Designing a European Fiscal Union

Lessons from the Experience of Fiscal Federations

Carlo Cottarelli, Martine Guerguil, Carlo Cottarelli, Martine Guerguil

• Publisher: Taylor & Francis
• Year: 2014
• Print ISBN: 9781138783225
• eBook ISBN: 9781317667506
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

Does the European Union need closer fiscal integration, and in particular a stronger fiscal centre, to become more resilient to economic shocks? This book looks at the experience of 13 federal states to help inform the heated debate on this issue. It analyses in detail their practices in devolving responsibilities from the subnational to the central level, compares them to those of the European Union, and draws lessons for a possible future fiscal union in Europe.

More specifically, this book tries to answer three sets of questions: What is the role of centralized fiscal policies in federations, and hence the size, features and functions of the central budget? What institutional arrangements are used to coordinate fiscal policy between the federal and subnational levels? What are the links between federal and subnational debt, and how have subnational financing crises been handled, when they occurred? These policy questions are critical in many federations, and central to the current discussions about future paths for the European Union.

This book brings to the table new, practical insights through a systematic and comprehensive comparison of the EU fiscal framework with that of federal states. It also departs from the decentralization perspective that has been prominent in the literature by focusing on the role of the centre (which responsibilities are centralized at the federal level and how they are handled, rather than which functions belong to the local level). Such an approach is particularly relevant for the European Union, where a fiscal union would imply granting new powers to the centre.

1
Distribution of fiscal responsibilities in federations

Julio Escolano, Dora Benedek, Hui Jin, Carlos Mulas Granados, Masahiro Nozaki, Joana Pereira, Gregoire Rota Graziosi, Laura Sinn, and Jose Torres

I. Introduction

This chapter discusses the distribution of the main budgetary functions (revenue, expenditure and inter-government transfers) across levels of government in a sample of fiscal federations.¹ It takes a primarily descriptive perspective, although drawing as appropriate from the vast body of theoretical and empirical studies on fiscal federalism. The theory and practice of fiscal federalism has evolved substantially in recent years. The current literature typically distinguishes between two approaches to fiscal federalism. First generation fiscal federalism theory, rooted in the normative approach developed during the 1950s–60s, studies the performance of decentralized systems under the assumption of benevolent social planners. The second generation fiscal federalism theory builds on those models, but also incorporates the fiscal and political incentives facing subnational officials.² This chapter draws on both approaches to assess and put in perspective the practices of federations in our sample.

Since we focus on fiscal federations, not surprisingly, these countries are characterized by the allocation of a large proportion of the total revenue and expenditure to subnational governments (SNGs). While fiscal decentralization is seldom undertaken in pursuit of fiscal efficiency, there are well-established efficiency reasons to allocate budgetary decisions to lower levels of government whenever possible – the “subsidiarity principle.” Essentially, allocating fiscal decisions to a level of government that is closer to the taxpayers and beneficiaries of the government services allows a closer tailoring of fiscal policy to regional social preferences and a tighter accountability (Oates, 1972). This may potentially lead to efficiencies in spending and to a tax-expenditure package with better balanced costs and benefits. Indeed, empirical evidence indicates that the fiscal performance of the government sector as a whole tends to improve with decentralization (Baskaran, 2010; Escolano et al., 2012; European Commission, 2012).

Potential gains from decentralization notwithstanding, a minimum size of the central government is necessary for the effective dispatch of its core functions. From inception, fiscal federations have invariably conferred on the central government national defense and foreign relations, as well as other traditional public goods such as countrywide justice and law enforcement, communications (e.g., postal service), and key transportation systems. Since the 1880s introduction by Bismarck of a national social insurance system in Germany, the center has also increasingly assumed social insurance and redistributive functions and expanded the provision of public goods and services with large positive network externalities, such as national transportation, energy, and communication grids. In addition, the central government is invariably responsible for carrying out macroeconomic counter-cyclical policies, providing risk-sharing against regional idiosyncratic and asymmetric shocks (such as natural disasters), and responding to other aggregate shocks. Stabilization and social protection were crucial factors in the growth of central governments through the 20th Century. For example, in 1929 the size of the U.S. federal government budget was about 2.5 percent of GDP, about 33 percent of the states’ budgets, while in 1939 after the New Deal, the figures were 10 percent for the federal and 9 percent of GDP for the state budgets (Vanistendael, 2011). In all, the evidence from fiscal federations shows that, today, the central government often accounts for more than half of total government spending.

The distribution of functions is somewhat different in the European Union. Regional equalization and cross-country transportation networks consume an important share of the joint budget. While social protection policies remain in the hands of member countries, stabilization policies are increasingly coordinated and overseen at the central level, including through a single monetary policy for euro member countries, a strengthened framework for fiscal policies, and Union-wide central firewalls to help maintain financial stability.

The rest of this chapter is divided in four sections. The following two sections discuss in detail the assignment of responsibilities in fiscal federations across levels of government in the areas of taxes and spending. The next section covers the design of inter-governmental transfers, followed by a section which discusses the European Union’s budget. The final section draws some conclusions.

II. Distribution of revenue responsibilities

A. Inter-governmental tax assignment criteria

The underlying criteria for the distribution of taxing powers between the central and subnational governments are similar to those that apply to fiscal decentralization in other areas: delegation to a lower level of government allows for a better matching of the tax system to the preferences of the community, closer accountability, and more participatory and transparent decision-making. On the other hand, economies of scale, risk-sharing, and externalities argue for the centralization of taxes where these features are dominant. These considerations apply both to the tax policy decision-making powers and to the administration of the different tax instruments – an aspect that has often been overlooked by the theoretical literature (Box 1.1). Finally, decentralization of tax powers often aims at minimizing transfer dependency, allocating as an integral package the decision-making on public services’ provision and their funding.

Taking into account the interplay among intrinsic features of different tax instruments, their administration requirements, and the allocation of government

Box 1.1 Fiscal federalism and tax administration

The assignment of tax administration and collection responsibilities between the federal and SNGs reflects a trade-off between minimization of administration and compliance costs and SNGs’ sovereignty. Solutions take several forms including decentralization to SNGs of most central taxes (Germany, Switzerland), coordinated but separate administration of their respective taxes, and central administration of some SNG taxes (Australia, Canada, Spain).

Germany combines a decentralized tax administration and a highly harmonized tax system: PIT, CIT, and VAT are regulated by federal law but administered by the SNGs’ fiscal authorities. However, the Constitution provides the federal government with power to secure a homogeneous enforcement of tax compliance. For instance, the Federal Ministry of Finance is entitled to issue instructions, supervise, and contribute to federal audits in SNG operations to safeguard the interests of the federation and the uniform application of tax law. Other federations (Australia, Canada, Brazil, India, and the United States) have independent separate tax administrations for each level of government.

The administration of two-level (federal and local) consumption taxes can be particularly challenging. Brazil has state VATs levied by SNGs at multiple rates and with a hybrid model combining the destination and origin principles – the introduction of the latter was motivated by low SNG admin istrative capacity and the absence of borders controls – with national tax rules applying to interstate trade. In the United States, SNGs (states and munici palities) have and administer separate sale taxes, with voluntary partial harmonization and coordination taking place among some SNGs. Most Canadian provinces with VATs delegate their administration to the central Canadian Revenue Authority, so that both VATs (central and provincial) are administered centrally, except for Quebec where the federal and the provincial VATs, which share the same base, are administered by the provincial tax administration. In Australia, Mexico, and Spain, a single VAT is administered centrally.

Income taxes (CIT and PIT) are often administered centrally to minimize costs – occasionally with formal or informal agreements between the center and SNGs. In Canada, almost all SNGs (except Quebec for PIT and Quebec and Alberta for CIT) have voluntarily delegated the administration of income taxes to the central tax administration.

functions, the literature on fiscal federalism points to the following principles for assigning taxing powers across levels of government (Musgrave, 1983; Dahlby, 2001; Bird, 2010a):

• Central taxation of bases that are highly mobile across regions minimizes distortions; reciprocally, less mobile bases are well suited for SNG taxation. This is a particular case of the Ramsey’s optimal taxation principle that postulates that taxation should be inversely related to the elasticity of the base. When tax avoidance leads to a shift of the tax base across regions, it gives rise to economic inefficiency as a result of suboptimal location.
• Inter-regional equalization argues for central taxation of tax bases unequally distributed across regions. While this policy objective is present to some extent in all countries, it is often balanced, particularly in fiscal federations, by the desire to protect the economic policy autonomy of regions and allow the more dynamic regions to reap the benefits of their economic success. Also, most countries allow natural resource-rich regions to benefit from a portion of the tax potential associated with these resources that goes well beyond the local costs and negative externalities generated by the resource exploitation.
• Centralization of progressive taxation instruments (e.g., progressive personal income taxation) facilitates cross-regional income redistribution. As with inter-regional equalization, the concentration of progressive taxation at the center is a function of the social demand for redistribution. Central taxes typically contain a certain level of progressivity, which regional authorities can complement with an additional tier of regional tax progressivity to achieve intra-regional redistribution according to regional preferences.
• Risk-sharing and counter-cyclical policies are enhanced by centralizing volatile and pro-cyclical taxes – as the central government is better able to absorb revenue shocks over the cycle or across SNGs. Part of the risk-sharing function of the central government – that is, insurance against idiosyncratic regional shocks – can be achieved by allocating centrally the most volatile revenue sources, such as the corporate income tax. The central government is also better placed to absorb revenue shortfalls stemming from business cycles, as central governments have better access to financing than do SNGs, while SNGs are sometimes constrained by thin debt markets or management capacity.

In light of the prin...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Introduction and overview
• 1 Distribution of fiscal responsibilities in federations
• 2 The role of fiscal transfers in smoothing regional shocks
• 3 Constraints on subnational fiscal policy
• 4 Budgeting, accounting, and reporting
• 5 Financing of central and subnational governments
• 6 Subnational fiscal crises
• 7 Lessons from the crisis: Minimal elements for a fiscal union in the euro area
• Index