Fiscal Federalism and Political Decision

Transcription

1 Work Session Proceedings: Reports Lars P. Feld Fiscal Federalism and Political Decision Structures (Work Sessions 9 and 21) 1. Introduction A central issue in the theory of economic federalism is the assignment of competencies to different tiers of government. Scholars in fiscal federalism usually aim at providing convincing arguments for a specific assignment of public services and taxes to the federal, regional and local levels of government. The bottom line of their reasoning is that public services should be allocated to the different levels so that the citizens obtaining benefits from, those paying the costs of, and those deciding on public services belong to the same group (Olson, 1969; Oates, 1972). Distortions arise if citizens from other jurisdictions do not pay the cost of or politically decide on public goods in the jurisdiction considered. In such cases, public services may not be provided efficiently. Arguments for the assignment of taxes, income distribution and macroeconomic stabilisation to different government levels follow similar lines of reasoning (Musgrave, 1983). Departing from this outcome-oriented assignment of competencies, the more recent discussion focuses on legal and constitutional procedures for 761

2 sustainable public finances in a federation. It is asked which type of procedures help to adapt the assignment of competencies in a federal state to changing needs in a dynamic environment and prevent the political decisions from deviating too much from citizens preferences (Weingast, 1995). Three main areas of analysis can be distinguished. First, the role of political decision-making rules in determining fiscal policy is discussed. Some argue that presidential systems can achieve sustainable public finances more easily than parliamentary systems (Persson and Tabellini, 2001). Others focus on different forms of democracy, perhaps even instruments of direct democratic decision making such as referendums and popular initiatives (Feld and Kirchgässner, 2001; Feld and Matsusaka, 2002; Matsusaka, 2002). Second, budgetary procedures are analysed in order to find out which procedural safeguards secure sound public finances. Von Hagen argues, for example, that a strong finance minister helps to prevent different groups or spending ministries from exploiting the fiscal commons (von Hagen, 1992; Hallerberg and von Hagen, 1999). Third, constitutional provisions are inspected: is it possible to keep the government within certain limits by imposing constitutional constraints (Buchanan, 1987; Bohn and Inman, 1996)? What are the constitutional procedures for changes in the assignment of competencies, and which of them brings constitutional outcomes as close as possible to citizens preferences (Schaltegger and Feld, 2001)? A synthesis of both lines of thought, the traditional question on the optimal assignment of fiscal responsibilities in a federation, and the political economy question on procedures shaping favourable fiscal outcomes, is of high practical relevance given that a constitutional assignment of responsibilities is 762

3 often unstable. In a recent comparative study on the evolution of fiscal constitutions in Australia and Canada, Winer (2000) demonstrated that a strong centralisation to the federal level happened in Australia despite the general will of the framers of the Australian constitution. This is quite different in Canada where the basic act allocates taxing powers exclusively to the federation and the provinces, but leaves any residual power to the federal government. Nevertheless, Canada developed into one of the most fiscally decentralised countries in the world. Winer emphasises the procedures of the two types of federalism that were important for a constitutional evolution of the federations. The two work sessions on fiscal federalism and political decision structures at the International Conference on Federalism 2002 brought these two lines of thought more closely together. Three cases were discussed. For an understanding of the Swiss case, the interaction between the constitutional design of fiscal federalism and the procedural rules is crucial. That the effectiveness of one class of institutions cannot be assessed without considering the other class is illuminated by the cases of Mexico and Argentina. In particular the imbalance of spending and revenue competencies in these two countries, but also the political struggles between different tiers of government, allow for an understanding of which policy may help to enhance citizen confidence in government action. The discussion is summarised in this paper as follows: the institutional rules of the budgetary process are discussed using the Swiss case as a prominent example. The proper assignment of governmental tasks and revenue sources is analysed by drawing extensively on the experiences of Mexico and 763

4 Argentina together with the controversial discussion surrounding these cases. These discussions are followed by a conclusion and some general remarks. 2. Institutional rules of the budgetary process The theory of fiscal federalism starts with the basic observation that the individual citizens are customers of the public services provided by the government. As many economists emphasised in the discussion, the individualist basis of the state should thus also be reflected in institutional rules. In that sense, Switzerland stands out in the degree of voter participation, in the form of referendums and popular initiatives, that helps citizens to have a say in determining the level and cost of public services. However, voter participation may stop jurisdictions from having sufficient financial resources, since selfish citizens may not accept an unfavourable redistribution of funds. In such a situation, tensions between the principle of fiscal responsibility and the principle of equity in the federation may arise. According to proponents of the theory of fiscal federalism participating in the work session, federal systems are generally characterised by tensions between these principles. If jurisdictions differ significantly, situations may arise where stressing the principle of responsibility (equivalence) creates inequity between cantons or states. From a purely fiscal perspective, one way of dealing with these tensions is a system of fiscal equalisation. However, such a system creates problems on the other side of the equation. First, a common pool problem arises. People who spend see the full benefits but do not pay the full bill, giving rise to a tendency for overspending. Second, the transfer system establishes soft budget constraints. Local governments can 764

5 extract more resources from the centre ex post by excess borrowing compared to their ex ante plans. Problems of soft budget constraints and fiscal commons may be mitigated by a reliance on ex ante rules like balanced budget restraints such as those in many US states and in the case of the Stability and Growth Pact in the European Union (EU). On the one hand, balanced budget rules appear to force governments to keep public finances sustainable. On the other hand, balanced budget rules provide incentives for creative accounting and off-budget activities. The Portuguese deficit for example was 2% larger than officially stated in the last two years. In any case, there is a trade-off for balancing out the requirements imposed by the principles of (fiscal) responsibility and of equity. The more widely income differences among jurisdictions are politically accepted, the more easily jurisdictions fiscal responsibility for their own business can prevail. In that trade-off, the basic rules for fiscal responsibility as well as the details of the fiscal constitution may play an important role in the fiscal stability of the federation. In addition, the question emerges of what the role of direct popular rights in the budgetary decision-making process of the different government levels in a federation may be Basic rules for fiscal responsibility in Switzerland From the point of view of the upper house of the legislature, the assignment of responsibilities is crucial. However, the procedures for a dynamically stable distribution of powers are equally important. Though the principle of subsidiarity was only recently imported from the EU debate to the Swiss discussion on fiscal federalism, it does apply to the Swiss case. The principle of subsidiarity states that the higher levels of a federation are not allowed to 765

6 cover those tasks which the individual or lower units can satisfactorily cope with on their own. At first sight, the principle therefore seems to call for as much decentralised provision of public services as possible. It is however not clear how the principle is to be actually implemented. Should a higher level of government intervene when it observes that lower levels cannot cope with certain tasks? When is a task satisfactorily coped with? Who decides when a shift of responsibilities occurs? In that respect a conflict between the principle of subsidiarity and the principle of democracy and the rule of law may arise. According to legislators present in the work session, Switzerland resolves the conflict between the different principles by putting the strongest weight on the principle of democracy. The decision as to which responsibility is allocated to which government level is usually decided upon directly by using instruments of direct democracy. A centralisation from the cantonal to the federal level can only occur if a majority of the Swiss people and the majority of the cantons accept such a shift of responsibilities. Procedurally, the people are the final decision-making body, not the cantonal or federal governments. The relationships between cantons are settled by inter-cantonal cooperation. From the above perspective, additional conflicts arise between the agreements reached through that cooperation and the democratic requirement that legislatures and the citizens of single cantons should be able to state their consent ex ante. The more parties are participating in this cooperation, the more strongly democratic control is excluded. This holds with respect to the cantonal and the federal level alike and is considered as problematic from the point of view of the legislature, in particular the upper house representing the interests of the cantons. The control is even more 766

7 difficult ex post, since contractual agreements do not exhibit the same degrees of transparency as democratic decisions. And most importantly, multilateral agreements are difficult to change. In that cooperative struggle, Switzerland has decided to conduct a reform of Swiss fiscal equalisation that also aims at redesigning the assignment of competencies at the Swiss cantonal and federal levels Budgetary rules and the role of the citizens in the budgetary process The predominance of the principle of democracy that is observed when making changes in the assignment of (fiscal) responsibilities in Switzerland prevails in the design of budgetary procedures as well. To differing degrees, the cantons have additional fiscal procedures to augment citizens ability to influence budgetary outcomes by fiscal referendums. In that respect, the canton of St Gallen is an interesting case. Each public spending project with cost exceeding 15 million CHF in the case of non-recurring expenditures and 500, 000 CHF in the case of recurring expenditures has to be approved by the citizens in a fiscal referendum. An optional fiscal referendum exists for lower spending thresholds if at least 4,000 voters sign up for such a referendum. Under these procedures citizens set the level of public service they prefer. However, citizens in St Gallen are not allowed to change the tax rates of personal or corporate income taxes or wealth taxes as the main sources of state revenue. The parliament has the ultimate jurisdiction for tax rate changes. If cantonal spending exceeds revenue, an additional procedure starts in St Gallen as particularly emphasised by participants from the cantonal 767

8 administration in the work session. It is legally fixed that only investment spending is allowed to be covered by borrowing. Spending qualifies as investment if the outlays for durable assets exceed the credit requirement of 3 million CHF. In short, legally binding depreciation periods are used to write off investment. The government current account must be balanced. Anti-cyclical policy in the current account is only possible if public equity can be used to cover deficits. If nevertheless a deficit is budgeted in the current account, it must be carried forward to the next budget year. In order to build up equity in booms, tax rates can be reduced only if a minimum amount of equity is reached. In sum, these provisions have helped to keep public debt in the canton of St Gallen at relatively low levels as compared to other cantons The gap between the Swiss case and economic considerations The Swiss experience appears to contradict economic considerations. The citizens in the cantons have obviously accepted the legal constraints imposed without demanding off-budget activities. In more general terms, instruments of direct democracy have been successful in restricting government spending (Feld and Kirchgässner, 2001; Feld and Matsusaka, 2002). The Swiss solution to resolve the trade-off between fiscal responsibility and equity appears to be successful. Given the fiscal commons problem it can indeed be questioned whether it is at all equitable to equalise. The youth participants particularly emphasised this point: is it fair to take funds from St Gallen and give it to cantons which do not perform so well? While the economic theory of federalism focuses on subsidiarity and fiscal equivalence, the Swiss experience helps to highlight the role of a dynamically sustainable decision-making system. In the economic theory of federalism, the 768

9 question of who gives the upper level the right to vote over a majority of lower levels, or more generally, who decides what and who can overrule, is often neglected. In reality, such questions have to be answered. In each federal system, diversity has to be accepted. This not only holds with respect to income, but also politically. For example, in Switzerland a person in the small canton of Appenzell Inner Rhoden has 35 times the power of a person in Zurich. The key for an understanding why Switzerland is successful in coping with political and cultural differences without putting the sustainability of public finances at risk, is the Swiss type of federalism and direct democracy. It was emphasised by economists in the session that although these Swiss institutions appear to be peculiar and have provided Switzerland with a special culture for more than 150 years, Swiss people are not different from other people. That is to say that a culture of fiscal responsibility and democratic participation can also emerge in other countries. 3. Assignment of governmental tasks and revenue sources While the Swiss case highlights the role of constitutional provisions in creating sustainable fiscal federalism, it implicitly rests on a precondition seldom mentioned: the shares of spending and revenue at each level roughly correspond to each other. This is important for the stability of fiscal federalism in a country. Otherwise, the wisdom of economic federalism may not apply as fully as is suggested by the theoretical arguments. The political tensions in cases of strong imbalances between spending and revenue authority are best illustrated by the experiences of Mexico and Argentina. 769

10 3.1. Underlining the power of the centre: the case of Mexico Mexico is composed of 32 states and 2,430 municipalities. According to data presented in the work session, the most important revenue sources the income tax, the value added tax, excise and import taxes are collected by the federal government, so that about 77% of total tax revenue is collected by the federal level. States collect only 18% of total government revenue with payroll taxes being the most important source of state taxation. The local level collects less than 5% of government revenue, mainly in the form of property taxes. The real estate tax and the tax on purchase of real estate is fully in the hands of local authorities so that their current disbursements can be financed. However, sub-federal jurisdictions have more spending than revenue responsibilities. In the case of government expenditure, the federal government covers about 49%, the states 44% and the local jurisdictions 8% of combined government spending. Education, health, police, regional and local infrastructure are mainly financed by the states and local jurisdictions. The dependency of states on centrally collected revenue amounts to 85%, that of the local jurisdictions to 70%. According to the participants from Mexican regional administrations, additional taxing powers must be granted to the states in order to make them less dependent. The Mexican assignment of fiscal responsibilities should be interpreted along with the current political change in Mexico. Until recently, regions with governments that did not belong to the formerly dominant party, the Institutional Revolutionary Party (PRI), like Baja California, had difficulties in obtaining their fair share of state spending. It must be understood that the federal government did not provide grants on a regular, legally secured basis, 770

11 but made use of its discretion to distribute funds. But recently the PRI has lost power. The new Mexican president, Vicente Fox, as a member of the Partido Acción Nacional (PAN), has federalism and more effective procedures of citizen participation on his agenda. Currently, however, the attempts to provide a more balanced assignment of fiscal responsibilities in Mexico are endangered because the president s party is in a minority in the Mexican senate and the PRI is in a majority among state governors as well. Fox tries to accomplish a consensus on the issue, but the states still largely depend on federal grants. The discussion in the work session revealed the political differences between the regional administrations belonging to the different political camps in Mexico. In the current system there is no direct fiscal competition between the Mexican states. The most important state tax is the payroll tax, which exhibits only small inter-state differences. The main reason for the current tax system is the political control of the country, as some Mexican participants explained. The federal government aims at having the state governors under its control. Transfers are made as donations. In a unimodal political system such as the Mexican one, fiscal competition would impose restraints on the collusion of the federal government with state governors Underlining the power of the regions: the case of Argentina The Argentine case is similar to that of Mexico, but there are important differences. Mexico benefits from relatively stable macroeconomic conditions while Argentina does not. At the beginning of the year 2002, the federal government had to declare default of public and private debt that induced a breakdown of the financial system. Work session participants from Argentina 771

12 claimed that about 16 different local currencies are in circulation in Argentina today. Between 1998 and 2001, the country had to cope with a loss of 10% of Gross Domestic Product (GDP); in 2002 an additional 15% loss of GDP occurred, according to the data presented in the work session by representatives of the provinces and the local jurisdictions. People in Argentina suffer from an unemployment rate of 22%. The income gap between the rich and the poor is enormous: the rich earn 40 to 50 times the (average) income of the poor. The current economic turmoil in Argentina can only be understood if the influence of the regional governments is properly considered. Today, Argentina is comprised of 23 provinces with Buenos Aires as an autonomous city, 1,178 municipalities and 977 communes. According to official statistics, Argentine federalism suffers from a similar imbalance between spending and revenue responsibilities as Mexico. The federal level collects about 75% of total government revenue, the provinces 19% and the local level 6%. In contrast, the federal government only covers 53% of total government spending, while the provinces have to cover 38% and the local level 9%. Legally, Argentine federalism appears to be more advanced than the Mexican system, but it experiences the same disproportional vertical allocation of resources. Representatives of the Argentine provinces and local jurisdictions complained that like Mexican states, Argentine provinces suffer from the distribution of grants according to political favouritism. The situation is however more complex than it might appear at first sight and as emphasised by legislators from regional parties or the administration at the local level. It is common knowledge today that each government level in 772

13 Argentina attempts to keep the financial resources that it gets. While representatives of the provinces claim that nothing came down to the municipalities and point at the great corruption in the government, the provinces appear to hide financial resources from the federal government and see federalism as a way to defend against the main federal parties. Corruption appears to prevail at each government level and not only in the federal government. For example, provinces which received huge funds to finance education were not able to pay the teachers salaries. Additional government revenue is sometimes created by privatisation as in the case of oil firms. However, privatisation attempts were considerably hampered by the current provincial wastage. Some provinces have still not privatised their state banks. Overall it appears that the political market in Argentina contains a lot of transaction costs as one participant put it The link between fiscal federalism and political economy The cases of Mexico and Argentina are more about the political economy than the efficiency of economic federalism. In general, they illustrate the strong relationship between the development of federalism and democracy. In Mexico, federalism appears to be a means to overcome the one-party system and to be a check on the Leviathan government that suppresses individual freedom. The key condition for a federalist system to function as a check on the government is a strong and viable democracy at the local level. In the discussion of both cases there was general agreement on responsibilities, but disagreement on the distribution of resources prevailed. Both countries are characterised by a large degree of vertical imbalance. In both countries, favouritism and lack of transparency destroy accountability. In 773

14 this environment, co-participation is even worse. It combines a lack of transparency with the creation of a common fiscal resource from which each province tries to get as much as it can. Bailouts through inflation or through national debt for state debt create an additional tendency for exploitation of the fiscal pool. According to the economists in the session, one solution for this unsustainable situation is the exclusive assignment of certain taxing powers to the provinces: X% of certain taxes should be given to the cities or provinces as a fixed rule. One final point was also highlighted by the economists in the discussion. There is a close relationship between democracy, federalism and the development of local markets: decentralised government has a role in developing local markets, but there can also be incentives to create trade barriers favouring special business. The central government should therefore maintain a market constitution, while the local governments take care of traditional public goods. 4. Conclusions The three cases emphasised the strong relationship between traditional economic theory and the political economic rationale for federalism. The Latin American countries Mexico and Argentina suffer from vertical fiscal imbalances, but their main problem is a general lack of accountability to citizens. In both cases the solution could not consist in a demand for additional responsibility for the sub-federal jurisdictions in the sense of collecting and distributing funds. There must be an increase in democratic accountability in order to gain the trust of the people that have to be served. 774

15 Institutional change is what is needed. Compared to the situation described above, the Swiss experience appears as relatively favourable. Despite some criticism by Swiss participants of their own system, the Swiss assignment of competencies is quite balanced, and democratic accountability is secured by strong elements of direct democracy. Samuel Huntington once said that the solution to the challenges of democracy is more democracy. Similarly, the answer to the challenges of federalism is more federalism. If challenges come from both sides, the answer may be the Swiss model. References Bohn, H. and Inman, R.P., Balanced Budget Rules and Public Deficits: Evidence from the US States. Carnegie-Rochester Conference Series on Public Policy, 45, Buchanan, J.M., The Constitution of Economic Policy. American Economic Review, 77, Feld, L.P. and Kirchgässner, G., The Political Economy of Direct Legislation: The Role of Direct Democracy in Local and Regional Decision- Making. Economic Policy, 33, Feld, L.P. and Matsusaka, J.G., Budget Referendums and Government Spending: Evidence from Swiss Cantons. Forthcoming in: Journal of Public Economics, Hallerberg, M. and von Hagen, J., Electoral Institutions, Cabinet Negotiations, and Budget Deficits in the European Union. In: J. Poterba and J. von Hagen, eds. Fiscal Institutions and Fiscal Performance. Chicago: Chicago University Press and NBER,

16 Matsusaka, J.G., For the Many or the Few: How the Initiative Process Changes American Government. University of Southern California at Los Angeles, mimeo. Musgrave, R.A., Who Should Tax, Where and What? In: C.E. McLure, ed. Tax Assignment in Federal Countries. Canberra: Center for Research on Federal Financial Relations, Oates, W.E., Fiscal Federalism. New York: Harcourt/Brace/Jovanovich. Olson, M., The Principle of Fiscal Equivalence : The Division of Responsibilities among Different Levels of Government. American Economic Review, Papers and Proceedings, 59, Persson, T. and Tabellini, G., Political Institutions and Policy Outcomes: What Are the Stylized Facts? CESifo Working Paper No. 459, Munich. Schaltegger, C. and Feld, L.P., On Government Centralization and Budget Referendums: Evidence from Switzerland. CESifo Working Paper No. 615, Munich. von Hagen, J., Budgetary Procedures and Fiscal Performance in the European Communities. Economic Papers. Commission of the European Communities. Economic Papers No. 96, October. Weingast, B.R., The Economic Role of Political Institutions: Market- Preserving Federalism and Economic Development. Journal of Law, Economics and Organisation, 11, Winer, S.L., On the Reassignment of Fiscal Powers in a Federal State. In: G. Galeotti, P. Salmon and R. Wintrobe, eds. Competition and Structure. 776

17 The Political Economy of Collective Decisions: Essays in Honor of Albert Breton. Cambridge: Cambridge University Press,