Fiscal Federalism

The concept of fiscal federalism refers to the financial relations between units of governments in a federal government system. Fiscal federalism is part of broader public finance discipline. The term was originally developed and used first by Richard Musgrave in 1959. Fiscal federalism deals with the division of governmental functions and financial relations among levels of government.

In the early years of federalism, geographic separation, slow communication, and clear division of labor made it possible for each level of government to function without significant interactions with other levels of government. Several reasons caused more interactions and central planning among the levels of government: world wars and the Cold War, improvement in transportation and communication technologies, the New Deal, and the war against poverty. These developments increased the interactions among levels of governments and helped the development of national policy making and state local policy implementation. This also changed traditional intergovernmental relations. National fiscal policies and financial decisions have been the predominant vehicle forming the intergovernmental relations.

The theory of fiscal federalism assumes that a federal system of government can be efficient and effective at solving problems governments face today such as just distribution of income, efficient and effective allocation of resourses, and economic stability. Economic stability and just distribution of income can be done by federal government because of its flexibility in dealing with these problems. Because states and localities are not equal in their income, federal government intervention is needed. Allocation of resources can be done effectively by states and local governments. Musgrave argues that the federal or central government should be responsible for the economic stabilization and income redistribution but the allocation of resources should be the responsibility of state and local governments.

The following are benefits of fiscal decentralization: regional and local differences can be taken into account; lower planning and administrative costs; competition among local governments favors organizational and political innovations; and more efficient politics as citizens have more influence. There are several disadvantages of fiscal federalism as well: the lack [Page 314]of accountability of state and local governments to constituents; the lack of availability of qualified staff; the possibility for people to choose where to reside; a certain degree of independence of the local governments from the national government; and unavailability of infrastructure of public expenditure at the local level.

Fiscal federalism in a mature federal system, such as the United States, refers to the development of a centralized federal budgetary and financial system including all members of the system. In the United States, fiscal federalism operates through the various federal taxes, grants, and transfers that occur in addition to states and localities. The federal government regulates, subsidizes taxes, provides goods and services, and redistributes income. The government has recently shifted its fiscal federalism practices to empowering the states through a series of reforms and deregulations.