Fiscal Federalism: Public Goods, Transfers, and Common Pools

The design of a federation raises important questions which have found very different answers in practice. An efficient assignment of public policies and revenues is important to make a federation viable, to maintain a balance of power between the central government and the states, and to find a good compromise between a strong government and a competitive market system. Transfers between the federal government and the state governments often become sources of conflict. Avoiding such conflicts demands a high degree of transparency, which can be better achieved with horizontal transfers among states of different tax capacity than vertical transfers from the centre to the states. Sustainability of public finances can be achieved best by either full fiscal autonomy of the states and/or fiscal unions, where the states with no borrowing autonomy are viable. Federations in which some states are highly and systematically dependent on transfers from the central government are likely to end up as debt union. Finally, an important part of the design problem is to find an efficient way of changing the federal constitution, one that avoids the tendency for excessive centralism and yet allows for responding to changing circumstances in adequate ways.