Subnational Revenues: Realities and Prospects

The traditional theory of fiscal federalism prescribes a very limited tax base for subnational governments. The only "good" local taxes are said to be those (1) that are easy to administer locally, (2) that are imposed solely (or mainly) on local residents, and (3) that do not raise problems of "harmonization" or "competition" between subnational governments or between subnational and national governments. 2 The only major revenue source usually seen as passing these stringent tests is the property tax, with perhaps a secondary role for taxes on vehicles, but not much else other than user fees. Since this conclusion fits in well with the reluctance of most central governments to provide subnational governments access to more lucrative sales or income taxes, it is not surprising that it has become conventional wisdom. Subnational governments almost everywhere are thus urged to make more use of property taxes, and criticized when they do not do so enthusiastically. Up to a point, there is much to be said for this argument. Unfortunately, that point falls far short of the task facing subnational governments in many countries for a number of reasons. First, the conventional case for property taxes is to some extent flawed. Such taxes are in fact costly and difficult to administer well, and these problems are greatly exacerbated as the tax burden increases. Moreover, in practice political realities mean that increases in property taxes are often concentrated primarily on non-residential properties that most lend themselves to tax exporting, thus undercutting one of the principal arguments for local use of this tax base. Second, even a well-administered local property tax cannot finance major social expenditures (education, health, social assistance) except perhaps in the richest (and usually largest) communities. To the extent it is desirable for governments to finance from their own revenues the services they provide, either local governments financed by property taxes are confined to providing "local" services (street cleaning, refuse removal, etc.), or they are inevitably heavily dependent on transfers from higher levels of government. This is the pattern in most developed countries, including even the relatively few in which the property tax is the mainstay of local finance. In most other OECD countries, to the extent they are not dependent on national transfers. local governments impose significant direct taxes on business or levy surcharges on national income taxes (Bird and Slack, 1991). Third, the conventional argument does not take adequately …