Mind the Gap: Mind the Gap: Reflections on Fiscal Reflections on Fiscal

Balance in Balance in Decentralized Decentralized FederationsFederationsRobin Boadway, Queen’s Robin Boadway, Queen’s

UniversityUniversity

Prepared for Prepared for The Federal The Federal Idea:Idea:

A Conference in Honour of A Conference in Honour of Ronald L. WattsRonald L. Watts

IIGR, October 18-20, 2007IIGR, October 18-20, 2007

OutlineOutline

IntroductionIntroduction CaveatsCaveats Evolving views of the fiscal gapEvolving views of the fiscal gap Fiscal imbalance vs. Fiscal GapFiscal imbalance vs. Fiscal Gap Fiscal imbalance I: The soft budget Fiscal imbalance I: The soft budget

constraintconstraint Fiscal imbalance II: Tightening the Fiscal imbalance II: Tightening the

budget constraintbudget constraint Seeking some balanceSeeking some balance

IntroductionIntroduction

Fiscal gap—transfers from higher to lower Fiscal gap—transfers from higher to lower level—is a feature of multi-level level—is a feature of multi-level governmentsgovernments

Applies to both federal-provincial abnd Applies to both federal-provincial abnd provincial-local levelsprovincial-local levels

Fiscal gap varies widely across countries, Fiscal gap varies widely across countries, mainly due to differences in revenue-raisingmainly due to differences in revenue-raising

Gradual tendency for growing expenditure Gradual tendency for growing expenditure decentralization; revenue side mixeddecentralization; revenue side mixed

Introduction, cont’dIntroduction, cont’d

No consensus about the most suitable No consensus about the most suitable fiscal gap for any given nation, but some fiscal gap for any given nation, but some common mantrascommon mantras

Changing circumstances (scope of Changing circumstances (scope of government policy) and changing views government policy) and changing views about decentralization have fed into about decentralization have fed into changes in ideals about the fiscal gapchanges in ideals about the fiscal gap

Among economists, decentralists have Among economists, decentralists have taken center stage, and to some extent taken center stage, and to some extent among policy makers and advisors as wellamong policy makers and advisors as well

Introduction, cont’dIntroduction, cont’d

Recently, concept of fiscal imbalance Recently, concept of fiscal imbalance has entered the lexiconhas entered the lexicon

In Canada, distinction between fiscal In Canada, distinction between fiscal gap and fiscal imbalance made by gap and fiscal imbalance made by SSéguin Commissionéguin Commission

Some suggestion that the two are relatedSome suggestion that the two are related This talk: exploration of the evolution of This talk: exploration of the evolution of

thinking about fiscal gap and its relation with thinking about fiscal gap and its relation with fiscal imbalancefiscal imbalance

CaveatsCaveats

Draw heavily on Canadian experienceDraw heavily on Canadian experience Economists’ perspective vs. broader onesEconomists’ perspective vs. broader ones

Economic dimension of policy choicesEconomic dimension of policy choices Relevance of incentivesRelevance of incentives

Importance of one’s view of benevolence of Importance of one’s view of benevolence of government, or quality of governancegovernment, or quality of governance

Importance of value judgments: Importance of value judgments: solidarity/social citizenship vs. efficiencysolidarity/social citizenship vs. efficiency

Evolving Views of the Fiscal Evolving Views of the Fiscal GapGap

Arguments determining the size of fiscal gapArguments determining the size of fiscal gap Decentralization of spending versus revenuesDecentralization of spending versus revenues AccountabilityAccountability EqualizationEqualization Exercise of the spending powerExercise of the spending power Fiscal harmonizationFiscal harmonization Potential for federal-provincial-local cooperationPotential for federal-provincial-local cooperation Importance of fiscal competition?Importance of fiscal competition?

The fiscal gap versus the responsibility gapThe fiscal gap versus the responsibility gap

Evolving Views, cont’dEvolving Views, cont’d

Evolution of expenditure decentralizationEvolution of expenditure decentralization Spending now dominated by services to people, Spending now dominated by services to people,

transfers and social insurance: decentralized transfers and social insurance: decentralized provision efficient but national interests at stakeprovision efficient but national interests at stake

Infrastructure: potential conflict between Infrastructure: potential conflict between provincial responsibility and national interest, provincial responsibility and national interest, especially if highly decentralized (lessons from especially if highly decentralized (lessons from econ geography)econ geography)

Reconciliation of benefits of decentralized Reconciliation of benefits of decentralized delivery with national interest is a key issuedelivery with national interest is a key issue

Evolving Views, cont’dEvolving Views, cont’d

Case for revenue decentralization Case for revenue decentralization weakenedweakened More reliance on VATMore reliance on VAT Evolution toward schedular (dual) income Evolution toward schedular (dual) income

taxestaxes Globalization and mobility of tax basesGlobalization and mobility of tax bases CompetitivenessCompetitiveness Importance of harmonized tax basesImportance of harmonized tax bases Increase in horizontal disparitiesIncrease in horizontal disparities Growing importance of citiesGrowing importance of cities

Evolving Views, cont’dEvolving Views, cont’d

The elusive concept of accountabilityThe elusive concept of accountability Economists argue fiscal gap deters Economists argue fiscal gap deters

accountabilityaccountability In fact, revenues from major tax bases little In fact, revenues from major tax bases little

different from transfers in terms of different from transfers in terms of accountabilityaccountability

Effect of incentives on gov’t vastly overstatedEffect of incentives on gov’t vastly overstated Watertight division of responsibilities Watertight division of responsibilities

misconceivedmisconceived Accountability argument overstatedAccountability argument overstated

Has decentralization mantra gone too far?Has decentralization mantra gone too far?

Fiscal Imbalance vs. Fiscal Fiscal Imbalance vs. Fiscal GapGap

The existence or otherwise of a fiscal The existence or otherwise of a fiscal imbalance has been a highly charged issue imbalance has been a highly charged issue in Canadain Canada

SSéguin argument: Given expenditure éguin argument: Given expenditure responsibilities and division of tax room, responsibilities and division of tax room, transfers inadequate, given major transfers inadequate, given major cutbackscutbacks

Also, they suggested fiscal gap too largeAlso, they suggested fiscal gap too large Horizontal imbalance also pronouncedHorizontal imbalance also pronounced Some observers deny possibility of fiscal Some observers deny possibility of fiscal

imbalanceimbalance

Fiscal Imbalance vs. Fiscal Fiscal Imbalance vs. Fiscal Gap, cont’dGap, cont’d

Distinction conceptually meaningful, but Distinction conceptually meaningful, but ambiguousambiguous Concept of fiscal imbalance judgmental: Concept of fiscal imbalance judgmental:

relies on views about optimal fiscal gaprelies on views about optimal fiscal gap Large fiscal gap not inconsistent with fiscal Large fiscal gap not inconsistent with fiscal

balancebalance In the long run, imbalance should not persist, In the long run, imbalance should not persist,

assuming provinces have fiscal discretionassuming provinces have fiscal discretion In the short run, sudden changes can cause In the short run, sudden changes can cause

imbalance: can go either way imbalance: can go either way

Fiscal Imbalance I: The Soft Fiscal Imbalance I: The Soft Budget ConstraintBudget Constraint

Excessive lower-level spending and Excessive lower-level spending and debts leading to higher transfers: debts leading to higher transfers: negative imbalancenegative imbalance

Some causes/symptomsSome causes/symptoms Lack of commitment (bailouts: Nwfld?)Lack of commitment (bailouts: Nwfld?) Lack of lower-level accountabilityLack of lower-level accountability Lack of lower-level policy-making discretionLack of lower-level policy-making discretion Use of central discretionary fundingUse of central discretionary funding Excessive central controlsExcessive central controls Fiscal gap too high?Fiscal gap too high?

Fiscal Imbalance II: Fiscal Imbalance II: Tightening the Budget Tightening the Budget

ConstraintConstraint Restriction on higher-level transfers Restriction on higher-level transfers

starting from a situation of fiscal balancestarting from a situation of fiscal balance Some causes/symptomsSome causes/symptoms

Debt imbalanceDebt imbalance Discretionary central transfersDiscretionary central transfers Horizontal imbalance increasingly expensiveHorizontal imbalance increasingly expensive Sub-national governments able to raise Sub-national governments able to raise

revenuesrevenues Responsibilities for spending programs ill-Responsibilities for spending programs ill-

defineddefined Fiscal gap too low?Fiscal gap too low?

Seeking Some BalanceSeeking Some Balance

How to combine benefit of decentralized How to combine benefit of decentralized public services and targeted transfers public services and targeted transfers with efficient harmonized tax system, with efficient harmonized tax system, horizontal balance and balanced horizontal balance and balanced response to fiscal shocks?response to fiscal shocks?

1.1. Significant fiscal gap: federal control of Significant fiscal gap: federal control of VAT, environmental tax, and income taxVAT, environmental tax, and income tax

2.2. Constraint on federal government: Constraint on federal government: revenue sharing (Australian/German revenue sharing (Australian/German system)system)

Seeking Some Balance, Seeking Some Balance, cont’dcont’d

3.3. Provincial revenue-raising discretion: Provincial revenue-raising discretion: access to harmonized income tax and access to harmonized income tax and narrow taxesnarrow taxes

4.4. Reduced discretion on year-to-year Reduced discretion on year-to-year transfers transfers

5.5. More cooperative decision-makingMore cooperative decision-making

6.6. Institutional cooperation: federal Institutional cooperation: federal provincial advisory fiscal commissionprovincial advisory fiscal commission

7.7. Use of the spending power an open Use of the spending power an open questionquestion