Second generation fiscal federalism: The implications of fiscal incentives

First generation fiscal federalism (FGFF) studies the performance of decentralized systems under the assumption of benevolent social planners. Second generation fiscal federalism (SGFF) studies performance based on the fiscal and political incentives facing subnational officials. The paper focuses on three aspects of SGFF. First, it considers the design of intergovernmental transfers. While FGFF emphasizes correcting vertical and horizontal equity, SGFF emphasizes the importance of fiscal incentives for producing local economic prosperity. SGFF extends FGFF approaches by showing how non-linear transfer systems can produce both equalization and high marginal fiscal incentives to produce local economic growth. Second, the paper raises the fiscal incentive approach, showing how different tax systems produce different fiscal incentives for political officials to choose policies. Third, the paper discusses the interaction of democracy and fiscal federalism.