Tax Assignment and Revenue Sharing

A decentralised economy comprises different levels of government with independent fiscal powers. A crucial issue is the design of appropriate assignment of taxes and expenditures to different levels of government. The rationale for decentralising fiscal responsibility derives from the premise that the welfare generated by providing public goods and services is maximised by reflecting, as closely as possible, the preferences revealed by the population at the subnational levels of government. Accordingly, governments that comprise several levels assign different expenditure responsibilities to each level. Tax assignment also follows a stratification of objectives. A central government function is achieving appropriate redistribution which should be assigned to it since, otherwise, people bearing any resultant burden of local redistribution policies would emigrate to another state or province or local jurisdiction. The central government must also remain ultimately responsible for overall macroeconomic stabilisation since local attempts at stabilisation policies would have spillover effects across jurisdictions. Subnational—state and local—governments, on the other hand, are assigned taxes that do not adversely affect the efficiency of resource allocation. The mix of tax and expenditure responsibilities of different levels of government is referred to as fiscal federalism. This chapter focuses on the taxation side of fiscal federalism.