A look into fiscal aspect of federalism

-This article was originally published by Ashesh Shrestha in the Himalayan Times on April 29, 2018

In order to make federalism work efficiently, a clear framework regarding the fiscal aspects of federalism is one of the areas that needs careful examination and diagnosis. Unlike in the unitary system, a federal structure encapsulates more than one tier of government involved in providing public goods and services in overlapping jurisdictions. Their powers and functions are mandated by the constitution so as to avoid conflict between them and assure mutual co-operation. Fiscal federalism mainly deals with various ways through which these governments allocate revenue and expenditure assignments on various headings of types of taxation (direct taxes, charges, fee etc.). They can collect taxes on constitutionally delegated headings and allocate tax burdens among the citizens within their jurisdiction in the way they find most appropriate.

But the problem arises due to the presence of the difference in fiscal capacities of the states. Here fiscal capacity does not only account for the difference in the ability to raise taxes because of the difference in total income/ output generated by each state, but also captures the difference in needs/ requirements of the public goods and services in these states. One of the major role of the federal government then becomes to equalise this fiscal gap among the states. The equalization principle would basically be to transfer funds in such a way that funds are transferred from high income – low need state to low income – high need state. The optimal situation can be reached by equating the ratio of total income to index of need for all the states.

But the main challenge here would be to calculate the index of need for public goods and services for all the states. In order to calculate index of need, detail statistics on demographics, existing supply of various public goods and services, economic potential etc., of all the states are required. An example cited by Richard Musgrave, an American economist is that the need for the educational expenditure in a state would be determined by the number of children of school going age in that state. An aggregation of all the needs for public goods and services will give the index of need of that state. As mentioned earlier, this would require complete set of accurate statistics, which underdeveloped countries like Nepal lack.

Apart from balancing the needs and revenues of the state, James Buchanan, a Nobel laureate has identified another important function of the central government. The federal government is responsible for maintaining horizontal equity termed as equal treatment of equals. In other words, citizens of a certain level of productivity (expressed in terms of level of income as per Buchanan) must be treated equally (in fiscal sense) with the citizens of the same level of productivity in any other state by the federal government. Here, equal treatment in fiscal sense does not mean equalising tax burden, but it means equalising the fiscal residuum.

Fiscal residuum refers to the excess of expenditure benefits over the tax payments. It is the total benefits received in the form of public goods and services minus the total tax payment. Equalising fiscal residuum for the equals living in all the states would prevent distortionary transfer of both human and non- human resources to the state with least fiscal pressure. Therefore, Buchanan suggests that the entire fiscal structure should be as neutral as possible in geographical sense and the federal government has to play a vital role in maintaining such neutrality.

The residents of the state with larger number of highly productive people tend to have higher fiscal residuum in comparison to the residents of the state with fewer number of highly productive people. In this case, in order to maintain horizontal equity, the federal government has to transfer funds from the productive citizens of the state with larger number of productive people to the productive citizens with fewer number of productive people. Similarly, transfer of funds from less productive people of the state with larger number of highly productive people to the less productive people of the state with fewer number of highly productive people will ensure the horizontal equity. The amount of funds that is transferred is determined by the exact measurement of productivity of the people (measured in terms of income generated), states’ taxation and expenditure policy and federal government’s taxation policy.

In order to have a clear picture of framework explained above, we will also have to have knowledge of underlying assumption. The assumption is that provision of public goods and services delivery is carried out at sub-national level, whereas the federal government has access to larger revenue collection. However, as per framework in Nepal it is yet to be determined if the same follows suit. If this assumption is not fulfilled, the fiscal redistribution mechanism explained above cannot work in efficient manner.