Mind the Gap: Reflections on Fiscal Balance in Decentralized Federations

1. Mind the Gap: Reflections on Fiscal Balance in Decentralized Federations Robin Boadway, Queen’s University Prepared for The Federal Idea:A Conference in Honour of Ronald L. Watts IIGR, October 18-20, 2007

2. Outline • Introduction • Caveats • Evolving views of the fiscal gap • Fiscal imbalance vs. Fiscal Gap • Fiscal imbalance I: The soft budget constraint • Fiscal imbalance II: Tightening the budget constraint • Seeking some balance

3. Introduction • Fiscal gap—transfers from higher to lower level—is a feature of multi-level governments • Applies to both federal-provincial abnd provincial-local levels • Fiscal gap varies widely across countries, mainly due to differences in revenue-raising • Gradual tendency for growing expenditure decentralization; revenue side mixed

4. Introduction, cont’d • No consensus about the most suitable fiscal gap for any given nation, but some common mantras • Changing circumstances (scope of government policy) and changing views about decentralization have fed into changes in ideals about the fiscal gap • Among economists, decentralists have taken center stage, and to some extent among policy makers and advisors as well

5. Introduction, cont’d • Recently, concept of fiscal imbalance has entered the lexicon • In Canada, distinction between fiscal gap and fiscal imbalance made by Séguin Commission • Some suggestion that the two are related • This talk: exploration of the evolution of thinking about fiscal gap and its relation with fiscal imbalance

6. Caveats • Draw heavily on Canadian experience • Economists’ perspective vs. broader ones • Economic dimension of policy choices • Relevance of incentives • Importance of one’s view of benevolence of government, or quality of governance • Importance of value judgments: solidarity/social citizenship vs. efficiency

7. Evolving Views of the Fiscal Gap • Arguments determining the size of fiscal gap • Decentralization of spending versus revenues • Accountability • Equalization • Exercise of the spending power • Fiscal harmonization • Potential for federal-provincial-local cooperation • Importance of fiscal competition? • The fiscal gap versus the responsibility gap

8. Evolving Views, cont’d • Evolution of expenditure decentralization • Spending now dominated by services to people, transfers and social insurance: decentralized provision efficient but national interests at stake • Infrastructure: potential conflict between provincial responsibility and national interest, especially if highly decentralized (lessons from econ geography) • Reconciliation of benefits of decentralized delivery with national interest is a key issue

9. Evolving Views, cont’d • Case for revenue decentralization weakened • More reliance on VAT • Evolution toward schedular (dual) income taxes • Globalization and mobility of tax bases • Competitiveness • Importance of harmonized tax bases • Increase in horizontal disparities • Growing importance of cities

10. Evolving Views, cont’d • The elusive concept of accountability • Economists argue fiscal gap deters accountability • In fact, revenues from major tax bases little different from transfers in terms of accountability • Effect of incentives on gov’t vastly overstated • Watertight division of responsibilities misconceived • Accountability argument overstated • Has decentralization mantra gone too far?

11. Fiscal Imbalance vs. Fiscal Gap • The existence or otherwise of a fiscal imbalance has been a highly charged issue in Canada • Séguin argument: Given expenditure responsibilities and division of tax room, transfers inadequate, given major cutbacks • Also, they suggested fiscal gap too large • Horizontal imbalance also pronounced • Some observers deny possibility of fiscal imbalance

12. Fiscal Imbalance vs. Fiscal Gap, cont’d • Distinction conceptually meaningful, but ambiguous • Concept of fiscal imbalance judgmental: relies on views about optimal fiscal gap • Large fiscal gap not inconsistent with fiscal balance • In the long run, imbalance should not persist, assuming provinces have fiscal discretion • In the short run, sudden changes can cause imbalance: can go either way 

13. Fiscal Imbalance I: The Soft Budget Constraint • Excessive lower-level spending and debts leading to higher transfers: negative imbalance • Some causes/symptoms • Lack of commitment (bailouts: Nwfld?) • Lack of lower-level accountability • Lack of lower-level policy-making discretion • Use of central discretionary funding • Excessive central controls • Fiscal gap too high?

14. Fiscal Imbalance II: Tightening the Budget Constraint • Restriction on higher-level transfers starting from a situation of fiscal balance • Some causes/symptoms • Debt imbalance • Discretionary central transfers • Horizontal imbalance increasingly expensive • Sub-national governments able to raise revenues • Responsibilities for spending programs ill-defined • Fiscal gap too low?

15. Seeking Some Balance How to combine benefit of decentralized public services and targeted transfers with efficient harmonized tax system, horizontal balance and balanced response to fiscal shocks? • Significant fiscal gap: federal control of VAT, environmental tax, and income tax • Constraint on federal government: revenue sharing (Australian/German system)

16. Seeking Some Balance, cont’d • Provincial revenue-raising discretion: access to harmonized income tax and narrow taxes • Reduced discretion on year-to-year transfers • More cooperative decision-making • Institutional cooperation: federal provincial advisory fiscal commission • Use of the spending power an open question