Second generation fiscal federalism: The implications of fiscal incentives

a r t i c l e i n f o a b s t r a c t JEL classification: H77 H11 H71 R11 R58 Keywords: Fiscal federalism State and local taxation Intergovernmental relations Revenue First generation fiscal federalism (FGFF) studies the performance of decentralized systems under the assumption of benevolent social planners. Second generation fiscal federalism (SGFF) studies performance based on the fiscal and political incentives facing subnational officials. The paper focuses on three aspects of SGFF. First, it considers the design of intergovernmental transfers. While FGFF emphasizes correcting vertical and horizontal equity, SGFF emphasizes the importance of fiscal incentives for producing local economic prosperity. SGFF extends FGFF approaches by showing how non-linear transfer systems can produce both equalization and high marginal fiscal incentives to produce local economic growth. Second, the paper raises the fiscal incentive approach, showing how different tax systems produce different fiscal incentives for political officials to choose policies. Third, the paper discusses the interaction of democracy and fiscal federalism. [Second generation fiscal federalism represents] a new literature on fiscal federalism that examines the workings of different political and fiscal institutions in a setting of imperfect information and control with a basic focus on the incentives that these institutions embody and the result behavior they induce from utility-maximizing participants (Oates, 2005, p. 356). Much fiscal analysis of developing countries is on the following pattern: the academic literature is drawn on to construct a model fiscal system; the existing situation in a particular country is examined to determine how it diverges from the model; and a fiscal reform is then proposed to transform what is into what ought to be.. .. In contrast, my approach is first to study in detail exactly how the existing system works, and why it works that way, in order to have a firm basis for understanding what changes may be both desirable and feasible. My emphasis has thus always been more on what can be done than on what should be done (Bird, 1992, x, emphasis in original).