The authors describe Bosnia's current arrangements in fiscal federalism, outline the unique challenges that the Dayton system proposed, and draw lessons for the design of fiscal federal systems in ethnically diverse economies. Traditional economic models of federalism suggest a government structure assuming there is an intent to achieve Pareto-efficiency for the entire country. Current attitudes in Bosnia challenge this paradigm's aptness unmodified, since many people in each ethnic group see themselves as members of their group, rather than as Bosnians, and are not broadly concerned about the entire country's welfare or access to public services outside the group. The motivation for the fiscal federalism structure proposed in the Dayton Accords is better interpreted as an effort to manage conflict between the ethnic groups. Federalism, in a conflict management sense, does not require that each group be given its own state; rather it leads to the conclusion that institutions of power should be brought closer to the people so that decisionmaking can be more sensitive to the different ethnic groups. Decentralization in this context is a means to lessen the points where disagreement exists, rather than a structure to obtain economic efficiency. Common institutions at the state, entity or canton levels are maintained, but only for functions that must be broader in scope. The fiscal (and other) interdependencies flowing from these institutions present opportunities to build relationships and trust over time. While the government structure included in Dayton is workable, governments must negotiate other arrangements to prevent, in the short to medium term, diseconomies of scale in providing certain services that are more cost-efficient at other levels. In the latter scenario, services with geographic spillovers would be underprovided because governments would fail to adequately account for benefits received by other ethnic group members. Further, little concern would be given to equitable distribution of services, resulting in widely different access across the country. Better service delivery mechanisms -from a national, Pareto-efficient perspective- will not be selected given the very strong distaste for cross subsidies and minority group fears of larger group domination. Despite these concerns, the authors conclude that more efficient arrangements can be expected to evolve over time as confidence in the government structures evolve.
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