n.a.  5  6  7  1  2  7 n.a.  6  9  8  1  1  9  3  6  3  4  7  1

Low Bracket (Under)

High Bracket (Over)

$500 n.a. 10,000 3,600 6,828 n.a. 10,000 2,000 n.a. 750 2,400 1,198 n.a. n.a. 1,343 15,000 3,000 25,000 4,750 1,000 n.a.

$3,000 n.a. 150,000 30,000 1,000,000 n.a. 10,000 60,000 n.a. 7,000 48,000 23,963 n.a. n.a. 60,435 30,000 75,000 50,000 18,950 200,000 n.a.

No. of Brackets State Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia

7 4 n.a. 1 6 4 5 4 5 9 7 3 1 5 6 n.a. 1 n.a. 1 5 4

Low Bracket (Under) $2,499 2,400 n.a. n.a. 20,000 5,500 8,000 12,750 31,850 5,000 1,000 2,850 n.a. 31,850 2,630 n.a. n.a. n.a. n.a. 31,850 3,000

High Bracket (Over) $14,899 27,000 n.a. n.a. 500,000 16,000 20,000 120,000 349,700 200,000 8,700 7,150 n.a. 349,700 13,150 n.a. n.a. n.a. n.a. 349,700 17,000

Table 5 continued Michigan Minnesota Mississippi Missouri D.C. Federal

 1  3  3 10  3  6

n.a. 21,310 5,000 1,000 10,000 8,025

n.a. 69,990 10,000 9,000 40,000 178,850

Washington West Virginia Wisconsin Wyoming Average 50 states Std Dev 50 states

n.a. 5 4 n.a. 4.93 2.28

n.a. 10,000 9,510 n.a. 8705.36 9166.42

n.a. 60,000 142,650 n.a. 118606.58 190956.94

Source : the authors.

Table 6 Lowest, mid, and highest statutory PIT rates and number of brackets, United States states, 2008

State

First tax rate (%)

Mid point tax rate (%)

Highest tax rate (%)

Number of brackets

Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii

 2.00 no PIT  2.59  1.00  1.00  4.63  3.00  2.20 no PIT  1.00  1.40

 4.00  –  3.36  3.50  6.00  n.a.  –  4.80  –  3.00  6.80

 5.00  –  4.54  7.00 10.30 n.a.   5.00  5.95  –  6.00  8.25

 3    5  6  7  1  2  6    6  9

State Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma

First tax rate (%)

Mid point tax rate (%)

 1.00  2.56 no PIT  5.00  1.40  1.70  4.00  6.00  2.10  0.649  0.50

3.00 3.57 –  n.a.  3.50 3.20 5.25 7.00 4.34 3.895 3.00

Highest tax rate (%) 6.90 6.84 –   n.a. 8.97 4.90 6.85 7.75 5.54 6.555 5.50

Number of brackets 7 4   –  1 6 4 5 3 5 9 7

Table 6 continued Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri D.C. Federal Source : the authors. n.a.: flat tax

 1.60  3.00  3.40  0.36  3.50  2.00  2.00  2.00  2.00  5.30  4.35  5.35  3.00  1.50  4.00 10.00

 5.10 n.a. n.a.   6.12  6.25  4.00  4.00  4.50  4.75  n.a. n.a.   7.05  4.00  3.50  6.00 25.00

 7.80 n.a. n.a.  8.98  6.45  6.00  6.00  8.50  5.75  n.a. n.a.   7.85  5.00  6.00  8.50 35.00

 8  1  1  9  3  6  3  4  7  1  1  3  3 10  3  6

Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Average (%) 50 states Std Dev 50 states CV 50 states

 5.00  3.07  3.75  0.00 no PIT  6.00 no PIT  5.00  3.60  2.00 no PIT  3.00  4.60 no PIT  2.96  1.90  0.64

7.00  n.a. 7.75 4.00 –  n.a.  –  n.a.  8.50 3.00  – 4.50 6.15  – 5.41 3.68 0.68

9.00  n.a. 9.90 7.00 –  n.a.  –  n.a.  9.50 5.75  – 6.50 6.75 –  7.72 4.85 0.63

3 1 5 6    – 1   – 1 5 4   – 5 4   –  4.44 2.50 0.56

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Vaillancourt and Guimond

Chart 2

Source : calculations by authors.

The cvs are for the minimum, the second, and the highest statutory rate. Chart 3

Source : calculations by authors.

The cv are for incomes of $25 000, 50 000, 75 000, and 200 000.

5 the variability in tax rates – either minimum or maximum, with a cv of 0.64 and 0.63 respectively. One possible explanation of the differences between Canada and the United States is the latter’s large number of subnational units. Another explanation is the lack of past centralized collection arrangements. We cannot control for the difference in the number of subnational units, but we can examine how things



Evidence from Canada 115

have evolved over time in Canada since 2000. This is what we do in the next section of the paper.

The Evolution of Provincial pits in Canada, 2000–2008 Charts 2 and 3 present the evolution over four years of the statutory tax rates and effective tax burdens for Canada. Both figures show higher cvs in 2008 than in 1999. Thus it appears that tax rate setting freedom allowed provinces to express their differing preferences for various degrees of progressivity more clearly as the time period over which this freedom is available lengthens.

The Use of Tax Freedom When the provinces first acquired the possibility of changing their personal income tax brackets and marginal rates, they used this freedom sparingly. They simply copied the federal income brackets. The only notable difference is that Nova Scotia, New Brunswick, and Manitoba did not implement the then new federal income brackets; they used the previous set of brackets. In 2000, every Canadian province used three income brackets,8 and there were slim income tax cuts for every Canadian. Following the year 2000, most provincial governments responded very positively to their new fiscal freedom. They described these fiscal changes, generally, using the same arguments as those put forward by Norman Betts, New Brunswick minister of finance in 2000:9 The increased flexibility offered by the “tax on taxable income” system means that the Province can design its personal income tax policy, more independently of the federal government. ­Having gained more control over the Province’s personal income tax ­revenues, the people of New Brunswick will have the opportunity to ensure that our tax system better meets our own social, economic, and fiscal needs. This government is committed to ensuring that New Brunswickers have the benefits of a tax structure that is simple, fair, transparent, efficient, and competitive.

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Vaillancourt and Guimond

By 2004, every province was using this fiscal tool, and all moved from a tax on tax to a tax on taxable income method of calculating provincial personal income tax, meaning that they all have their own income brackets and marginal rates. Some made drastic changes from the previous system. British Columbia increased the progressiveness of its income tax by raising the number of income brackets to five, the highest bracket being for income over $90,555. The new system is described as being “‘fairer and more effective”’ and “more focused on middle-class and lowincome British Columbians.” Like many other provinces, British Columbia used the opportunity of the income tax reform to offer tax cuts to most of its population. “‘Nine out of every ten British Columbians – the vast majority – will pay under 12 per cent in provincial income tax.”10 On the other hand, in 2001 Alberta introduced a flat tax at the rate of 10 per cent. This new “made in Alberta personal income tax system”11 measure was explained to the population as being both competitive and fair. Competitive since “it rewards initiative [making people] willing to work harder and invest more in education and savings.” And fair since 200,000 low-income Albertans would no longer pay income tax. Note that there was no discussion of reduced progressivity. It is interesting to see that these two neighbouring provinces went in opposite directions. The other provinces did not make big changes to their fiscal systems. In 2004, six of the Canadian provinces still had three income brackets, as in 2000. Another similar feature in the provinces’ new systems is the prevention of bracket creep. The 2000 budgets from Ontario12 and British Columbia13 and the 2004 budget from Saskatchewan14 mention restoration of full indexation of brackets to inflation which would protect all taxpayers from paying more tax just because their income increased to keep up with inflation. Many provinces used the income tax marginal rates and brackets to help their financially disadvantaged citizens. Newfoundland,15 Nova Scotia,16 New Brunswick,17 Saskatchewan,18 and British Columbia19 all implemented a low-income personal income tax reduction program. They decreased the tax payable by lower income individuals by lowering the tax rate of the first



Evidence from Canada 117

income bracket, or by increasing the basic personal amount exempted from personal income, and often by also introducing new provincial non-refundable tax credits. The budgets of the four Atlantic provinces (Newfoundland, Nova Scotia, Prince Edward Island, and New Brunswick) tend to include comparisons with each other. It seems important or politically interesting for each finance minister in that region to be able to point out that his/her government offers “the lowest personal income tax burden in Atlantic Canada”20 or “the lowest statutory tax rates in Atlantic Canada.”21 We found such comparisons in several budget speeches of the Atlantic provinces. We did not find this almost systematic comparison with other provinces in budget speeches for provinces outside that region.22

Conclusion The acquisition by Canadian provinces of more powers over personal income tax has increased the diversity of personal income taxation at the provincial level. This diversity is less than the diversity observed in the United States. One explanation for this may be the difference in number of jurisdictions. Another may be the difference in the nature of federalism in each country. Canadian fiscal federalism, at least in the case of the nine English-speaking provinces, may foster more cooperative federal-subnational government relations than its equivalent in the United States. One indication of this greater co-operation is the existing tax collection arrangements which both result from and ­create intergovernmental co-operation. These arrangements may yield more harmonized outcomes in Canada. Indeed, the outlier (tax-wise), Alberta, is the Englishspeaking province that has historically been most protective of its autonomy and has had a major conflict with the federal government over energy policy in the early 1980s. Finally, this autonomy does not seem to have had major impacts on the Canadian economy, be they positive or negative. This outcome is based in part on the fact that differences in pit are

118

Vaillancourt and Guimond

rarely m ­ entioned in public policy debates as a determinant of migratory behaviour; economic ­opportunities and transfers to individuals appear to be the key drivers of personal migration, at least for English-speaking Canadians.

notes 1 We do not discuss the three northern territories since their autonomy is not the same as that of the provinces. 2 Succession duties were abolished in 1972 at the federal level; by 1985, all provinces had abolished them. 3 Canada forms One Dominion under the Name of Canada; article 3 of the Constitution. 4 Both decided to impose their own corporate income tax (cit), initially at a rate of 8.5 per cent, which was higher than the 7 per cent credit for provincial cit offered by the federal government. 5 Sometimes referred to as Tax on Income or toni. 6 At the time of writing in 2009 7 Tax-wise, Alberta, with no provincial goods and services tax and a flat provincial pit, is the most distinct province. 8 http://www.cra-arc.gc.ca/tx/ndvdls/fq/2000_rt-eng.html. 9 New Brunswick. 2000 Budget Speech, 25. 10 British Columbia. 2000 Budget speech, 9. 11 2001 Alberta budget, 112. 12 Ontario. 2000 Ontario Budget, 30. 13 British Columbia. 2000 Budget speech, 9. 14 Saskatchewan. 2004 Budget Address, 8. 15 Newfoundland. 2004 Budget, 22. 16 Nova Scotia. 2008 Budget speech, 9. 17 New Brunswick. 2000. Budget Speech, 25. 18 Saskatchewan. 2000. Budget Address March 2000, 41. 19 British Columbia. 2008 Budget speech, 3. 20 New Brunswick. 2000 Budget speech, 25. 21 Nova Scotia. 2003 Budget speech, 10. 22 For a more general discussion of yardstick or mimicking in Canada, see Vaillancourt (2007).



Evidence from Canada 119

References Bird, R., and F. Vaillancourt. 2006. “Changing with the Times: ­Success, Failure and Inertia in Canadian Federal Arrangements, 1945–2002.” In Federalism and Economic Reform International Perspectives, edited by J. Wallack and T.N. Srinasavan, 189–248. New York: Cambridge University Press. Cordes, Joseph J., and Jason N. Juffras. 2012. “State Personal Income Taxes.” In The Oxford Handbook of State and Local Government Finance, edited by Robert D. Ebel and John E. Petersen, 300–32. New York and Oxford: Oxford University Press. Lachance, R., and F. Vaillancourt. 2001. “Quebec’s Tax on Income: Evolution, Status and Evaluation.” In Tax Competition and the Fiscal Union: Balancing Competition and Harmonization in Canada, edited by D. Brown, 39–47. Kingston: Institute of Intergovernmental Relations, 2001. Ruiz Almendral, V., and F. Vaillancourt. 2006. Choosing to Be Different (or not): Personal Income Taxes at the Subnational Level in Canada and Spain. http://www.ief.es/Publicaciones/PapelesDeTrabajo/ pt2006_29.pdf. Smith, E.H. 1998. Federal-Provincial Tax Sharing and Centralized Tax Collection in Canada. Toronto: ctf. Vaillancourt, F. 2007. “Interjurisdictional Competition in Regulation: Evidence for Canada at the Provincial Level.” In Political Competition and Economic Regulation, edited by P. Bernholz and R. Vaubel, 53–102. New York: Routledge.

Provincial Budgets Cited British Columbia. 2000. Budget speech – Minister of Finance and Corporate Relations, 9. http://www.fin.gov.bc.ca/archive/budget00/ default.htm. – 2008. Budget speech – Minister of Finance and Corporate ­Relations, 3. http://www.bcbudget.gov.bc.ca/2008/default. htm New Brunswick. 2000. Budget Speech, 25. http://www.gnb.ca/0160/ budget/buddoc2000/Budgetspeech2000.pdf – 2008. Budget 2007–2008, 20. http://www.gnb.ca/0160/budget/ buddoc2007/index-e.asp

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Newfoundland. 2004. Budget speech – Minister of Finance and President of Treasury Board, 22. http://www.budget.gov.nl.ca/ budget2004/speech/default.htm Nova Scotia. 2003. Budget speech – Minister of Finance, 10. http:// www.gov.ns.ca/finance/site-finance/media/finance/Budget2003. pdf – 2008. Budget speech – Minister of Finance, 9. http://www.gov. ns.ca/finance/en/home/budget/budgetspeeches.aspx Ontario. 2000. 2000 Ontario Budget, Budget Speech: Balanced Budgets – Brighter Futures, 30. http://www.fin.gov.on.ca/en/budget/ ontariobudgets/2000/ Saskatchewan. 2000. Budget Address March 2000, 41. http://www. finance.gov.sk.ca/budget/2000-01/ – 2004. Budget Address March 2004, 8. http://www.finance.gov. sk.ca/budget/2003-04/

6 Cantonal Tax Autonomy in Switzerland: History, Trends, and Challenges Fabrizio Gilardi, Daniel Kübler, and Fabio Wasserfallen Introduction Swiss fiscal federalism is characterized by extensive tax autonomy for subnational governments. These subnational taxing powers are the basis for strong fiscal competition not only among the cantons but also among municipalities within cantons. This competition is a characteristic feature of Swiss federalism in general (Braun 2003). There are several theoretical arguments regarding tax competition (Gilardi and Wasserfallen 2012). Tiebout predicts that policy-makers will take the decisions of neighbouring municipalities or cantons into account, as do yardstick models of tax competition. This behaviour can be explained in two ways. First, citizens may be expected to look at neighbouring municipalities or cantons to evaluate the relative tax performance of their own incumbent governments. In election years, tax performance is, in turn, sensitive to the neighbour’s tax decisions (Besley and Case 1995). A second possible explanation is that governments of subnational units compete with each other for the same taxpayers (Tiebout 1956). In the long run, given a set of assumptions, this will lead to pressure for optimal allocation of public resources. However, there is also a risk of dysfunctional outcomes.

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In a perfect economic setting, a jurisdiction should be sufficiently large that total costs of a collective good are minimized (economies of scale), while beneficiaries of and payers for a collective good overlap within administrative boundaries. This is what Olson (1969) termed “fiscal equivalence.” A subnational government providing public services with beneficial spillovers beyond its borders should be compensated accordingly. This principle is theoretically compelling but difficult to apply in the real world, and whenever it is violated the outcome is ­ dysfunctional. Dysfunctionality increases according to the importance of the specific spillovers that are not compensated. Moreover, in a tax competition setup, as in other prisoner’s dilemma situations, there is a mismatch between individual and collective rationality. We can think about tax competition as a social dilemma in which the rationality of individual subnational governments leads to collective irrationality of the public sector, ending at unsustainable income levels. Policy-makers might yield to the temptation to set tax rates slightly lower than their competitors to maximize taxable income. Of course, this should have a particular impact on the wealthy because they are assumed to be more mobile and they are of particular importance to the capacity of a canton to raise revenue. However, empirical evidence does not corroborate fears of such a “race to the bottom” scenario in Switzerland. This paper pursues two goals. First, we discuss how the power to set tax rates is being exercised in Switzerland, including both the terms of the political debate on this topic in Switzerland and the recent fiscal reforms. We show that cantonal tax autonomy is deeply rooted in the history and institutions of this country, that harmonization is limited, and that recent reforms have strengthened financial equalization but have not restricted cantonal autonomy. Second, using the case of personal income taxation, we discuss what the Swiss experience teaches us about the likelihood of a race to the bottom. On one hand, cantons are to some extent engaged in competition and try to attract wealthy taxpayers. On



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the other, competition has not led to a nationwide race to the bottom. This is partly explained by three factors: 1 the presence of intercantonal co-operative arrangements, such as the system of fiscal equalization; 2 the fact that tax rates are only one parameter among many for the choices of individuals and companies about where to locate; and 3 the institution of direct democracy. Moreover, competitive behaviour as a strategy for maximizing taxable income is a feasible option for only some cantons. Small units, especially those in proximity to large units, with a modern and comprehensive infrastructure, can profit from a competitive setting (Wasserfallen 2012).

The History of Cantonal Tax Autonomy Origins Historically, Swiss federalism has been a bottom-up construction. The crucial period in Swiss constitutional history was the transition from the ancien régime confederation of independent states, as it existed before 1798, to the foundation of the modern federal state in 1848 (Kölz 1992). This transition was characterized by tensions between federalist conservatives and unitarian liberals. The conservatives were concerned with maintaining the old Swiss Confederation of sovereign cantons with aristocratic prerogatives. The liberals defended economic and civil liberties, as well as political centralization, as part of a capitalist project to establish a unified economic space. During this period, as Switzerland was caught up in major historical currents, the pendulum swung back and forth between these two political models. After Bonaparte invaded Switzerland, the French established the centralized Helvetic Republic in 1798. The recreation of the cantons in 1803 was followed

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by the re-establishment of aristocratic prerogatives and full cantonal sovereignty after the Vienna Congress in 1815. However, a progressive move toward liberal republicanism continued in some cantons from the 1830s onward. Finally, after a short civil war between liberals and conservatives, the modern federal state was established in 1848. According to Linder (2010), the main reason for the subsequent stability of the 1848 constitution was the federalist arrangement – directly inspired by the American constitution – that permitted a balance between the conservative and the liberal political models. Central to Swiss federalism from the outset was the subsidiarity principle, which states that tasks not explicitly assigned to the federation fall within the competence of the cantons. Any transfer of tasks from the cantons to the federation requires a constitutional revision. A basic organizing principle of Swiss federalism is the notion of non-centralization (Braun 2003) which, as we have seen, is rooted in the historical conflict preceding the establishment of the modern Swiss state in 1848. The extensive tax autonomy of Swiss cantons, together with their extensive regulatory powers and responsibilities for determining expenditures, is a logical consequence of the non-centralization principle. It is interesting to note that during the founding transitional period the tax regime closely followed the institutional back and forth between centralization and cantonal sovereignty. Before 1798, taxing power was entirely in the hands of the cantons. The centralist Helvetic Republic was armed with considerable taxing powers, but the Republic’s centralized tax legislation remained a singular historical exception. After 1803, when the Helvetic Republic came to an end, cantonal tax autonomy was re-­established and has endured to the present. Cantonal tax autonomy is a principle of Swiss federalism with deep historical roots and constitutional protection. It includes the power to define the type of tax that is levied, as well as the rates. The only limitation to cantonal tax autonomy is a provision in the federal constitution – derived from nineteenthcentury liberal principles – stipulating that the tax burden on



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the taxpayer should be commensurate with his or her economic capacity.1 The lowest institutional level in the Swiss federation, the municipality, also enjoys significant tax autonomy. While municipalities generally cannot determine the type of taxes they levy, they can set their own tax rates. Historical Change and Current Debates As we have seen, the Swiss tax system is deeply rooted in the principles of Swiss federalism and therefore closely aligns with federalist architecture. The same is true of the political debate about the tax system; it is framed according to principles of a more general discussion of the functioning of Swiss federalism. The main line of this debate concerns the weight of the federation with respect to the cantons. During the second half of the nineteenth century, customs duties (indirect taxes) were the main source of income for the federal government. In the early twentieth century, the left started to call for stronger centralization of the system to achieve income redistribution. These early attempts to transfer taxing powers from the cantons to the federation were unsuccessful. The substantial federal taxing powers introduced in the early twentieth century were a result of exceptional historical circumstances. The first direct federal tax was a tax on war profits. It was approved in 1915, during the Great War, at a time of considerable federal financial need. Similarly, a new indirect federal tax on general sales was introduced in 1941 to cover military expenditures of the federal state during the Second World War. However, in accordance with the overriding principle of noncentralization, these federal taxing powers are granted only provisionally. This means that the federal power to levy direct taxes and sales taxes must be periodically confirmed by the Parliament and in referenda. As a result of the new federal taxing powers, the federation’s share in the overall tax income was significantly increased. In 1900, each institutional level – the federation, the cantons, and the municipalities – raised roughly one-third

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of the overall tax income. By 2000 the federation’s share had increased to 45 per cent, while the cantons represented 30 per cent and the municipalities took only 25 per cent of the overall tax income. Since the early days of the modern Swiss federal state, there has been an evolution in the tax systems of the cantons.2 During the nineteenth century, most cantons introduced direct taxes on natural persons and businesses, mainly in the form of property tax. Toward the end of the nineteenth century, cantons began introducing progressive taxes on income, as well as a broad range of other taxes, including death duties, gift taxes, dog taxes, taxes on financial transactions (taxes on change of property, stamp duties), and consumption taxes (on tobacco and luxury goods). As a result of the specific historical trajectories, and despite the increasing weight of the federation over the twentieth century, the cantonal tax systems are characterized today by an impressive variety, as shown in table 1. Given the increased mobility of taxpayers, this variety of cantonal tax systems has reinforced tax competition among cantons and among municipalities within cantons. Beginning in the 1980s, some cantons began to pursue a low-tax strategy, based primarily on the abolition of death duties and gift tax and a substantial reduction of tax rates. This not only led to a further increase in the variety of cantonal tax systems but also widened the gap between high-tax and low-tax cantons. Table 2 shows cantonal personal income tax rates (in four income categories for a married person without children, 2007). Note that table 2 displays only cantonal tax rates. Swiss residents are taxed by all three government levels. The federal income tax is quite progressive, and municipal income tax rates differ within cantons, whereas the municipal levels of progressivity are fixed to the respective cantonal systems. As the table illustrates, cantonal tax levels vary substantially in all income categories. For the lowest income categories, tax rates, generally, lay between 0 per cent and 1 per cent; but there are exceptions. An example is the canton of Glarus where individuals who earn chf 25,000 per year, which even for a single person represents a very



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Table 1 Cantonal Taxes Taxes Direct

Indirect

Income tax of natural persons Property tax of natural persons Personal or household tax Tax on profit of businesses Tax on capital of businesses (flat rate) Tax on inheritance Gift tax Tax on lottery gains Tax on real estate gains (natural persons and businesses) Real estate tax (natural persons and businesses) Tax on owner charge Casino tax Tax on motor vehicles Dog tax Leisure tax Stamp duties Lottery duties Visitors tax Tourism duties Waterwork tax

# cantons 26/26a 26/26b 10/26 26/26c 25/26 25/26 25/26 26/26 12/26 19/26 20/26 10/26 26/26 26/26  9/26  4/26  6/26 23/26  2/26  4/26

Source : Eidgenössische Steuerverwaltung (2009). a   Progressive rate in 24 cantons, flat rate in 2 cantons; b Progressive rate in 19 cantons, flat rate in 7 cantons; c Progressive rate in 1 canton, flat rate in 18 cantons, mixed in 7 cantons.

low income, are taxed at an exceptionally high rate of 2.1 per cent. For income categories of chf 50,000 per year, cantonal tax rates vary between 1.2 per cent in Zug and 5.34 per cent in Glarus, the mean being 2.57 per cent. The top tax rate in the canton of Glarus is again an outlier. The second highest rate in this income category, in Berne, is at 3.78 per cent. For people earning chf 100,000 Zug is again the canton with the lowest rate, 2.64 per cent. By comparison, the rate is three-and-a-half times higher in Neuchâtel, at 9.37 per cent. The tax rates vary widely for higher income levels too. For individuals with annual incomes of chf 200,000, the tax rate was slightly more than

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Table 2 Cantonal personal income tax rates in four income categories and 200k/50k tax rate ratio for a married person without children in 2007 Canton

25k

50k

100k

200k

200k/50k

Zurich Berne Lucerne Uri Schwyz Obwalden Nidwalden Glarus Zug Fribourg Solothurn Basle-City Basle-Country Schaffhausen Appenzell OuterRhodes Appenzell InnerRhodes St. Gall Grisons Aargau Thurgau Ticino Vaud Valais Neuchâtel Geneva Jura Mean

 .71  .29  .19  .14  .69 1.36  .21 2.10  .17 1.01  .78 0  .56  .49  .53

1.93 3.78 2.70 2.64 1.81 2.57 1.90 5.34 1.20 3.74 2.67 3.21 1.58 2.84 2.76

3.70 7.81 4.86 6.53 2.96 3.82 3.92 8.96 2.64 6.48 5.51 6.43 5.51 5.17 4.60

 5.74 11.15  6.70 11.34  4.24  4.31  5.41 12.46  4.30  9.48  7.71  8.94  9.51  7.16  6.28

2.97 2.95 2.48 4.29 2.35 1.68 2.84 2.34 3.58 2.54 2.89 2.78 6.01 2.52 2.28

 .87

2.11

3.66

 5.32

2.52

0  .87  .04 0  .08 0  .41  .86  .08  .22 0.47

2.23 2.12 1.81 1.68 1.23 2.97 2.91 3.66 1.61 3.71 2.57

4.63 4.63 4.29 4.62 4.32 8.34 4.54 9.37 7.99 7.60 5.50

 7.01  7.64  7.25  6.62  7.83 11.21  7.54 13.33 13.17 10.71  8.17

3.15 3.60 4.00 3.93 6.35 3.78 2.59 3.64 8.17 2.88 3.43

Source : Gilardi and Wasserfallen (2012).

4 per cent in Schwyz, Zug, and Obwalden, but the rate was more than 12 per cent in Glarus, Geneva, and Neuchâtel.3 Table 2 shows that cantons also differ greatly in the progressivity levels of their tax rates, that is, in the differences between tax rates for different income categories. The last column displays the ratio of the tax rates for annual incomes of chf 200,000 and chf 50,000. On average, the tax rate for a high income of



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chf 200,000 is 3.43 times higher than the tax rate for an annual income of chf 50,000. Basle-Country, Ticino, and Geneva have the most progressive tax systems with a ratio above 6. Geneva is the frontrunner in this category with a value of 8.17, which means that this canton has very low taxes for less affluent people and high taxes for high-income earners. Obwalden is the outlier on the other side with a ratio of just 1.68. The explanation for this figure is that the canton of Obwalden favours high earners by taxing their incomes of chf 200,000 at a very low level, while taxing low earners, with chf 50,000 annual incomes, at an average rate. Besides resulting in unequal treatment of taxpayers across cantons, intercantonal tax competition, according to some observers, has led to fiscal disparities. On the one hand, high-tax cantons are also those with fewer wealthy taxpayers or businesses and therefore they struggle with budget deficits. On the other hand, low-tax cantons have proportionally more wealthy taxpayers and profitable businesses, and their public finances are generally in good shape. The causal link between these disparities and tax competition is a matter of debate. While some accuse low-tax cantons of simply externalizing costs onto their neighbours (e.g., central infrastructures that are within cantonal financial competence such as universities, airports, cultural institutions), others argue that deficit-ridden high-tax cantons tend to live above their means and should cut costs (e.g., generous welfare programs or subsidies). Be that as it may, the deepening fiscal disparities between cantons stirred a long-running political debate that ultimately led to the introduction of a system of financial equalization in the mid-twentieth century. That equalization system has recently been substantially reformed. In addition to the debate over cross-cantonal fiscal disparities and equalization, there is a second line of intense political debate over the Swiss taxation system. This is fuelled by the increasingly unequal treatment of taxpayers across cantons. The debate concerns possible ways to reduce the variety of cantonal tax systems and to what extent this should be done. This debate

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has led to attempts at tax harmonization and implementation of subsequent reforms in 2000. Compensating Drawbacks of Cantonal Tax Autonomy: Fiscal Equalization and Tax Harmonization T h e S w i s s S y s t e m o f F i s c a l E q u a l i z a t i o n  The financial autonomy of cantons is one of the founding principles of Swiss federalism. The independence of cantons’ financial trajectories is thus inherent in this system. From the beginning, there have been differences between rich and poor cantons. However, it was only around the Second World War that the federation began to compensate for cantonal differences in wealth.4 In 1938, the first equalization policy program was introduced in the form of conditional grants, with rates graded according to the tax capacity of the cantons. But only in 1958 was a constitutional article introduced providing the federation with the authority to equalize fiscal disparities between cantons. Still, no quantitative objective was fixed regarding the level to which the cantonal revenue-raising capacities or the costs of public service provision should be compensated. Following adoption of the constitutional article, a system of intercantonal fiscal equalization was set up. The original objective of this system was to correct fiscal imbalance (meaning that all cantons should be able to provide some minimum levels of service without excessive differences in tax burdens across cantons). This system rested on three main equalization mechanisms (Dafflon 2004). The first two consisted of transfer flows from the centre to the cantons in the form of conditional federal grants-in-aid and revenue sharing. The third was a transfer flow from the cantons to the federation in the form of cantonal contributions to social security policies. In all three mechanisms, transfer payments were weighted according to the financial capacity of cantons, calculated with a formula that takes into account per capita economic capacity, tax burden, tax revenue, and the cost of public services provided.



Cantonal Tax Autonomy in Switzerland 131

The transfer payments within this system steadily increased and, by the year 2000, accounted for roughly 25 per cent of federal expenditures. Nevertheless, the system was ineffective; it was unable to reduce the fiscal disparities between cantons and differences in tax burdens across cantons continued to increase. In 1994, an expert group commissioned by the federal government identified several flaws in this system of financial equalization and urged major reforms (Frey et al. 1994). A reform process was initiated, and a totally new system of financial equalization was implemented in 2008 (Eidgenössisches Finanzdepartement 2007). The new system was based on two pillars: resource equalization (redistribution of financial resources between cantons) and compensation of charges (the federation pays contributions to cantons that face excessive costs related to public infrastructure requirements in large urban areas or mountain regions). In addition, the reform of fiscal equalization was paralleled by a process of disentangling federal and cantonal responsibilities in a whole range of policy fields. Indeed, co-operative arrangements had, in the past, led to blurring of responsibilities between the cantons and the federation (Politikverflechtung, see Scharpf [1979]), a situation that had also been diagnosed as a major cause of the ineffectiveness of the past equalization scheme. The new system of financial equalization (Neuer Finanz- und Lastenausgleich) is comprehensive and can, no doubt, be recognized as a major innovation in Swiss (fiscal) federalism. However, it is too early to assess the effects of this reform. We will have to await the results of future evaluations to see whether the new system effectively contributes to reducing financial disparities between cantons. A first effectiveness analysis by the Federal Council reports mixed results (Bundesrat 2010). T a x H a r m o n i z a t i o n  The variety of cantonal tax systems results in unequal treatment of taxpayers across cantons. Complications and inequalities also arise from the highly complex laws that govern cantonal tax collection. For instance, not only

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do types of taxes, tax rates, and tax allowances vary among cantons, but also the legal procedures for determining tax liability and calculating taxes due, and even the definitions of tax fraud and the extent of penal sanctions. The legal complexity of the Swiss tax system was increasingly criticized until, in the late 1970s, a new constitutional provision was adopted, giving the federation the power to work toward harmonization of direct taxes levied by cantons and municipalities. However, it is important to note that this harmonization objective is limited to formal legal dispositions. The harmonization of tax types, tax rates, and tax allowances – so-called material tax harmonization – is explicitly excluded by Art. 129 of the Federal Constitution, dated 18 April 1999, which reads as follows (our emphasis): 1 The Confederation shall set out principles on the harmonization of the direct taxes imposed by the Confederation, the Cantons and the municipalities; it shall take account of the efforts toward harmonization made by the Cantons. 2 Harmonization shall extend to tax liability, the object of the tax and the tax period, procedural law and the law relating to tax offences. Matters excluded from harmonization shall include in particular tax scales, tax rates and tax allowances. 3 The Confederation may issue regulations to prevent unjustified tax benefits. This article makes clear that the idea of material tax harmonization has not yet found a political majority, notwithstanding the claims of the left which has criticized cantonal tax autonomy for a very long time. Subsequent to the adoption of this new constitutional provision, the general goal of formal tax harmonization was detailed in new federal legislation (Steuerharmonisierungsgesetz) that took effect in 1993. Cantons were given a transition period of eight years to adapt their tax laws to the new standard set out in the federal law. Formal tax harmonization was achieved at the end of 2000.



Cantonal Tax Autonomy in Switzerland 133

A Race to the Bottom? Given the extensive autonomy of cantons with respect to tax policy, the danger of ruinous tax competition is real. Indeed, this concern has been at the forefront of political debate for a long time. Most recently, the Social Democrats launched an initiative which aimed to restrict tax competition with a harmonized minimal marginal tax rate for incomes higher than chf 250,000.5 They argue that tax differences for high income earners, as shown in table 2, are too large and unfair. Centre and right parties took an opposite view. They view tax competition as a major advantage in Switzerland and prefer no restrictions at all. The cantonal authorities also opposed the initiative because it would have restricted cantonal tax autonomy. The limitation of cantonal sovereignty in tax policy was eventually indeed the major reason why 58.5 per cent of the electorate rejected the initiative in November 2010. A critical point in the debate was the question of whether tax competition would trigger a race to the bottom in taxation. How much empirical evidence is there in support of this argument? If competition occurs, we would expect the tax rates of neighbouring cantons to be similar, as cantons attempt to attract more taxpayers. It is fair to expect that this regional clustering of tax rates would be stronger for higher income categories because wealthier taxpayers are obviously a better asset for cantonal finances. Figure 1 displays the geographic distribution of tax rates for two income categories, namely chf 25,000 and chf 200,000. The darker the grey shades, the higher taxation; the respective tax rates of the shades are displayed on the right side of the maps. Figure 1 shows that tax rates for the chf 200,000 income category are significantly clustered geographically, with lower tax rates concentrated in the cantons in the middle of the map (roughly in the region of Zurich), while tax rates for the chf 25,000 income category are more scattered, with fewer regional similarities.

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Figure 1 Regional clustering of cantonal personal income tax rates for an annual income of chf 200,000 (top panel) and chf 25,000 (bottom panel) (married person without children, 2007).

12

10

8

6 4

2.0

1.5

1.0

0.5

0.0 Source : Gilardi and Wasserfallen (2012).

These spatial effects, as well as the differences between income categories, are confirmed by more systematic analyses (Gilardi and Wasserfallen 2012; Feld and Reulier 2008) and are also consistent with abundant anecdotal evidence. Figure 1 shows that the small cantons close to Zurich, at the economic centre



Cantonal Tax Autonomy in Switzerland 135

of Switzerland and providing extensive public infrastructure, tax people with high incomes at very low rates. Most critics of tax competition do not criticize it per se, but rather its consequences, in particular a possible race to the bottom in tax rates that would put cantons under strong pressure to reduce expenditures and cut services. Gilardi and Wasserfallen (2012) analysed in detail how cantonal tax rates changed in Switzerland from 1990 to 2007. Results can be summarized as follows: 1 Tax rates for low incomes decreased in almost all cantons. There has been a large degree of convergence toward a lower taxation level, or, in other words, a race to the bottom. Revenue raised by taxing low incomes is fiscally negligible. In 1990, a large number of cantons taxed low incomes at a near-poverty level. Given the taxation levels in 1990 for low incomes, general cuts in these categories might not be that surprising. 2 For middle incomes the general trend has also been a lowering of income taxation between 1990 and 2007, although the general downward dynamic was much less consistent than in the case of the low income categories. 3 Cantonal tax changes for high incomes have been much more heterogeneous. The majority of cantons have decreased tax rates for high incomes, but a significant number of cantons have increased tax rates since 1990. Hence, convergence toward a lower level does not characterize the overall dynamic in the high income categories. To summarize, tax rates between 1990 and 2007 generally decreased for low and middle incomes, but not for high incomes. This is surprising because if competition leads to a race to the bottom, then tax rates for high incomes should converge toward a lower level. This dynamic can be observed for the lower and middle income categories, although competition cannot be the driving factor. Empirical evidence seems to contradict the wasteful tax competition hypothesis. That hypothesis

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posits that tax competition triggers a race to the bottom in terms of taxation rates for higher income individuals, i.e., those who are most mobile. The hypothesis continues that all governments would seek to attract higher income individuals by lowering taxes. Looking back at figure 1, we can note, again, that low tax rates are concentrated in a relatively narrow region, which means that, to the extent that competition exerts a downward pressure on tax rates for high incomes, its effects do not reverberate nationwide. Part of the explanation for this contradictory pattern lies in institutionalized forms of co-operation among cantons. Although, as explained earlier, there are few limits to cantonal autonomy in tax policy, cantons strive to coordinate their policies in forums such as the national and regional conferences of cantonal finance ministers. Although these institutions do not make binding decisions and members are often more interested in preserving their autonomy than in achieving meaningful co-operation, regular interaction may be a way out of the prisoner’s dilemma that characterizes tax competition (Gilardi and ­Wasserfallen 2012). In addition to these co-operative arrangements, other factors limit the extent of competition. First, in their choice of where to locate, residents and businesses obviously look at other factors besides tax rates. They also consider the level of public services, e.g., traffic infrastructure. Hence, it is not the tax level as such, but rather the ratio between tax and services that is important for choosing where to locate. Second, differences in tax levels are capitalized. In cantons and municipalities with low tax levels, prices for land and housing are higher. By moving to low-tax locations, residents and businesses might save tax expenses but may incur higher costs for housing and living. Third, thanks to extensive direct democracy at the subnational level, citizens can decide about tax levels and government expenditures. Tax cuts might be supported in the short term, but, again, the ratio between taxation and public services is critical for the support of tax reform. If service levels are considered too low, tax cuts are unlikely to be supported. Also,



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tax reforms that are considered unfair because they serve the interests of the rich exclusively might be overturned by direct democratic vote. Finally, there are other factors that come into play when a canton considers whether to pursue a low-tax strategy to attract taxable income. A tax cut implies reduction of revenue from the people already residing in a canton, and it is likely associated with some influx of supplementary taxable income. For small cantons, the additional revenue might compensate for losses, but for a large canton, this mechanism is fiscally risky because the initial losses are simply too great to be covered by extra revenues. A similar pattern can be observed on the country level in Europe: small countries have lower corporate tax rates than large countries (Ganghof and Genschel 2008). In the case of Swiss cantons, proximity to Zurich is another important factor. Zurich is economically the most vibrant place in Switzerland, and public services and benefits – cultural institutions, an international airport, and a large university, for example – are extensive compared to what other cantons offer. Therefore, it comes as no surprise that small cantons around Zurich are successful at attracting high-income earners with comparatively low taxes. Because of the short travel distance, residents of these low-taxation cantons can work in Zurich and profit from the benefits of a large city. Whether the fiscal equalization system is sufficient to compensate for such distortions is an open question.

Conclusion: Tamed Competitive Federalism The sovereignty of subnational units is deeply rooted in Switzerland. Non-centralization and subsidiarity are ruling principles in the structuring of taxation. Direct taxes, especially, are largely decentralized, meaning that cantons differ substantially not only in tax rates but also in tax systems, while tax harmonization is limited to formal legal dispositions. A system of financial equalization, which has recently been substantially reformed, should reduce fiscal disparities to some extent. It is still too early to evaluate the effect of this new system. What is clear, however,

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is that the old system, which was criticized extensively, was neither transparent nor targeted and was unable to reduce fiscal disparities. Despite a high degree of cantonal responsibility in income taxation and the poor functioning of the old equalization system, we see a general downward dynamic in tax rates (often labelled a race to the bottom) only for low and middle income groups. Reductions in tax rates for these income groups cannot be explained by competitive dynamics. The picture for high incomes is more nuanced: while systematic analyses corroborate competition-effects (Wasserfallen 2012; Gilardi and Wasserfallen 2012; Feld and Reulier 2008), tax rates for high incomes generally did not decrease between 1990 and 2007. Hence, even though Swiss fiscal federalism is characterized by strong competitive elements, this has not led to the dysfunctions commonly associated with tax competition. We argue that co-operative arrangements, the institutions of direct democracy, and the capitalization of tax differences (for example in housing prices and rents) act as balancing factors to competitive pressures. Moreover, a low tax strategy is fiscally too risky for large cantons, and, in fact, only a handful of small cantons around Zurich have taxed high incomes at very low levels for an extended period of time. Whether the differences in taxation between cantons are acceptable is ultimately a political question. What this paper shows is that differences are indeed extensive. However, over the last twenty years, a wasteful downward dynamic among high incomes could not be observed. It is still too early to evaluate the effects and functioning of the new fiscal equalization systems. Such analysis will be critical for the further development of the complex decentralized tax system in Switzerland, with its competitive, co-operative, and compensatory elements.

notes 1 This is an important basic principle of the Swiss tax system, found in Art 127 Abs. 2 of the Federal Constitution: “Provided the nature



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of the tax permits it, the principles of universality and uniformity of ­taxation as well as the principle of taxation according to ability to pay shall be applied” (SR 101). On 1 June 2007, the federal court declared that a regressive tax system with flat-decreasing tax rates, which the canton of Obwalden attempted to implement, violated this basic redistributive principle (iustitia distributiva). 2 For an overview, see the article “Steuern” in the Historisches Lexikon der Schweiz (www.hls-dhs.dss.ch, accessed 10 February 2010). 3 Wealthy foreigners with residency but no occupation in Switzerland can apply for lump-sum taxation, which is typically very advantageous and also varies between cantons. In February 2009, the electorate of the canton of Zurich abandoned this tax practice in a referendum, and in September 2011, the electorate of the canton of Schaffhausen followed Zurich’s example. In other cantons, the proposal for the abolition of this tax practice is pending. 4 For an overview, see Dafflon (2004). 5 www.steuer-gerechtigkeit.ch.

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Feld, L.P., and E. Reulier. 2008. “Strategic Tax Competition in Switzerland: Evidence from a Panel of the Swiss Cantons.” German Economic Review 10, no. 1:91–114. Frey, R.L., A. Spillmann, B. Dafflon, C. Jeanrenaud, and A. Meier. 1994. Der Finanzausgleich zwischen Bund und Kantonen. Expertise zu den Finanzhilfen und Abgeltungen des Bundes an die Kantone im Auftrag der Eidg. Finanzverwaltung und der Konferenz der kantonalen Finanzdirektoren. Bern: Eidg. Finanzverwaltung. Ganghof, S., and P. Genschel. 2008. “Taxation and democracy in the eu.” Journal of European Public Policy 15, no. 1:58–77. Gilardi, F., and F. Wasserfallen. 2012. “How Socialization Attenuates Tax Competition.” University of Zurich. Kölz, A. 1992. Neuere Schweizerische Verfassungsgeschichte: Ihre Grundlinien vom Ende der Alten Eidgenossenschaft bis 1848. Bern: Sämpfli. Linder, W. 2010. Swiss Democracy. Possible Solutions to Conflict in Multicultural Societies. London: Palgrave Macmillan. Olson, M. 1969. “The Principle of ‘Fiscal Equivalence’: The Division of Responsibilities among Different Levels of Government.” The Amercian Economic Review 59, no. 2:479–87. Scharpf, F.W. 1979. “Die Theorie der Politikverflechtung: ein kurzgefasster Leitfaden.” In Politikverflechtung im föderativen Staat. Studien zum Planungs- und Finanzierungsverbund zwischen Bund, Ländern und Gemeinden, edited by Joachim Jens Hesse, 21–31. Baden-Baden: Nomos. Tiebout, C.M. 1956. “A Pure Theory of Local Expenditures.” Journal of Political Economy 64, no. 5:416–24. Wasserfallen, F. 2012. “The Uneven Playing Field in Tax Competition.” University of Zurich.

Contributors

C h a r l e s   B .   B l a n k a r t is professor emeritus in economics. He has served as chair at different German universities, last at Humboldt University, Berlin. E r i k   R .   F a s t e n holds a PhD in economics, Humboldt University, Berlin. F a b r i z i o   G i l a r d i is associate professor, Department of Political Science, University of Zurich, Switzerland. D av i d   G u i m o n d is an MSc student, Political Science Department, Université de Montréal. C h a r l i e   J e f f e r y is professor of politics, head of the School of Social & Political Science and vice-principal (Public Security Sector) at the University of Edinburgh. D a n i e l   K ü b l e r is associate professor, Department of Political Science, University of Zurich, and Centre for Democracy, Aarau, Switzerland. V i o l e t a   R u i z   A l m e n d r a l is professor of tax and finance law, Universidad Carlos III de Madrid and, since 2011, law counsel (Letrada) at the Spanish Constitutional Court.

142 Contributors

F r a n ç o i s   V a i l l a n c o u r t is fellow, cirano, Montreal, and emeritus professor, Economics Department, Université de Montréal. M a g a l i   V e r d o n c k is professor, Department of Economics, Facultés Universitaires Saint-Louis, Brussels, Belgium. F a b i o   W a s s e r f a l l e n is a PhD student, Department of Political Science, University of Zurich, Switzerland.