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.
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