Dialogues on the Practice of Fiscal Federalism 9780773573338

Table of contents :
Contents
Preface
DIALOGUE INSIGHTS
Australia: Equity, Imbalance, and Egalitarianism
Brazil: Maintaining Fiscal Discipline amid Regional and Social Antagonisms
Canada: Emerging Issues in a Decentralized Federation
Roads to Reform of German Fiscal Federalism
Fiscal Federalism in India: Emerging Challenges
Fiscal Federalism in Malaysia: Challenges and Prospects
Fiscal Federalism in Nigeria: Unsettled Issues
Russian Federalism at a Crossroads
South Africa: Fiscal Federalism in Transition
Spain: Redefining Fiscal Equalization and Fiscal Relations
Sustainable Public Finances with Sub-Federal Fiscal Autonomy: The Case of Switzerland
The Changing State of Fiscal Federalism in the U.S.
Comparative Reflections on Emerging Challenges in Fiscal Federalism
Glossary
A
B
C
D
E
F
G
H
I
L
M
N
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P
R
S
T
U
V
Contributors
Participating Experts

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D I A L O G U E S ON THE PRACTICE OF FISCAL FEDERALISM: COMPARATIVE PERSPECTIVES

A GLOBAL D I A L O G U E ON F E D E R A L I S M

A Joint Program of the Forum of Federations and the International Association of Centers for Federal Studies EDITORIAL BOARD: CO-CHAIRS

Raoul Blindenbacher, Canada / Switzerland Cheryl Saunders, Australia SENIOR EDITOR, BOOK SERIES

John Kincaid, United States J. Isawa Elaigwu, Nigeria Patrick Fafard, Canada Thomas Fleiner, Switzerland Meenakshi Hooja, India Fernando Rezende, Brazil Horst Risse, Germany Ronald L. Watts, Canada www.forumfed.org www.iacfs.org A Global Dialogue on Federalism publications available BOOK SERIES

Constitutional Origins, Structure, and Change in Federal Countries (2005), Volume 1 Distribution of Powers and Responsibilities in Federal Countries (2006), Volume 2 BOOKLET

SERIES

Dialogues on Constitutional Origins, Structure, and Change in Federal Countries (2005), Volume 1 Dialogues sur les origines, structures et changements constitutionnels dans les pays federaux (2005), Volume 1 Dialogues on Distribution of Powers and Responsibilities in Federal Countries (2005), Volume 2 Dialogues sur la repartition des competences et des responsabilites dans ks pays federaux (2005), Volume 2 Dialogues on Legislative, Executive, and Judicial Governance in Federal Countries (2006), Volume 3

A Global Dialogue on Federalism Booklet Series Volume 4

DIALOGUES ON THE PRACTICE OF FISCAL FEDERALISM: COMPARATIVE PERSPECTIVES

EDITED BY RAOUL BLINDENBACHER AND ABIGAIL OSTIEN KAROS

Published by

Forum of Federations Forum des federation an

iacfs

INTERNATIONAL ASSOCIATION OF CENTERS I'OR FEDERAL STUDIES

© Forum of Federations, 2006 ISBN-13: 978-0-7735-3196-3 ISBN-10: 0-7735-3196-3 This publication was produced with generous financial support from the government of Canada, the World Bank Institute (WBI), the Swiss Agency for Development and Cooperation, and the Secretariat of Finance of the State of Bahia, Brazil.

Library and Archives Canada Cataloguing in Publication Dialogues on the practice of fiscal federalism: comparative perspectives / edited by Raoul Blindenbacher and Abigail Ostien Karos. (A global dialogue on federalism booklet series; v. 4) ISBN-13: 978-0-7735-3196-3 ISBN-10: 0-7735-3196-3 1. Intergovernmental fiscal relations. 2. Federal government. I. Blindenbacher, Raoul II. Karos, Abigail Ostien, 1971III. International Association of Centers for Federal Studies IV. Forum of Federations V. Series: Global dialogue on federalism booklet series ; v. 4 HJ141.D52 2006

336

Printed and bound in Canada by Imprimerie Gauvin

C2006-902183-X

Contents

Preface vii DIALOGUE INSIGHTS

Australia: Equity, Imbalance, and Egalitarianism 3 ALAN MORRIS

Brazil: Maintaining Fiscal Discipline amid Regional and Social Antagonisms 6 FERNANDO

REZENDE

Canada: Emerging Issues in a Decentralized Federation 9 ROBIN ROADWAY

Roads to Reform of German Fiscal Federalism 12 LARS P. FELD / J U R G E N VON HAGEN

Fiscal Federalism in India: Emerging Challenges 15 M. G O V I N D A RAO

Fiscal Federalism in Malaysia: Challenges and Prospects 18 SAIFUL AZHAR ROSLY

Fiscal Federalism in Nigeria: Unsettled Issues 21 AKPAN H. EKPO

Russian Federalism at a Crossroads 24 ALEXANDER DERYUGIN /

GALINA KURLYANDSKAYA

South Africa: Fiscal Federalism in Transition 28 RENOSI

MOKATE

Spain: Redefining Fiscal Equalization and Fiscal Relations 31 JOAQUIM SOLE VILANOVA

vi

Contents

Sustainable Public Finances with Sub-Federal Fiscal Autonomy: The Case of Switzerland 34 GEBHARD KIRCHGASSNER /

PRABHU

GUPTARA

The Changing State of Fiscal Federalism in the U.S. 37 MERL HACKBART

Comparative Reflections on Emerging Challenges in Fiscal Federalism 40 ANWAR SHAH

Glossary 47 Contributors 53 Participating Experts 55

Preface

With the booklet "Dialogues on the Practice of Fiscal Federalism: Comparative Perspectives" the Global Dialogue on Federalism Series concludes its fourth theme volume. The series, thus far consisting of corresponding theme books and booklets on federal constitutions, distribution of powers, and legislative, executive, and judicial institutions in federal countries, has become a globally recognized reference publication widely used by politicians, public servants, academics, and students. The success of the publications is undoubtedly based on the unique process by which the publications are generated. To date, more than 1000 practitioners and academics have participated in over 50 fruitful dialogues held in 20 countries around the world. Apart from the growing readership who benefit from these comparative volumes, the visibility of the series is enhanced through exposure at the international conferences on federalism. The already existing publications will form part of the content preparation for the Fourth International Conference on Federalism, to be held in New Delhi, India in 2007. The process by which the series is produced is the outcome of a greater project called A Global Dialogue on Federalism. The program explores federal governance by theme, and aims to bring experts together to inspire new ideas and fill a gap in the comparative literature on federal governance. Each theme process entails a multiple number of stages which starts with the selection of a "theme coordinator." Based on the most current research, it is this person's task to create an internationally comprehensive set of questions covering institutional provisions and how they work in practice. These sets of questions are the foundation of the program, as they guide the dialogue at the roundtables and ensure consistency in the book chapters. The roundtables themselves are led by a "country coordinator," and organized concurrently in a dozen selected federal countries. To create the most accurate picture of the theme in each country, the country coordinators invite a select group of practicing and academic

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experts with diverse viewpoints and experience who are prepared to share with and learn from others in a non-politicized environment. At the end of the day, the coordinators are equipped to write an article that reflects the highlights of the dialogue from each country roundtable. The articles presented here have been generated from such an exchange. Once each country has held its roundtable, representatives gather at an international roundtable to identify commonalities and differences and to generate new insights. Such insights are incorporated into the country chapters in the aforementioned theme book. The chapters reflect the fact that their authors were able to explore the theme from a global vantage point, resulting in a truly comparative exploration of the topic. The current booklet explores various aspects of the practice and the comparative perspectives of fiscal federalism in Australia, Brazil, Canada, Germany, India, Malaysia, Nigeria, Russia, South Africa, Spain, Switzerland, and the United States. Among the questions explored in the articles are: What is the extent of vertical and horizontal fiscal imbalance? What are the revenue sources and expenditures of both constituent unit and national governments? Accordingly, what is the degree of fiscal autonomy on the part of the constituent units and/or intrusiveness on the part of the national government? How does the local order come into play? How does public opinion influence fiscal policy and what is the overall commitment to nationwide standards? How is debt managed? What reforms are currently underway and why have they been deemed necessary? The exploration of these questions forms the body of the booklet in country articles entitled "Dialogue Insights/' The concluding chapter by Anwar Shah, Lead Economist of the World Bank Institute, summarizes commonalities and differences in the featured countries. A glossary at the end of the booklet contributes to the accessible and educative nature of this publication, laying the groundwork for a more comprehensive book on this same theme. As such, it is our intention that the articles presented here will serve to provide an entry point for Volume 4 of the book series, "The Practice of Fiscal Federalism: Comparative Perspectives," wherein the same authors explore the topic in comprehensive detail. The success of the Global Dialogue Program depends fully on the engagement of a variety of organizations and dedicated individuals. For their generous financial support we would like to thank the Government of Canada, the Swiss Agency for Development and Cooperation, the World Bank Institute (WBI), and the Secretariat of Finance of the State of Bahia, Brazil. The last of these, together with other Brazilian governmental and non-governmental organizations, funded the Global Dialogue International Roundtable held in Costa do Suipe, Bahia, Brazil. Special thanks are due to Anwar Shah for writing the final chapter, "Comparative Reflections," and for offering his feedback on the booklet as a whole. We wish to acknowledge the experts who took part in the dialogue events

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for providing a diversity of perspectives that helped to shape the articles themselves. Their names are listed at the end of the booklet. John Kincaid, Senior Editor of the book series, and the rest of the Global Dialogue Editorial Board have offered their invaluable advice and expertise. Thank you to Alan Fenna for doing the painstaking work of creating the glossary. We would like to acknowledge the support offered by several staff members at the Forum of Federations: Lisa Goodlet, Roderick Macdonell, RoseAnne McSween, Chris Randall, Carl Stieren, and Nicole Pedersen. Finally, we thank the staff at McGill-Queen's University Press for offering their support and advice throughout the publication process. The Global Dialogue on Federalism Series continues the Forum of Federations' tradition of publishing either independently or in partnership with other organizations. The Forum has produced a variety of books and multimedia material. For further information on the Forum's publications and activities, refer to the Forum's website at www.forumfed.org. The website contains links to other organizations and an on-line library which includes Global Dialogue articles and chapters. With the increasing distribution of the results of the Global Dialogue Program, the two founding partners of the program, the Forum of Federations and the International Association of Centers for Federal Studies, encourage practitioners and scholars to use the knowledge gained to inspire new solutions, thereby improving democratic governance, and to join the many active participants around the world to expand and strengthen the growing international network on federalism. Raoul Blindenbacher and Abigail Ostien Karos, Editors Forum of Federations

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D I A L O G U E S ON THE PRACTICE OF FISCAL FEDERALISM: COMPARATIVE

PERSPECTIVES

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Australia: Equity, Imbalance, and Egalitarianism ALAN MORRIS Australian fiscal federalism is clearly defined by two distinguishing features: (1) the extent of vertical fiscal imbalance within the federation, and (2) a detailed and comprehensive approach to horizontal fiscal equalization, which guides the distribution of funding transfers between the federal, or Commonwealth, government and the states and territories. While the origins of fiscal federalism in Australia go back to the founding of the federation and the Constitution enacted at that time, these two features owe much more to the historical evolution-of practice than they do to the original principles of the Constitution. The Australian Constitution does not differ markedly from most federations with regard to the powers of the Commonwealth and state governments. As set out in the Constitution, defence, foreign affairs, international trade, customs, and currency are managed by the Commonwealth government. Matters not specifically vested in the Commonwealth government, such as health, education, and law and order, are the responsibility of the states. The Constitution also defines the respective revenue-raising powers of the Commonwealth and state governments - including the fact that the Commonwealth government may grant financial assistance to any

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Alan Morris

state on such terms and conditions as it sees fit. But since the enactment of the Constitution in 1901, the allocation of taxing powers has changed significantly. As a result of decisions taken at time of historical crisis and a series of High Court rulings, the fiscal dominance of the federal government has greatly increased at the expense of the states. As a result of deci The Commonwealth government now raises sions takem at times substantially more revenue than it needs to meet of historical crisis its own expenditure obligations, while state and and a series of High territory governments raise substantially less. This Court rulings. the disparity between revenue-raising capacity and fiscal dominance expenditure obligations produces what federal of the federal financial analysts call a situation of "vertical fiscal government has imbalance" between the two orders of governgreatly increased ment. Currently, the Commonwealth goverment at the expense of raises about 80 percent of all government revethe states nue, but requires only 61 percent of the pie to meet its own expenditure needs, while state and territory governments raise just 17 percent of all revenue, but require 33 percent - twice that amount - to meet their expenditure responsibilities. The fiscal dominance of the Commonwealth government, and the way it has used its fiscal strength to intervene in areas that have traditionally been the prerogative of the states, has come to have implications for responsibility of government functions. In some areas, the roles and responsibilities of different spheres of government have become blurred, giving rise to duplication, overlapping, and cost-shifting. Many think that the vertical fiscal imbalance in Australia is too large and has unwelcome implications for accountability, and weakens the motivation for fiscal reform. Tax bases are accessed almost exclusively by one sphere of government, with the Commonwealth government having access to the more important tax bases, most notably the direct tax bases of personal and company income. Suggestions for improvement include that the Commonwealth government make room to allow the states and territories to "piggy-back" on this tax base by reducing its own tax rate. Other changes that would make a positive contribution include reform and strengthening of state tax bases (particularly in the area of land tax) and harmonization of the relevant tax bases across the states. The extent of vertical fiscal imbalance in the Australian federation raises the question of whether the concept of an optimum fiscal gap should be explored. While vertical fiscal imbalance in Australia might be considered undesirably large, some degree of centralization of tax powers provides a national fiscal capacity to undertake national objectives and priorities. The large vertical fiscal imbalance means that the transfer of funds from the Commonwealth government to the states to enable them to meet their

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expenditure needs is a critical issue. The principle and practice of horizontal fiscal equalization under which the transfers of untied grants are made to the states and territories is the second distinguishing feature of Australian fiscal federalism. The objective is to equalize the fiscal capacities of the state and territory governments, and the current approach is based on a comprehensive assessment of their relative revenue capacities and expenditure needs. These transfers are considerable, totalling about $58 billion Australian dollars per year, and comprise, on average, over 50 percent of total state revenue, up from about 10 percent in the 1950s. They are critical to state budgets. A significant proportion of the transfers from the Commonwealth government to the states and territories, currently of the order of 40 percent of total transfers, take the form of Specific Purpose Payments (SPPs). These are tied grants for designated purposes, essentially to support specific national priorities in areas such as health and education, and typically come with strings attached. Some observers see this as undermining genuine subsidiarity, competitive federalism, and the development by the states of more efficient ways of funding and delivering services, and hence effectively undermining the benefits of federalism. The untied transfers which, since the tax reform initiatives in 2000 and the Intergovernmental Agreement on Reform of Commonwealth-State Financial Relations between the Commonwealth and the states, have comprised the revenue raised from the goods and services tax (GST), can be spent by the states and territories in whatever way they choose. The size of the untied federal transfers raises the question of mutual obligation and accountability. There is no obligation on state and territorial governments to spend the grants in any particular way, or to justify the basis of that assessment in their expenditure decisions and priorities. There are indeed discrepancies between assessed expenditure needs and actual levels of spending in particular areas. The lack of monitoring of expenditures, even though this is fundamental in a system of untied grants, is a frequent basis of criticism of state spending choices. While horizontal fiscal equalization is generally accepted as the guiding principle for the distribution of untied grants to the states and territories, its implementation continues to be sensitive and contentious. Some states argue that the process has become too complex and detailed, and that many of the differential assessments of state revenue capacities and expenditure needs do not reflect real, material differences in state circumstances. The Australian approach to fiscal equalization indicates that Australians do not want the type and extent of regional disparities that exist in some other federations. This approach allows the various jurisdictions to determine their own local choices and preferences. It is a particular concept of equity that can perhaps best be described as aiming to deliver fairness rather than equality. And it is generally agreed that a fiscal federal system set in stone would not necessarily remain appropriate in another time.

Brazil: Maintaining Fiscal Discipline amid Regional and Social Antagonisms FERNANDO REZENDE In 1994, Brazil adopted a monetary stabilization plan that not only ended an era of high inflation, but also had a profound effect on federal finances. A newly stable currency brought structural imbalances to light and forced public administrators to come to terms with their accounts. In the fairly decentralized Brazilian federation, the enforcement of fiscal discipline required important institutional changes. A "fiscal discipline" law, enacted in 2000, imposed limits on personnel expenses and on the level of state and local government indebtedness. At the same time, hard budgetary constraints imposed by the macroeconomic goals of price stabilization impinged on subnational autonomy with respect to the disbursement of their budgetary resources. Currently, vertical and horizontal inequalities in the distribution of the fiscal resources, as well as a low degree of freedom in revenue allocation at all federal levels, are major sources of inefficiency in public spending. Due to citizen reaction to further increases in the overall tax burden, the growing awareness of the need to combat inefficiency and improve quality

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in the use of public resources has prompted a new wave of demands to focus the fiscal debate on the expenditure side of the budget. In the beginning of the monetary stabilization era, price stability was anchored on the overvaluation of the newly created currency, the real, but the successive external financial crises that hit emerging economies, such as Mexico, Southeast Asia, and Russia, in the second half of the 1990s forced the Brazilian government to abandon exchange rate controls in 1999 and let the national currency float on the market. With the devaluation of the real, monetary stability came to depend upon a responsible management of the fiscal accounts. A new inflation target policy was put into place and fiscal discipline took the place of the exchange rate as the anchor used to avert inflation. The 1988 Constitution enhanced subnational tax powers and, in an effort to protect social policies, established a dual fiscal regimen. It created a social budget with a specific set of federal taxes - the so-called "social contributions" - to which subnational governments were also required to contribute. However, the ensuing economic crisis did not favour state and local government revenues, whose finances also suffered from the impact of high interest rates on their budgets. With the new fiscal discipline, the extended social rights had to rely on the federal ability to raise enough money to meet a steep rise in social spending. To that end, the new federal taxes earmarked to the social budget began to rise, initiating a process that reversed fiscal decentralization. Besides concentrating spending power in federal hands, the recourse to the social contributions to meet increases in social spending had negative consequences for the economy and the federation. The cascading effect of such contributions generated economic inefficiencies and distorted foreign trade. For the federation, the rise of conditional grants cut deeper in subnational spending autonomy and increased vertical and, particularly, horizontal imbalances. The reversal of fiscal decentralization affected mainly the states. Even though Brazilian states enjoy a great degree of constitutional autonomy, their decision-making power is relatively limited. The federal government defines the limits within which states and local governments can set norms for applying and collecting taxes on goods and services; establishes detailed provisions concerning subnational budgets; and leaves almost no room in its laws for the states in areas such as public utilities, environmental protection, and the exploration of natural resources. Even on the expenditure side, state governors' degree of freedom to allocate budgetary resources has been reduced to almost none. Entitlements and earmarked revenues plus day-to-day operational expenses leave practically no money to finance investments and, as access to loans is very limited, their ability to pursue development policies has vanished. Furthermore, the "fiscal discipline law" prohibited state and local authorities from taking actions that lead to further expenses without specifying a source of financing or an equivalent cut in other outlays. So it is not by chance that

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the states have resorted to the only means available to attract manufacturing plants: to engage in a fierce tax competition that has become one of the main sources of antagonism among the Brazilian states. The situation at the local order is quite a different story; in fact, in Brazil local governments have more autonomy than the states. They are entitled to regulate the use of municipal land and the provision of urban services, impose service charges, and define their own norms for collecting property taxes. In general, they also have more autonomy over their budgets, as a significant part of their revenue comes from general purpose grants. The revenue-sharing mechanisms enshrined in the Constitution entitle the municipalities to 22.5 percent of the federal income and manufacturing taxes and 25 percent of the states' Value Added Tax (VAT) collections. However, the criteria applied to divide the municipal share on federal taxes are biased toward smaller municipalities and penalize the core metropolitan cities, which house one-quarter of the population but get only 10 percent of this pie. These distortions in the revenue-sharing mechanisms have led to a high degree of horizontal inequality in the distribution of the public money across the federation. Sparsely populated units in the Amazon and the centre-west regions receive higher amounts of money in per capita terms than those administered by the poorer but highly populated northern states. Due to the autonomy granted to municipalities, state governments cannot coordinate investments and the provision of urban and social services across the limits of local jurisdictions. And an increasingly direct relationship between the federal government and the municipalities, with large amounts of federal funds being As macroeconemic channeled directly into the local purse, underconstrains will mines the ability of the states to have any control remain in place for over the activities that take place in their territory. some time to come Super-imposition of programs and lack of integraand the national tion and coordination lead to waste of resources, reacton to further higher production costs, and an uneven access to increases in the tax public services, as poor people in less endowed burden does not municipalities may get fewer benefits than those open much space who are more well off and living in financially rich for deeper taxamunicipalities. As macroeconomic constraints will tion. a call for remain in place for some time to come, and the measures to reduce national reaction to further increases in the tax waste in the use of burden does not open much space for deeper taxathe budgetary tion, a call for measures to reduce waste in the use resources echoes of the budgetary resources echoes across the counacross the country try. Notwithstanding, the vertical and horizontal imbalances and strong antagonisms that characterize the current Brazilian federation make concrete advances in this direction very difficult without a thorough reform of Brazilian fiscal federalism.

Canada: Emerging Issues in a Decentralized Federation ROBIN ROADWAY For many observers, Canada epitomizes the classical system of fiscal federalism. Autonomous provincial governments are responsible for the provision of many important public services. They enjoy unfettered access to all the major tax sources and are responsible for raising a high proportion of their own revenues. Federal transfers to the provinces are fairly non-intrusive. The two main forms of transfers - unconditional equalization transfers and equal per capita bloc transfers to support provincial social programs - facilitate effective decentralized decision making by ensuring that provinces have comparable capacities for delivering important public services and by encouraging them to provide health, social assistance, and post-secondary education programs that meet minimal nationwide criteria. Federal-provincial agreements have led to textbook forms of income tax and sales tax harmonization and have established the rules of the game for an efficient internal economic union and for a fair and equitable social union. Additional transfers are made to the three northern territories to allow them to deliver public

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services to small, dispersed populations and to recognize their relatively weak fiscal capacity. Yet, new challenges are pending. Fiscal decentralization combined with the increasing demand for health care and education, which constitute a large proportion of the public services provided by provinces, has brought with it the prospect of fiscal imbalance, both vertical and horizontal. This challenge extends to municipal governments and to self-governing Aboriginal communities, where some of the need is greatest. Issues frequently stem from two seemingly contradictory elements of the Canadian federation. The first difficulty is that while the Constitution gives provinces exclusive legislative responsibility in the important areas of health, education, and welfare, the federal government shares a constitutional commitment to provide essential public services of reasonable quality and to promote equal opportunities for all Canadians. Since the public services that are most critical for fulfilling this commitment are provincial responsibilities, the policy instruments left to the federal government are conditional transfers both to governments and to individuals, elements of the socalled "spending power," which is the federal government's ability to provide and earmark funds for spending in specific areas of provincial jurisdiction. The second issue is that provinces own the natural resources within their boundaries and have the right to tax their use. But the Constitution commits the federal government to the principle of making equalization payments so that all provinces have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation. Given that a substantial source of fiscal disparity among provinces comes from natural resource endowments, some argue that the fulfillment of the equalization commitment implicitly contradicts the provincial ownership of revenues from natural resources. The key features of fiscal federalism in Canada are clear. The federal government takes on typically national functions, such as defence, foreign affairs, and the monetary system, as well as national social insurance programs and transfers to the provinces. The provinces and their municipalities are responsible for major public services in health, education, and welfare, as well as matters of provincial and local interest. As a result, federal and provincial program spending are comparable, but a high proportion of federal spending consists of transfers to the provinces. Still, the provinces have gradually assumed larger and larger responsibility for raising their own revenues, and do so using all the major taxes. The income tax system is selectively harmonized, with the federal government collecting taxes on behalf of the several provinces that agree to abide by the federal tax base, but are otherwise free to set their own tax rates. Harmonization also exists in the sales tax area with the four provinces that have adopted value-added sales tax systems. Federal-provincial agreements exist in which the provinces recognize the role of the federal government in the design of important

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public service programs delivered by the provinces, while the federal government agrees to consult with the provinces before undertaking new spending power initiatives. The result is that the Canadian federation has evolved into a highly decentralized one that at the same time has a reasonably harmonized tax system. This results in the provinces providing comparable programs in areas like health, education, and welfare, while at the same time allowing them to choose the specific features of program design to reflect their diverse needs and preferences. Some recent events and trends have put strain Faced with what it on the system. Faced with what it thought was an thought was an unsustainable debt, the federal government draunsustainable debt. matically cut its cash transfers to the provinces for the federal governsocial programs and instead consolidated them ment dramatically into a single bloc transfer. There was little consultacut its cash trans tion prior to the cuts, and the provinces argued fers to the provins that it effectively transferred part of the federal for social programs debt to them. In turn, the provinces cut transfers to their municipalities. This problem of alleged vertical imbalance is exacerbated by a growing horizontal imbalance, which is partly a natural consequence of decentralizing revenue-raising to the provinces and the rise in resource revenues for some but not all provinces. Many observers have suggested that the federal government has lost its sense of national purpose. Others argue that it has ceased to deal with the provinces in an open, cooperative, and predictable manner. Tension has been heightened by the federal government's use of accumulated fiscal surpluses for direct spending programs rather than to restore transfers to the provinces. In response, the provinces and territories have strengthened their ability to speak with one voice by setting up an inter-provincial institution, the Council of the Federation. These same concerns also affect municipal governments and Aboriginal communities, albeit in different ways. The fiscal imbalance felt by municipal governments needs to be addressed so that they can provide the necessary public services to ensure that their citizens are cared for and their businesses are competitive in an increasingly globalized world. The financial problems facing Aboriginal communities are even more immediate. These are communities whose residents are among the poorest in the country, and who in many cases lack basic public services. The challenge here is not just a matter of financing; it is also a matter of service delivery as the transition is made from a system in which the federal government had a very handson paternal approach to one where the communities themselves take on more and more responsibility. Both of these remain items of unfinished business, and ones that will occupy tax policy-makers in the coming years.

Roads to Reform of German Fiscal Federalism LARS P. FELD / J U R G E N VON H A G E N In theory, the German federal system is a cooperative one, but in practice, a lack of cooperation between the federal government and its constituent units has led to an impasse. The spending authority of Germany's 16 constituent units, the Lander, is restricted by federal mandates, and most legislation at the federal order requires the consent of the Lander in the upper chamber of parliament, the Bundesrat. This has allowed the Lander to acquire a veto on federal government legislation and has restricted the ability of the federal government to pursue its own policies. The veto power of the Bundesrat is often seen as a barrier to reform policies at the federal order, especially in times when each house of parliament is governed by a majority from a different political camp. Considerable control over levying taxes exists only at the municipal order, and it is of secondary importance. The most important taxes are decided jointly by the federal order and the Lander in the Bundesrat. The Lander cannot individually set tax bases or rates. Completing the system is a highly egalitarian fiscal equalization scheme to compensate poorer Lander. During the last 25 years, the need to amend the fiscal constitution has become increasingly obvious. First, there have been calls for reforms

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of fiscal equalization because of disparities among the Lander, the highly egalitarian nature of fiscal equalization, and strong disincentives to invest in the improvement of the tax base at the Lander order. Second, Lander in fiscal troubles due to excessive borrowing have taken the federal government to court to obtain bailouts of their debt. In 1992, the Federal Constitutional Court ruled that the federation must provide such bailouts for the Lander of Saarland and Bremen. These problems were already inherent in German federalism before unification, but have been exacerbated since then. Politicians at the federal and the Land orders, their civil servants, and scholars from different disciplines have long been aware of the imbalance in German fiscal federalism. For the general public, the urgency of that situation became obvious after the Land of Berlin sued the federal order for a bailout in 2003 followed by another such claim by the Saarland in 2005. In 2004, a federal commission made an attempt to develop reform proposals for German federalism, including fiscal relationships. Until the end of 2004, the commission was unable to come up with a compromise. On the basis of a new compromise between the Lander, prime ministers, and the work of the federal commission, the new Grand Coalition government of Christian Democrats and Social Democrats that was inaugurated in Berlin in November 2005 is trying to disentangle the responsibilities of the federal order and Because the the Lander. In a declaration of intent, the new German fiscal consgovernment is also proposing to discuss a reform titution depends of fiscal federalism at a later date. on the distribution Because the German fiscal constitution of powers in the depends on the distribution of powers in the German federal sysGerman federal system, a disentanglement of tem. a distangleresponsibilities ought to precede any reform of ment of responsibi the financial relationships among the Lander lities ought to pre and the federal government. The Lander and the cede any reformcial rela federal order must each receive greater autothe fiancial rela nomy in several areas before the assignment of tionships among the fiscal resources is possible. The reform proposal Fainder and the fede aims at reducing the share of legislation that ral government requires approval by the Bundesrat from about 60 percent today to less than 50 percent after the reform. This would be accomplished by assigning more exclusive competencies for the Lander, for example in school and university education or the remuneration of public employees and civil servants, and for the federal order, exclusive competency in environmental legislation, among other areas.

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Lars P. Feld / Jiirgen von Hagen

The extent to which greater tax autonomy should accompany a greater responsibility of the Lander in several policy areas remains highly contested among the Lander, and also between them and the federal order, with no agreement on the direction the reform should take. Moreover, the net recipients from the fiscal equalization system are reluctant to accept changes in their relative positions. Finally, the Lander have depended on the federal government to bail them out of severe financial crises, and there is no agreement on how to end this dependency. From an economic point of view, greater tax autonomy of the subnational jurisdictions and a greater responsibility to financial markets appear to provide a reasonable solution to re-establish the equilibrium of German fiscal federalism. However, no easy political solution to achieve greater fiscal autonomy is in sight. Exposing the Lander directly to an evaluation of their creditworthiness at the financial markets by denying a bailout is not feasible because some Lander would be subject to prohibitively high refinancing costs. However, the Lander are also reluctant to accept a reduction of their autonomy and provide the federal order with the power to enforce consolidation requirements for Lander that have accumulated excessive debt. In contrast, the net beneficiaries of the fiscal equalization system do not want to accept less fiscal equalization or greater tax autonomy. No matter how attractive it is to separate the distribution of powers from financial issues, in practice it will be difficult to discuss one without the other. Some observers argue that a gradual increase in tax autonomy would be politically feasible. It could consist of four components. First, the extent and number of common fiscal responsibilities could be reduced. In particular, the shared responsibility for construction of university buildings could be abolished. Second, the legislative responsibilities for the tax sources, the revenue of which belongs to the Lander exclusively (e.g. motor vehicle, real estate purchase, and inheritance taxes), could be completely assigned to the Land order. Third, the Lander could obtain the right to levy a surcharge on personal and corporate income taxes. In addition, fiscal equalization could be reduced step by step to allow tax autonomy of Lander to induce its beneficial effects. Greater tax autonomy would also be a precondition for solving the dependency of the Lander on federal bailouts or loans to meet expenses in the medium term. Today, the Lander seldom have an alternative to borrowing when they need to react to economic shocks. A short-term hardening of the Land budget constraints could be achieved by stricter rules to enforce consolidation of Lander with excessive debt. Solving the trade-off between more autonomy for each Land on the tax side and less autonomy on the borrowing side will render a reform of fiscal federalism difficult. Instead of discussing actual policy solutions, it may be better to consider procedures to diminish the dysfunctional elements of German fiscal federalism.

Fiscal Federalism in India: Emerging Challenges M. GOVINDA RAO The system of intergovernmental fiscal arrangements in India has served it well for over 50 years. It has achieved a significant equalization of services, instituted a workable system of resolving the outstanding issues between the national government - called the "Centre" in India - and the states, adjusted to changing requirements, and thus has contributed to achieving a degree of cohesiveness in a large and diverse country. While reflection brings up several areas in need of reform, the most enduring point is that such reform is eminently possible. The tax powers and expenditure responsibilities of the Centre and states are specified in the Constitution in terms of Centre, state, and concurrent lists. With the amendment to the Constitution in 1992, the local governments in rural and urban areas too have been accorded constitutional recognition. Besides ensuring law and order, the states have a predominant role in the provision of social services such as education, health, housing, and family welfare. They have an equal role with the Centre in the provision of economic services. In particular, their roles in agricultural development, irrigation, industrial promotion, and transport infrastructure are important. At the same time, most broad-based and progressive tax

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M. Govinda Rao

powers are assigned to the Centre. The important central taxes are customs, excise duties on manufactured goods, personal income tax, and corporate income tax. The states also have a few tax bases assigned to them, but from the viewpoint of revenues, the power to levy retail sales tax is the most important. The states can borrow from the central government. They can also borrow from the market, but if a state is indebted to the central government, continued borrowing must be approved by the Centre. Indian fiscal federalism is marked by high degree of vertical and horizontal fiscal imbalance. In 2003-04, the state governments collected nearly 39 percent of total revenues, but their share in expenditures was 57 percent. Over 55 percent of states' total expenditures were financed from central transfers and borrowed The Construction funds. On the horizontal imbalance front, the recognizes that the most disadvantaged are the 11 small, mountainous states' tax powers states which are classified as "special category" are inadequate to states with very little production activity or capameet their expencity to raise revenues from the sources assigned ditute nedds and to them. But even the remaining 17 "general catetherefore provides gory" states have significant differences in size, for the central tax revenue raising capacities, efforts, expenditure for central tax levels, and fiscal dependence. The average annual revenues per capita income for 1999-2002 in the highest income state of Goa (Rs. 56,599) was 8.7 times that of the lowest per capita income state of Bihar (Rs. 6,539). The Constitution recognizes that the states' tax powers are inadequate to meet their expenditure needs and therefore provides for the sharing of central tax revenues. A notable feature of transfers in India is the existence of multiple channels with which to- transfer funds. One such channel, the Planning Commission, set up by a Resolution of the Government of India in March 1950, provides assistance by way of grants and loans to the states to meet their plan requirements. Until 1969, the plan assistance to states was given for specific ventures and the degree of assistance, as well as grant-loan components, was decided on the basis of the nature of the venture chosen. Since 1969, however, the plan assistance to the states is given byway of both grants and loans on the basis of a formula approved by the National Development Council (NDC). The NDC is chaired by the Prime Minister and is composed of cabinet ministers, members of Planning Commission, and Chief Ministers of the states. The grants given by the Planning Commission constitute between 16 and 20 percent of the total central transfers. The Constitution requires the President of India to appoint a Finance Commission every five years to review the finances of the Centre and the states and recommend both devolution of taxes and grant-in-aid for the ensuing five years. When the aforementioned Planning Commission

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joined the Finance Commission in giving grants, the scope of the Finance Commission became confined to recommending transfers to meet nonplan requirements of the states. To date, 12 Finance Commissions have been constituted and have submitted their reports. Presently, Finance Commission transfers constitute about 60 percent of the total transfers and those by the Planning Commission constitute about 20 percent. In addition to the above two channels, various central ministries give specificpurpose transfers to states with or without matching requirements. There are over 200 such ventures, though from a financial viewpoint only a few are important. The transfer system is beset with many problems. Multiple transfer channels sometimes work at cross purposes, creating serious problems of focusing the transfers on fiscally disadvantaged states. The methodology adopted by the Finance Commission transfers - that of filling the gaps between projected revenues and expenditures - has not only created serious disincentives, but also results in inequity. The system does not attempt significant equalization, as projections of expenditures for poorer states are made from a low base. As the projected gaps are filled through transfers, disincentives are created for tax effort and expenditure economy. The distinction made between plan and non-plan transfers also has segmented the budget with adverse consequences on fiscal management. Furthermore, the proliferation of specific purpose transfers has led to inefficiency in expenditure management. These problems have significantly politicized the transfer system The intergovernmental policies and institutions in India evolved in the context of a public sector dominated, heavy industry based industrialization that was implicit in the planned development strategy. With economic liberalization and the opening up of the economy, significant changes in fiscal federalism have become imperative. Replacing public enterprise revenues with taxes, compensating revenue loss from customs, and evolving a destination-based, value-added tax are some of the challenges. Given the increasingly globalized economy, the state governments are required to be efficient in their predominant role of providing social services and their equal role of providing physical infrastructure. In addition, the fiscal system has to deal with the issue of ensuring fiscal discipline at subnational orders to arrest the deteriorating situation of higher state deficits and debt accumulation. The emergence of a coalition government at the Centre and at the state order has led to competitive populism, or adopting policies popular with voters while disregarding the fiscal consequences. Regional parties in power at the state order, in becoming pivotal members of the central coalition, have led to several asymmetric arrangements. These factors have all had an adverse impact on fiscal management.

Fiscal Federalism in Malaysia: Challenges and Prospects SAIFUL AZHAR ROSLY Although the Federal Constitution of Malaysia assigns clear responsibilities to the federal, state, and local orders of government, the much greater taxation power assigned to the federal government has led to fiscal centralization. The federal government has the power to collect individual income and corporate tax, sales tax, and taxes arising from exports and imports. With little left for each state to raise tax revenues, state governments are further constrained from borrowing by the Constitution and are too dependent on federal grants and loans to undertake increasing expenditures arising from rapid economic growth and urbanization. Tax revenues from fees, licenses, assessment rates, and taxes on minerals are simply not sufficient to cover modern-day expenditures by state and local governments. To balance this equation, the Constitution allocates responsibility to the federal government to deliver services in administration, defence, internal security, education, medicine, health, labour, and social security. To some extent, these expenditures have generated economic development in the federated states and may constitute indirect equalization as the states no longer pay for basic public amenities and infrastructure, such as interstate

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roads and public universities. In some sense, the state governments have less to worry about impending fiscal deficits since the federal government consistently provides loans to finance the shortfalls. With such great powers in taxation and expenditure, it is possible for the federal government to initiate mega-projects such as the "national car project," "multimedia super corridor project," and the establishment of the Federal Administration Center at Putrajaya. The national car project is expected to push Malaysia forward in engine, component, and automobile design technology - although challenges resulting from the highly competitive global automobile industry could be an obstacle. The multimedia super corridor (MSC) project is Malaysia's initiative for the global information and communication technology (ICT) industry. Finally, the federal administrative center at Putrajaya is a new hub intended to establish all major government ministries and departments in one location. Using lease and buy structure finance, the government does not initially bear the cost of development. Companies that won building contracts are expected to source their own capital. Unlike the state governments, the federal government has the power to borrow to finance public expenditures. In this case, payment of lease constitutes a public expenditure as well. Although a state government is not permitted to raise loans to carry out state-related projects, the federal Constitution does not prohibit stateowned companies from raising funds from bank loans and debt securities. Privatization in Malaysia usually gives birth to government-controlled companies at both the federal and state orders and does not imply a complete transfer of government assets into private hands. Rather, it introduces the corporate culture into the new outfit, but majority shareholding remains with the government. Privatization is expected to increase efficiency and reduce government expenditures. If all goes well, a government-linked company should be able to create new employment and further widen the federal tax base. However, if the company fails, it asks for a federal government bailout - a move that increases the burden of taxpayers. Governmentlinked companies have ventured into healthcare, auto and industrial products, transportation, property and construction, financial institutions, technology, power, media, and communication. The powers and fiscal resources given to state governments are carefully balanced in the federal Constitution. A "capitation grant" is given to each state based on its population size (although more variables should be added to the current formula) and a road-building grant based on the geographic size of each state. There are also tax-sharing grants such as revenue growth grants, which reflect tax revenues from economic growth in each state. Payment of funds may be held back or delayed, but funding is never cut outright. Federal loans to most state governments are usually writte off as the states have no capacity to pay and will not be financially independent in the foreseeable future.

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Saiful Azhar Rosly

Fiscal decentralization may not be the answer to the fiscal problems of Malaysia's states. Because of the small size of most states, the lack of any "economies of scale" may not make fiscal decentralization a good option. Instead, state grants could be revised every five years so that state governments would be able to fulfill their promises to the electorates, especially on such programs as A brighter future the prevention of squatter settlements and the les ahead for the provision of subsidized housing for the poor. A local government brighter future lies ahead for the local governwhich have more ments, which have more autonomy than state automony than governments. A local government can obtain bank state governments loans and use asset-backed securities to finance projects deemed profitable for the locality. Some local governments have substantial land assets that can be mobilized to raise funds for capital formation. There is a great need to examine Malaysian federalism in a modern context since new issues have surfaced in the last twenty years. Considering that the federal Constitution provided for special grants to the state of Sabah and Sarawak in 1967, it should be able to structure new grants based on current needs, which include those to address environmental degradation in the states and water supply issues involving rivers flowing from one state to the next. For example, lack of state funds to enforce monitoring operations led to a failure to stop severe illegal logging and disposal of toxic wastes in rivers, although acts of corruption by some government officials may also have contributed to these problems. Another issue is fiscal centralization in the government's recent exercise to further cut subsides on petrol, which has caused public uproar and discontent. These saved subsidies (i.e., US$1.2 billion or MYR4.4 billion) will be spent on improving the current transport system and infrastructure. But how the money is distributed to the states and federal agencies would demand closer consultation among officials at all orders of government, even though the federal government still holds the upper hand in making the final call. Apart from fuel price increases arising from a move to reduce government expenditures, the impending increase in electricity tariffs in the coming months further demonstrate the federal government's decisive control of utility companies and hence centralization of fiscal federalism in Malaysia. To some extent, federalism in Malaysia is able to foster a stable federal government, although at the state order it has not had a perfect score. The extraordinary power of taxation assigned to the federal government in Malaysia provides a potent instrument to ensure the long-term political reign of any political party elected into government. One counterbalance to this power would be continuous dialogue and consultation among political parties in the Parliament and State Executive Councils, carried out with vigour and sincerity.

Fiscal Federalism in Nigeria: Unsettled Issues AKPAN H. EKPO Nigeria obtained its independence from Britain in 1960 - and with it, a fiscal federal system that provided a large measure of autonomy to the regions. In the years since independence, Nigeria's federal structure has undergone many changes. Now there are 36 states, 774 local governments, and a separate Federal Capital Territory (FCT), Abuja, which replaced the old capital of Lagos in 1991. The oil-rich country's progression toward its current incarnation of fiscal federalism has evolved in a setting of significant economic, political, constitutional, local, and cultural developments. The level of regional autonomy, which increased up to the time of independence in 1960, evolved to the point where the regions had their own constitutions alongside the Nigerian (Federal) Constitution. However, the military coup of 1966 totally destroyed this arrangement and replaced it with a military system of government that was the antithesis of federalism. Even now, with a democratically elected government in place at every level, certain vestiges of the unitary system still plague the country's fiscal policies and operations. In certain federal arrangements, revenue flows from the federating units to the centre. It would seem that in Nigeria's form of federalism, the states

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Akpan H. Ekpo

ought to control their resources. Then each state could develop its resources to the best of its ability and contribute as appropriate to the maintenance of the centre. In fact, the opposite is the case: the centre controls the resources, including the most important one - oil. There is thus a pressing need to restructure the country's fiscal federalism based on the diverse strengths and weaknesses of the federating units. One of the contending issues in Nigeria's fiscal federalism relates to revenue-sharing among the three orders of government. This issue is the "derivation principle," a constitutional provision that requires that the federal government return 13 percent of revenues from the natural resources of a given state back to that state. Many Nigerians want this percentage increased. Before the ascendancy of petroleum as a major foreign exchange earner in the mid-1970s, agricultural products held this distinction and the derivation principle stood at 50 per cent. Paradoxically, the major agricultural products were derived from the three power and ethnic blocks - cocoa from lA;|Hiit:iia