On the Nature and Measurement of Vertical Fiscal Imbalances

Despite a vast literature on the financial structure of fiscally decentralized governments, there remains a great deal of confusion about the concept vertical fiscal imbalance (VFI) and how it relates to the amounts of intergovernmental transfers that flow between levels of government. This paper attempts to clarify the concept of VFI in fiscally decentralized countries. We distinguish between the 'optimal VFI' and the 'actual VFI.' The optimal VFI, defined for any level of government as the difference between the expenditure needs (associated with the optimal decentralization of expenditure responsibilities) and the fiscal capacity (associated with the optimal decentralization of revenue assignments), is generally not zero. Further, the actual VFI (based on actual levels of decentralization) typically exceeds the optimal VFI because of insufficient revenue assignments. The actual VFI equals the amount of unconditional intergovernmental transfers that 'should' be distributed across levels of government to ensure that all government units are able to provide a standard level of services for the responsibilities that have been assigned. We argue that such transfer amounts need not be equal, and might not even be correlated, to the amount of intergovernmental transfers distributed across levels of governments to close the VFI. This is an important distinction because it suggests that the negative effects of transfer found in the empirical literature do not necessarily imply, as commonly presumed, that those are the negative effects of VFI, and therefore do not necessarily reflect how the VFI should be adjusted.