Chapter 7 – A Fiscal Interest Approach to Subnational Government Incentives: Implications for the Design of Tax and Transfer Systems
Caroline Pöschl, London School of Economics and Political Science
Barry R. Weingast, Stanford University
The design of
the fiscal system vitally shapes subnational government institutions, policy
choices, and economic performance. In this chapter we focus on the fiscal
interest approach, the idea that the specific arrangements of tax and transfer
systems directly affect the interests and incentives of subnational political
officials. These incentives therefore affect these governments’ policy choices
and, consequently, the performance of their jurisdictions. This chapter reviews
several ideas in the literature that show how this occurs. When the taxation
and transfer system has subnational governments rely on own revenue generation
from broad based taxes, subnational governments tend to be responsive to their
residents’ needs, the overall health of their economies, and are more willing
to provide market-enhancing public goods. An excessive reliance on central
government transfers, on the other hand, has a detrimental effect on
subnational incentives to assist the production of wealth. We provide an
overview of how the type of tax that is assigned and the specific formula used
to divide central government funds among subnational governments either rewards
or punishes subnational government efforts at promoting growth and prosperity;
similarly, we investigate whether it promotes prudent fiscal management or
encourages subnational government spending beyond their means.
Ahmad, Ehtisham, James Rydge and Nicholas Stern. 2013. “Structural Change Drives Tax Reform Drives Structural Change”. Paper prepared for China Development Forum, London School of Economics and Political Science, March 2013.
Ambrosanio, Maria Flavia and Bordignon, Massimo. 2006. “Normative versus positive theories of revenue assignments in federations” in Ahmad and Brosio (eds.) Handbook of Fiscal Federalism. Cheltham: Edward Elgar.
Auty, R.. 2001. “The Political Economy of Resource Driven Growth”, European Economic Review 45.4-6: 839-46.
Auty, R. and A. Gelb. 2001. “The Political Economy of Resource-Abundant States”, in Auty (ed.) Resource Abundance and Economic Development. Oxford: Oxford University Press: 126-44.
Bahl, Roy W., Linn, Johannes, F., 1992. Urban Public Finance in Developing Countries, Oxford University Press, Oxford.
Beblawi, Hazem and Giacomo Luciani. 1987. The Rentier State. Croom Helm, Austrialia: Croom Helm Ltd.
Bird, Richard. 1999. Rethinking Subnational Taxes – A New Look at Tax Assignment. International Monetary Fund.
Bird, Richard. 2010. “Subnational Taxation in Developing Countries: A Review of the Literature”. Journal of International Commerce, Economics and Policy Vol. 2, No. 1 (2011) 139–161.
Bird, Richard. 2002. “Transfers and incentives in intergovernmental fiscal relations”. World Development Vol. 30, No. 6, pp. 899—921.
Bordignon, M. 2006. “‘Fiscal Decentralization : How to Harden the Budget Constraint’ in EF. Wierts, S. Deroose and A. Turrini (eds.), Fiscal Policy and Surveillance in Europe. New York: Palgrave MacMillan, pp. 109-136.
Bräutigam, D. 2008. “Contingent capacity: export taxation and state-building in Mauritius”. In: Bräutigam, Fjeldstad and Moore (Eds). Taxation and State-Building in Developing Countries: Capacity and Consent. Cambridge: Cambridge University Press.
Bräutigam, D. and S. Knack. 2004. ‘Foreign aid, institutions, and governance in Sub-Saharan Africa’, Economic Development and Cultural Change, 52, 255-285.
Brollo, Fernanda, Tommaso Nannicini, Roberto Perotti, and Guido Tabellini. “The political resource curse”, January 2010. IZA Discussion Papers, No. 4706.
Cabrero Mendoza, Enrique (2006) “Los Retos Institucionales de la descentralización fiscal en América Latina”, CIDE, división de Administración Pública Documento de Trabajo, No 181.
Careaga, Maite, and Barry R. Weingast. 2003. “Fiscal Federalism, Good Governance, and Economic Growth in Mexico,” in Dani Rodrik, ed., In Search of Prosperity: Analytic Narratives on Economic Growth. Princeton: Princeton University Press.
Caselli, Francesco and Guy Michaels. 2011. “Do Oil Windfalls Improve Living Standards?” http://personal.lse.ac.uk/casellif/papers/brazil.pdf.
Courchene, Thomas. 1981. “A market perspective on regional disparities”. Canadian Public Policy 7, 506–518.
Díaz Cayeros, Alberto. 1997. “Asignación política de recursos en el federalismo mexicano incentivos y limitaciones”. Perfiles Latinoamericanos Vol. 6, no. 10 (jun. 1997).
Di John, Jonathan. 2010. “The Political Economy of Taxation and Resource Mobilization in Sub-Saharan Africa” in Padayachee, V. (editor) The Political Economy of Africa. New York: Routledge.
Faguet, Jean-Paul. 2014. “Can Sub-National Autonomy Strengthen Democracy in Bolivia?” Publius: The Journal of Federalism, 44(1): 51-81; doi: 10.1093/publius/pjt020.
Faguet, Jean-Paul. 2012. Decentralization and Popular Democracy: Governance from Below in Bolivia. Ann Arbor: University of Michigan Press.
Faguet, Jean-Paul. 2004. “Why So Much Centralization? A Model of Primitive Centripetal Accumulation.” STICERD DEDPS No.43, London School of Economics
Faguet, Jean-Paul and Fabio Sánchez. 2013. “Decentralization and Access to Social Services in Colombia.” Public Choice. DOI 10.1007/s11127-013-0077-7.
Faguet, Jean-Paul and Frank-Borge Wietzke. 2006. “Social Funds and Decentralization: Optimal Institutional Design.” Public Administration and Development, 26(4): 303-315.
Gadenne, Lucie. 2013. “Tax me but spend wisely: The political economy of taxes. Theory and Evidence from Brazilian local governments”. ULC Working Paper.
Gervasoni, Carlos. 2010. “Measuring Variance in Subnational Regimes: Results from an Expert-Based Operationalization of Democracy in the Argentine Provinces” In: Journal of Politics in Latin America, 2, 2, 13-52,online: <www.jpla.org>.
Gervasoni, Carlos. 2011. “A Rentier Theory of Subnational Regimes: Fiscal Federalism, Democracy, and Authoritarianism in the Argentine Provinces” World Politics 65, 302-40, April.
Grabowski, Richard. 2008. “Modes of long-run development: Latin America and East Asia”. Journal of Institutional Economics. 4: 1, 25-50.
Krueger, Anne, 2006. The role of freedom, openness and individual enterprise in economic development. Paper given at the Conference on “Freedom and Development,” London School of Economics, May 25–26, 2006.
Levi, Margaret. 1988. Of Rule and Revenue. Berkeley: University of California Press.
McKinnon, Ronald I., 1997. “Market-preserving fiscal federalism in the American monetary union”. In: Blejer, Mario I., Ter-Minassian, Teresa (Eds.), Macroeconomic Dimensions of Public Finance. New York: Routledge, pp. 73–93.
Moore, Mick. 2007. “How Does Taxation Affect the Quality of Governance?”. IDS Working Paper 280. Brighton: Institute of Development Studies.
Moore, Mick. 2004. “Revenues, State Formation and the Quality of Governance in Developing Countries”. International Political Science Review, Vol. 25, No.3, 297-319.
Moore, Mick (2001), “Political underdevelopment: what causes ‘bad governance’”. Public Management Review, Vol. 3 Issue 3, pp. 385–41
Oates, Wallace. 1972. Fiscal Federalism. New York: Harcourt Brace Jovanovich.
Oates, Wallace E. 2005. “Toward a Second-Generation Theory of Fiscal Federalism,” International Tax and Public Finance 12, 349-373.
Olson, Mancur. 2000. “ In Mancur and Kähköhnen (editors) A Not-so-dismal Science: A Broader View of Economies and Societies. Oxford: Oxford University Press.
Prichard, Wilson. 2009. “The Politics of Taxation and Implications for Accountability in Ghana 1981-2008”. Institute of Development Studies. IDS Working Paper Volume 2009, No. 330.
Raich Portman, Uri (2004) “Impacto de la descentralización del gasto en los municipios mexicanos”, CIDE, Division de Economia, Documento de trabajo No.281.
Rodden, Jonathan. 2003. “Reviving Leviathan.” International Organization. (Fall) 57: 695-729.
Ross, Michael. 2001. “Does Oil Hinder Democracy?” World Politics 53 (April): 297-322.
Salmon, Pierre. 2013. “Horizontal competition in multilevel government settings”. Working Paper.
Salmon, Pierre (2006). “Horizontal competition among governments”, in: Ahmad and Brosio (eds), Handbook of Fiscal Federalism, Cheltenham: Edward Elgar, pp. 67-85.
Salmon, Pierre. 1986. “Decentralization as an incentive scheme”. Oxford Review of Economic Policy 3 (2), 24-43.
Schumpeter, Joseph. 1918. “Die Krise des Steuerstaates”. Reproduced in: Hickel, J.. 1978. (Ed): Die Finanzkrise des Steuerstaates. Beiträge zur politischen Ökonomie der Staatsfinanzen. Frankfurt/Marin, pp. 329-379.
Shleifer, Andrei, and Robert W. Vishny. 1998a. The Grabbing Hand: Government Pathologies and Their Cures. Cambridge, MA: Harvard University Press.
Shleifer, Andrei, and Robert W. Vishny.1998b. “Government in Transition,” ch. 11 in Shleifer and Vishny (1998a).
Singh, Nirvikar, and T.N. Srinivasan. 2006. “Federalism and Economic Development in India: An Assessment,” SCID Conference on the “Challenges of Economic Policy Reform in Asia,” Stanford University, June 1-3, 2006.
Skinner, Andrew S. 1995. “Adam Smith and the Role of the State: Education as a Public Service,” in Stephen Copley and Kathryn Sutherland, eds., Adam Smith’s Wealth of Nations: New Interpretive Essays. Manchester: Manchester University Press.
Smith, Adam. 1776 . An Inquiry into the Nature & Causes of the Wealth of Nations. London: Methuen & co., Ltd. 5th Edition.
Sokoloff, Kenneth L. And Eric M. Zolt. 2007. “Inequality and the Evolution of Institutions of Taxation: Evidence from the History of the Americas”. In: Edwards, Esquivel and Márquez, 2007. The Decline of Latin American Economies: Growth, Institutions, and Crises. NBER Books, National Bureau of Economic Research, Inc, number edwa04-1.
Ter-Minassian, Teresa (Ed.).1997. Fiscal Federalism in Theory in Practice (EPub). International Monetary Fund.
Tiebout, Charles, 1956. “A pure theory of local expenditures”. Journal of Political Economy 64, 416–424.
Timmons, Jeffrey F. 2005. “The Fiscal Contract: States, Taxes, and Public Services.” World Politics (July) 57: 530-67.
Weingast, Barry R. 2009. “Second generation fiscal federalism: the implications of fiscal incentives”. Journal of Urban Economics 65 (2009) 279–293.
Weingast, Barry R. 2013. “Second Generation Fiscal Federalism: Political Aspects of Decentralization and Economic Development”. http://dx.doi.org/10.1016/j.worlddev.2013.01.003