UNIT 16 FISCAL FEDERALISM AND FISCAL

POLICY
Structure
16.0 Objectives
16.1 Introduction
16.2 Fiscal Federalism
16.2.1 Welfare Gains from Fiscal Federalism

16.3 Fiscal Policy

16.3.1 Devolution
16.3.2 Vertical and Horizontal Fiscal Imbalance
16.3.3 Tax Sharing

16.4 Grants
16.4.1 Inter-Governmental Transfers
16.4.2 Correcting Vertical Imbalance
16.4.3 Horizontal Imbalance and Fiscal Equalization
16.4.4 Inter-Governmental Transfers to Correct Spillovers
16.4.5 Other Objectives
16.4.6 Types of Grants

16.5 Fiscal Competition

16.6 Let Us Sum Up
16.7 Key Words
16.8 Some Useful Books
16.9 Answer or Hints to Check Your Progress
16.10 Exercises

16.0 OBJECTIVES
After going through this unit, you will be able to:
• understand management of fiscal policy in the context of fiscal federalism;
• assess the functional assignment of responsibility and revenue sources in federal
counties;
• understand the rationale of intergovernmental transfers in the form of grants;
and
• understand the issues relating to fiscal competition among jurisdiction and its
effect.

16.1 INTRODUCTION
Countries are found to have unitary or federal governments. Federal countries as
distinct from unitary governments are organised at different levels – central, state 1
Fiscal Federalism and/or local governments and have constitutional powers in the spheres of functions
and finances. Fiscal policy of the governments in a federal set-up refers to the
management of the government finances based upon assigned functions and revenue
sources. Intergovernmental transfers or devolution of resources in the form of grants
and tax shares to the lower level of government are considered an important element
of fiscal policy in a federal structure. In this unit we shall discuss the concept of fiscal
federalism, fiscal policy management in a federal structure, need and forms of grants
flowing from higher level to lower level of government and the issues relating to fiscal
competition

16.2 FISCAL FEDERALISM

Before analyzing the management of government finances in federal countries, it is
useful to understand the concept of fiscal federalism.
Fiscal federalism relates to the division of government functions and finances in a
logical way among multiple layers of government. Traditional theory of fiscal federalism
lays out general framework for the assignment of functions to different levels of
government and appropriate financial powers for carrying out these functions. The
public sector across the countries is not organised as a unitary or cenrtralised system.
It is instead stratified into a number of levels of governments, each having its own
particular set of functions and tax-raising powers. For example, in India, there is a
top tier Central Government, below that the State Governments, and then local
governments like municipalities and rural local government called Panchayati Raj
Institutions. Fiscal policy in a federal structure is influenced by nature of functional
areas assigned to different levels of government, arrangement of revenue sources,
and the intergovernmental transfers.
Over the years the fiscal federalism has gained world-wide recognition and
decentralization of spending and revenue raising responsibilities to sub-central
governments has increased. Political developments in post-communist countries in
Central and Eastern Europe, and new trends in Latin America, Asia and Africa
show that the tendency to adopt the principles of fiscal federalism and decentralisation
of governance has increased.
Fiscal federalism in addition to being economically efficient in providing and financing
government services, can more effectively promote democratic and participatory
forms of government. Fiscal federalism improves the responsiveness and
accountability of policy makers and provision of services tends to respond to the
preference of beneficiaries and taxpayers. It has the capacity to promote coincidence
between the three circles of budgetary policy; those who decide, those who benefit
and those who pay.

16.2.1 Welfare Gains from Fiscal Federalism

Fiscal federalism with its inherent structure of decentralization of spending and revenue
sources promotes efficiency and welfare. The decentralisation theorem propounded
by Oates (1972) demonstrates fiscal federalism ensures that public services are
provided corresponding to the diversified demand conditions in a federation. The
provision of public services by a central government will be of uniform nature
throughout the country. The state and local governments being much closer to their
people and geography of their respective jurisdictions possess better knowledge of
2 both local preferences and cost conditions unlike a central government. The state
and local governments will be more responsive to particular preferences of their Fiscal Federalism and
Fiscal Policy
constituencies and will be able to find new and better ways to provide these services.
The economic condition and level of development in different jurisdictions tends to
be different depending upon many factors and thus requirements of public services
differ across regions, which the state Government will be able to recognize unlike
the central government.
The gains from decentralization, as propounded by Charles Tiebout (1956) were
due to highly mobile households. They choose a jurisdiction as their residence
based upon its fiscal package that suits their tastes. The consumer-voter exercises
his/her preferences by influencing public policies through some political mechanism.
The larger the number of jurisdictions, the wider is the consumer choice. Also, the
more diverse the demand for public services in different jurisdictions, the greater is
the welfare gains from fiscal decentralization.
Check Your Progress 1
1) What is fiscal federalism and how the governments are organised in a federal
country?
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2) Why fiscal federalism is efficient in provision of public services?
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16.3 FISCAL POLICY

Fiscal policy or management of government finances in a federal structure is linked
with devolution of functional responsibility to different levels of government and
fiscal instruments (sources of finances) to carry out the functions. The devolution of
functions demarcates the spheres of responsibility of different governmental units;
for instance provision of national defence by central government, irrigation by state
governments, and street lighting by municipalities. The demarcations of sources of
finances endow the ability and flexibility to different governmental units to undertake
the functions assigned to them. The functional responsibility and revenue powers to
different levels of government many a time are enshrined in the Constitution of the
country.
Efficient assignment provides sufficient flexibility to all governmental units in designing
levels of public services to be provided and levying reasonable tax keeping the
preference of citizens in mind. The functional demarcation also helps in minimising
the inter-jurisdictional tax and expenditure benefit spillovers and provides adequate
resources in the hand of central government to undertake regional equalisation.
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Fiscal Federalism On the revenue side, governments in different levels have access to taxation powers
and non-tax revenue sources. In addition to these revenue sources, there are others
ways allocating funds which is called intergovernmental transfers. Local governments
almost invariably depend in part, and some times heavily, upon transfers from upper-
level governments to finance the services for which they are responsible.
Intergovernmental transfer of resources play significant role financing the budget of
the lower level of governments. The appropriate level and design of such transfers
has been an important concern in the fiscal policy of governments in federal system.
Depending upon how the taxation powers are assigned and taxes collected, some
of the taxes having wide base are distributed between the governments. The flow of
resources from one level to another depends on institutional arrangement, like in
India Central Finance Commission and Planning Commission. In this context
borrowing from market and abroad are significant as the debt instruments and power
to borrow have been delineated in the assignment of financial powers.
Both the central government and state governments present their budgets annually
that give accounts of detailed expenditures under various heads and revenue sources
that finance the expenditures. In many countries including India fiscal plans are
prepared for a medium term (3 to 5 years) both at central and state levels by
projecting revenues and expenditures. The expenditures given in the budget typically
follows the functions assigned to each level of the government and revenues from
the assigned sources. In the case of central government budget the revenues
mentioned are net of the transfers to the state governments and in the case of state
governments, budgets include the revenue transfers from the central governments.
Let us take an example of a state government to know about the fiscal management
in the context of fiscal federalism. The revenues of a state government constitutes
tax and non-taxes collected from its own sources (assigned revenue power) and
transfers from the central government in the form of share in central taxes and grants.
The expenditures incurred are categorised into two types- revenue/current
expenditures and capital expenditures. Revenue/current expenditures consists of
salaries, pensions, interests, operation and maintenance, subsides and any other
transfer payment. The capital expenditure are incurred basically to create durable
assets like infrastructure spanning over social and economic sectors that can be
helpful in creating further income in future. The capital expenditures are generally
financed from borrowed funds. The state can borrow from market meaning
development and commercial banks, from central government and use the funds
under small savings. The loans from central government are part of overall central
assistance to state plans. The states to borrow from market require the permission
of central government if they have outstanding loans to the Central government.
However, a prudent management of government finances emphasizes creating
surpluses in the revenue account, i.e., generating surpluses after meeting the current
expenditures, to be invested in capital assets. The borrowings are to be repaid over
a period of time with interest payments. The overall management of the finances of
the government is expected to create income and employment in the economy and
thus more revenues for the government that would enable it to repay the loans. In
this context the transfers from the central government play crucial role in the finances
of state government. In India, invariably the state governments depend heavily on
the central transfers to finance their expenditure responsibilities. Various issues in
fiscal federalism that affects the designing of fiscal policy are discussed in later sections.

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16.3.1 Devolution Fiscal Federalism and
Fiscal Policy

Devolution is the granting of powers from central government to government at

regional or local level. In federal systems the sub-national governments are guaranteed
with the devolved power constitutionally. In the unitary countries, on the other
hand, the central government can devolve powers temporarily and can withhold the
devolved powers. The devolution can be financial, e.g. giving regions budgetary
support to manage their finances. However, the power to make legislations relevant
to the area may also be granted.
Functional Devolution
The main question for any federal structure is which task should be assigned to
which government level and how it should be financed. Following the distinction of
Musgrave (1959), the government has to perform three main tasks;
1) Allocation function: changing the allocation by providing public goods and
correcting the external effects of the private sector
2) Redistribution function: redistributing income in order to equalize income
distribution which is the result of market forces; and,
3) Stabilization function: stabilizing the economic process in order to reduce business
cycle fluctuations. This entails to maintain high employment, price level stability
and appropriate level of economic growth.
Primary responsibility for macroeconomic stabilisation and redistribution of income
and wealth (fair state of distribution) rests with the central government. The local
governments being small in size are not suitable to pursue independent stabilisation
and redistributive polices affecting the whole country. The local or state governments
are better placed to undertake allocative functions through decentralised provision
of public goods and services. Decentralised provision of public goods and services
cater to varying preferences of people better and thus enhances social welfare.
Devolution of various functions to different governmental units depends upon the
benefit span of functions and goods provided. Public goods that have nation wide
benefit span, like the national defence and foreign policy should be provided by the
central government. Public goods those are local in nature like primary education,
health services and so on should be primary responsibility of local or state government.
However, a strict demarcation of functions and compartmentalizing them into central
and local government level may not be possible. There could be overlapping of
provision of services by both central and state governments. The basic argument for
decentralization in a federal structure - to provide public services corresponding to
the diversified preferences remains the guideline for functional assignment.
The functions undertaken by the central government can be classified as those required
for maintaining macroeconomic stability, and those assigned for reasons of economies
of scale and cost efficient provision of public services. Issuing currency and coinage,
dealing in foreign exchange, foreign loans, operation of Central bank of the country,
international trade, banking, insurance and operation of stock exchange are some
major functions assigned to the central government to maintain macro economic
stability. Functions like operation of railways, posts and telegraphs, national highways,
shipping and navigation on inland waterways, air transport, atomic energy, space,
regulation and development of oilfields and major minerals, inter-state trade and
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Fiscal Federalism commerce and regulation and development of inter-state rivers are the major functions
assigned to the centre for reasons of scale economies (national coverage).
In India the functions of central and state governments are listed in ‘Union List’ and
‘State List’. In addition there is a ‘concurrent list’ in which both central and state
governments have jurisdiction. The important items included here are economic
and social planning (all items in economic and social services), commercial and
industrial monopolies, trade unions, social security, welfare of labour, and price
control.
The major subjects that can be assigned to state governments include public order,
police, public health, agriculture, irrigation, land rights, fisheries, industries and
minerals other than mentioned in central list. In regard to subjects like education
and transport, social security and social insurance, the states are compelled to assume
a significant role, being proximate to the people within a democratic policy.
Tax Devolution in a Federal System
The determination of vertical structure of taxes – taxes assigned to central government
and to state government, is referred as tax assignment or devolution of tax powers in
a federal structure. The basic issue here is a normative question as to which taxes
are best suited for use at different level of governments. There are basically two
models available in fiscal federals structures that address the assignment of revenue
sources.
First, there is a separation between revenue and expenditures of the different federal
levels, and each has its own revenue source as practiced in Switzerland, USA and
India. This gives different governmental units and local and central level considerable
flexibility in designing their tasks and fulfilling their responsibilities. Second, the German
type of federalism in which all major revenue sources are taken together, and different
governmental units receive fixed shares of total revenue, distributed at state and
local levels according to certain criteria. The flexibility of sub-central governments
to collect taxes is strictly limited and this makes it difficult for them to follow the
correspondence principle.
In reality, all federal systems are located somewhere between these two extremes
and the question of which tax should be devolved to which level of government
remains pertinent. According to conventional criteria, the only revenues clearly
suitable to sub-national governments are those they can administer efficiently, and
which fall primarily on their own residents. Sub-national governments should not for
example, be allowed to impose taxes that are shifted to other jurisdictions.
At decentralised level , economic agents , goods and resources have significant
movement as reflected in the nation wide market . The difference of mobility of
taxed units has significant implicatons for design of vertical structure of taxation .
The decentralised levels of government should avoid the taxation of highly mobile
economic agents (be they households , capital or final good)
The tax devolution based on the principle of separation need more elaboration. In
this type of tax assignment tax handles are exclusively assigned either to centre or to
the states as is the case in Indian federation. Under this arrangement most of the
broad based and productive tax handles have been assigned to the centre, perhaps
for reasons of stabilisation and redistribution stated earlier. These include taxes on
income and wealth from non-agricultural sources, corporation tax, excise duty on
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manufactures (excludes liquor and narcotics), and customs duty. A number of tax
handles have been assigned to the states as well, but, from the point of view of Fiscal Federalism and
Fiscal Policy
revenue productivity , only tax on sale and purchase of goods is a broad based tax
assigned to states. The clear demarcation of tax handles of the central and state
governments has been prescribed to avoid tax overlapping and concurrency.
The Indian experience with separation of tax powers clearly contrasts with
assignments prevailing in number of federations like Australia, US, and Canada,
where the constitution itself assigns concurrent powers of taxation in respect of
some broad based taxes. In Australia, the federal government levies all major taxes
though in some taxes the states have concurrent power do so. In the USA and
Canada, the federal and state/provincial governments have concurrent powers to
levy income taxes, but cooperation and coordination among the two levels of
government have ensured uniformity in tax base. In the USA, the federal government
does not levy any broad based indirect tax and the states have exclusive rights to
levy retail sales tax. In Canada both federal and provincial governments can levy
consumption taxes. The essence of the above discussion is that many of the developed
federations have, to a large extent, tried to resolve the problem of vertical tax
overlapping either through tax assignment or through coordination.
The tax devolution across the federal countries show that many problems arise
because sub-national governments are commonly assigned revenue sources that are
inadequate to finance the expenditures for which they are responsible. Traditionally,
central governments have claimed as their own most of the major revenue sources
notably, income tax, payroll, and customs and so on, leaving little room for sub-
national governments to levy their own taxes on these bases and hence rendering
them dependent on federal transfers.

16.3.2 Vertical and Horizontal Fiscal Imbalance

Vertical fiscal imbalance occurs when the revenues of different levels of government
do not match their expenditure responsibilities. As discussed earlier, the assignment
of tax and expenditure between the centre and sub-national levels is often not
coordinated and lower level governments have revenues that do not match their
needs. This will necessitate intergovernmental transfers from the over endowed central
government to the under endowed sub-national governments. This is known as
vertical fiscal equalization.
Horizontal fiscal imbalance occurs when different regions of a country have different
abilities to provide services, due to different abilities to raise funds. This can occur if
some regions are able to raise more funds through their tax bases than other regions
and/or the cost of provision of services is higher in some regions than in others. This
is usually rectified by weighting transfers payments toward the needier regions, referred
to as horizontal fiscal equalization.

16.3.3 Tax Sharing

The central government shares a percentage of taxes under its own jurisdiction with
the state governments to account for the mismatch between low revenue assignments
and higher expenditure responsibilities of the state governments. The tax sharing
arrangements in the case of India can be referred to here. The central taxes in India
are shared with the state governments based on the recommendations of the ‘Finance
Commission’, a statutory body constituted at interval of five years. Its award
period covers five years. The Finance Commission after reviewing the finances of
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Fiscal Federalism central and state governments determines the percentage of central taxes to be
devolved to the state governments. The Finance Commission also determines inter
se distribution of central taxes among the state governments. Already 12 Finance
commissions have been constituted in India. The last Finance Commission (12th
Finance Commission) has recommended that 31.5 percent of all the central taxes to
be shared with the State Governments. The inter se distribution of central taxes
among the state government is determined on the basis of a formula that takes into
account various factors like population, area, per capita income, tax effort and fiscal
discipline of the state governments. The share in central taxes is a significant source
of revenue for the state governments. Other transfers to state governments, notably
grants are discussed in a latter section.
Check Your Progress 2
1) What are the basic elements of fiscal policy in federal countries?
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2) What are the tasks governments should undertake according to Musgrave and
which level of government should perform which task?
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3) What are the two major tax models that describe tax devolution in federal
countries?
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4) Why vertical and horizontal imbalances arise and how these problems are
resolved?
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16.4 GRANTS
16.4.1 Inter-Governmental Transfers
In most federal countries inter-governmental transfers have been employed as an
8 effective instrument to resolve fiscal imbalances, both vertical and horizontal, and to
offset inter-jurisdictional spillovers. Inter-governmental transfers are also often used Fiscal Federalism and
Fiscal Policy
by the central government to influence the spending pattern of sub-central
governments or to implement its expenditure plans through sub-central governments
using them as agencies. Inter-governmental transfers have been emphasized in
federations as political tools to pursue national goals, enabling the sub-central
governments to follow their objectives, while influencing their priorities through
conditionalities and coordination.
The inter-governmental transfers are designed to fulfill certain objectives. The
economic objectives are important parameters for designing and evaluating the transfer
scheme. The analysis of inter-governmental transfers should focus on allocative
efficiency, distributional equity and macroeconomic stability. The efficient transfer
system depends to a great extent on the institutional mechanism that determines the
overall scheme. Economic rationale of inter-governmental transfers is significant,
though in actual practice, the quantum and distribution of transfers are influenced by
non-economic factors like political considerations.
Intergovernmental transfers target four principal objectives;
1) Correcting vertical fiscal imbalance: transfers are used to fill the gap between
revenue-raising capacity and needs
2) Reducing horizontal fiscal imbalance and harmonizing tax burdens: transfers
may bring in additional resources to government units with lower fiscal capacity
3) Compensating for jurisdictional spillovers: local government units providing
services to people living in other jurisdictions must receive adequate
compensation. The rationale for transfers is both equity and allocative efficiency.
4) Implementing federal public policy through local governments: transfers make
it possible to achieve minimum standard of provision of certain services imposed
by regulation, while leaving local governments more freedom in the choice of
instruments

16.4.2 Correcting Vertical Imbalance

Vertical imbalance results when revenue sources assigned to sub-central governments
do not match the expenditure requirements. Sub-central governments, it is felt, are
also not able to raise tax rates due to political considerations. It is also a fact that
sub-central governments in their quest to attract trade and industry, try to provide
attractive packages by reducing tax rates. As a result central government succeeds
in raising more taxes and the sub-central governments are left with more spending
responsibility. Due to weak revenue base the public services provided by sub-
central governments suffer. This vertical imbalance can be corrected by making
inter-governmental transfers from central to sub-central governments to finance the
required level of public services.

16.4.3 Horizontal Imbalance and Fiscal Equalization

The fiscal equity argument is significant in inter-governmental transfers as an instrument
used to resolve horizontal imbalances. State governments differ in their economic
conditions and stages of development. The revenue raising capacity and expenditure
responsibilities of states vary significantly. The inter-jurisdictional differences in
revenue capacity and expenditures needs are present even with the efficient assignment
of functions and sources of finances. The provision of public services, therefore, is 9
Fiscal Federalism lower in poorer states having weak fiscal base and higher unit cost of providing such
services. Thus inter-governmental transfers are required to offset the fiscal disabilities
of the states with lower revenue capacity and expenditure needs. To fulfill the concept
of horizontal equity, it is necessary to give transfers so that each state is enabled to
provide same level of public services at a given tax rate. This type of transfer is
known as equalizing transfers and is designed to offset differences in revenue capacities
and variations in the unit cost of providing public services due to reasons beyond
states’ control.

16.4.4 Inter-Governmental Transfers to Correct Spillovers

In the fiscal federalism literature, very frequently mentioned objective of inter-
governmental transfers is on the ground of internalising externalities. When public
service is provided by one state but also enjoyed by the non-residents, it is called
spillover of benefits. The particular state while deciding about the amount of public
services to be provided ignores this benefit accruing to non-residents. If local residents
are taxed only according to the benefits they receive then this will result in allocation
of resources to collective consumption which is below optimum if all benefits were
taken into account. The inter-governmental transfers are designed to handle such
spillover of services provided by the states. These transfers need to be specific
purpose in nature requiring matching contributions from the states. The matching
contribution is determined on the basis of externality generated by the various public
services.

16.4.5 Other Objectives

There are two other objectives of inter-governmental transfers, namely, ensuring
minimum standards of services known as ‘merit goods’ in all the states and giving
transfers to implement central programmes using states as agencies. Certain services
considered as meritorious needs to provided in all the states. The Central government
may make provision of outlays for these eservices and use the states to implement
them.

16.4.6 Types of Grants

In most countries the local governments rely to differing degrees upon central
government transfers through grants as source of revenue. These grants are financed
through central government tax revenues, like income tax, custom duties and so on,
which are more buoyant than the local level taxes. The provision of grants serve
various purposes as discussed in the previous section.
The taxonomy of grants is based on certain types of criteria. First there is the
question of whether the amount received can be used freely (general grants) or must
be spent for specific purpose (selective grant). Moreover, the grants as can be seen
in the chart 1 represent a fixed proportion of the expenditure (matching grant) or
bear no relation to it (non-matching grant).

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 Chart 1- Transfer of Grants: Categories Fiscal Federalism and
Fiscal Policy

Transfer of Grants

General Purpose Grants Specific Purpose Grants

(Unconditional) (Earmarked)

Matching Grants Non-matching Grants

1) General Purpose Grants: To resolve vertical and horizontal imbalances,

general purpose transfers from the central to sub-central units are recommended.
As the objective of these transfers is to enable the sub-central governments to
provide a given level of public service at a given tax rate, the transfers should
offset the fiscal disadvantages arising from lower revenue capacity and higher
unit cost of providing public services. This is achieved by giving unconditional
transfers equivalent to the needs and revenue gap. This gap measures the
difference between what a state ought to spend to provide specific levels of
public services and the revenue it can raise at a given standard level of tax
effort.
2) Specific Purpose Grants: These grants are transferred for specific purposes
at local government level. Specific purpose transfers are intended to set the
prices right to ensure optimal provision of sub-central services having spillovers.
The specific purpose grants could have the provision of matching contributions
from the local governments to make them more responsive and make them
involved in the programmes and schemes for which grants are transferred.
When the states perform agency functions of the central government grants are
transferred for specific purposes and projects. The purpose-specific transfers
could be with or without matching requirements from local government as
mentioned above. The matching transfers could be close-ended with varying
matching ratio. The specific purpose non-matching transfers, however, can
achieve the objective of ensuring a specified minimum expenditure outlay, only
when the entire amount required for the particular projects is given as transfers.
In developing countries large flow of resource to sub-national government tends to
create problems of reducing accountability and efficiency at lower level. The transfers
should be designed properly with economic objectives to make the fiscal
decentralisation successful. The difference between constituent members, in terms
of size, geography, population and economic potential may be so great that without
equalization measures, fiscal federalism would result in such regional disparities which
would be unacceptable.

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Fiscal Federalism Check Your Progress 3
1) Why intergovernmental transfers become essential in fiscal federalism?
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2) How transfer of grants correct vertical imbalance in a federal country?
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3) How transfer of grants correct horizontal imbalance in a federal country and
achieve fiscal equalisation?
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4) What is an inter-jurisdictional spillover and what is role of intergovernmental
grants in this context?
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5) What are the different types of grants and what purpose they serve?
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16.5 FISCAL COMPETITION

While more emphasis has been given ‘cooperative federalism’ in the fiscal federalism
literature, it is necessary to note that the relationship between government units is
essentially competitive. Cooperation means conformity to a centralized policy regime
and this could imply negation of concept of federalism altogether.
Fiscal competition has been considered as wasteful and distorting while some
undesirable actions are taken to enhance tax base. The fiscal competition when
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results in multiple tax rates impose high compliance cost on tax payers. Fiscal
competition is considered as fiscal wars or ‘races to the bottom’ when competing Fiscal Federalism and
Fiscal Policy
jurisdictions lower their tax rates in an effort to retain their tax bases. The reasons
for inter jurisdictional fiscal competition is that the states compete to lure business
into their areas in order to create economic activity that can ultimately increase tax
revenues and expenditures which go into improving quality of life. This is based on
the presumption that tax rates influence the business decisions and ultimately, economic
growth.
The use of tax instruments to attract trade and business alter relative prices in
unintended ways and can bring in various types of barriers – fiscal as well as physical
– to the free movement of factors and products, and thus distort the pattern of
resource allocation. As jurisdictions are not homogenous, the ability from jurisdiction
to jurisdiction to attract trade and business will differ. It can give rise to exploitation
of the weak by the strong.
In developing country federations, the inter-state inequities are acute in the levels of
development. There is no link between tax and expenditure decisions wherein costs
and benefits of public decisions are not clearly perceived. When the states attempt
to indulge in fiscal competition and pass the burden of financing public services to
other states, it results in a very inefficient system.
In most developing countries, consumption taxes predominate in the aggregate
revenues. Administrative apparatus in these countries tend to be weak and often,
origin based indirect taxes are used over destination based ones as soft options for
revenue raising. The tax system is not transparent and a cascading type of tax
system is adopted wherein inputs and capital goods are taxed, cross boarder
purchases are taxed at low rates to attract business, and exports to other jurisdictions
are taxed at the highest rate possible. The implications of such a policy are as
follows:
• The strategy of choosing different tax rates on residents and non-residents
increases rate differentiation.
• The tax exportation and provision of tax incentives to attract capital complicates
the tax structure and makes it open to abuse.
• The tax competition can cause significant unfavourable impact on equity and
efficiency.
Thus the gains from autonomy in choosing their preferred public services and tax
rates can come into conflict with the welfare loss arising from inter-state fiscal
competition. It has the potential to increase regional inequalities and in some
circumstances affect the sustainability of the public sector in general. This problem
can be tacked with the scheme of tax harmonization with the cooperation of
jurisdictions and the central government.
A competitive relationship among governmental units can be welfare improving if it
is harnessed and monitored properly. As in the market, it is necessary to satisfy
certain pre-conditions to ensure that competition among jurisdictions leads to welfare
gain. Ensuring competitive equality among government units and the appropriate
application of principle of cost-benefit analysis are conditions that results in welfare
gain from inter-jurisdictional fiscal competition.
The efficient organization of a federation will depend upon the way competitive
relationships are harnessed productively. Fiscal policy can be effective when the 13
Fiscal Federalism policies of different levels of government are coordinated. Similarly, satisfactory
resolution of tax and expenditure conflicts between different levels of government
and jurisdictions can be achieved only when there is a certain degree of coordinated
behaviour among government units. In order to be successful, competitive federalism
should have:
• Clearly enforceable property rights or the assignment of functions and sources
of finances
• Adherence to the set rules by each of the government units and effective
mechanism to foster interactions based on mutual trust and understanding, and
• An independent and just mechanism to conduct and monitor inter-governmental
relationships. The mechanism should ensure that no governmental unit is able
to exploit, free ride and dominate other units so as to ensure competitive equality
and application of appropriate cost benefit principles.
Check Your Progress 4
1) How fiscal competition is wasteful and results in inefficient system?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) What are the requirements of a competitive federalism to be successful?
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16.6 LET US SUM UP

In this unit we have discussed the essential features of fiscal federalism and structure
of a federal country as distinct from a unitary country. We have seen that in the
federal countries, fiscal policy to a large extent depends upon the devolution of
functions and revenue sources under the Constitutional mandate. We have shown
that the fiscal federalism has welfare implications due to large nationwide market
access, optimal public service delivery based on the preferences of citizens, and
efficient institutional arrangement due to participation of the citizens.
In the federal countries the government functions are devolved, based on the suitability
of different levels of government. The local governments due to their nearness to the
people have the best capability to provide wide ranging public services responding
to taste and preferences of their people. The revenue sources are also devolved to
different levels of government to carry out their functions smoothly. The devolution
of tax powers differ across the federations and in most cases the central government
has the most buoyant and important sources of revenue. Due to their weak fiscal
capacity, the sub-central governments depend heavily on the transfer of grants from
14
central government to carry their responsibilities.
The transfer of grants, as we have discussed, have several purposes; notable among Fiscal Federalism and
Fiscal Policy
them is to reduce the vertical gap between expenditure needs and revenue capacity
of sub-central governments. The grants also serve the purpose of reducing inequities
among the jurisdictions that arise due to their differing fiscal capacity and cost of
providing public services. Grants are of different types and are designed on the
basis of requirements and purpose for which they are transferred.
We have also discussed the basic competitive relationship between government
units in a federation. The fiscal competition many a time degenerates into an
undesirable tax competition, in which the sub-central government units try to attract
business by lowering tax rates and giving other tax incentives. The undesirable
effect of fiscal competition is harmful to not only the sub-central government units
but also to the economy as well. However, the basic competitive strength of the
fiscal federalism can be harnessed to increase welfare and provide competitive
equality.

16.7 KEY WORDS

Allocation Function
Concurrent Powers of
Taxation
Devolution of Functions
Devolution of Revenue
Fiscal Federalism
Fiscal Competition
Fiscal Decentralisation
Fiscal Policy in a Federal
: Changing the allocation by providing public
goods and correcting the external effects of
the private sector.
: When both the levels of governments have
power to tax the same base.
: Demarcation of responsibility between
different levels of government, i.e., which
function is assigned to which level of
government.
: The distribution of different tax and non-tax
powers between different levels of
government.
: Fiscal federalism relates to the division of
public sector functions and finances in a logical
way among multiple layers of government.
: Competition among sub-central government
units using their revenue powers to attract
trade and business. The reasons for inter
jurisdictional fiscal competition is that the
states compete to lure business into their areas
in order to create economic activity that can
ultimately increase tax revenues and
expenditures that improve quality of life.
: The decentralisation theorem demonstrates
fiscal federalism ensures provision of public
services corresponding to the diversified
demand conditions in a federation based on
clear demarcation of spending and revenue
sources.
: Management of government finances in a
federal country depending upon distribution 15
Fiscal Federalism
Horizontal Fiscal
Imbalance
Inter Governmental
Transfers (Grants)
Inter-jurisdictional
Spillovers
Redistribution Function
Separation of Tax Powers
Stabilization Function
Tax Exportation
Vertical Fiscal Imbalance
16.8 SOME USEFUL BOOKS
Rao, M. Govinda, and Tapas K. Sen, Fiscal Federalism in India, Macmillan,
1996
Oates, W. E, Fiscal Federalism, New York, Harcourt, Brace and Jovanovich
Bird, R. M, Federal Finance in Comparative Perspective, Toronto, Canadian
Tax Foundation
16
of responsibility to different levels of
government and sources of finances to carry
out the responsibilities.
: Horizontal Fiscal Imbalance occurs when
different regions of a country have different
abilities to provide services, due to different
abilities to raise funds
: Transfer of resources from one level of
government (Centre) to another level of
government (States) to correct vertical and
horizontal transfers is called inter governmental
transfers.
: When public service provided by one state
and also enjoyed by the non-residents, it is
called spillover of benefits. The particular state
while deciding about the amount of public
services to be provided ignores this benefits
accruing to non-residents.
: Redistributing income in order to equalize
income distribution which is the result of
market forces.
: In this type of tax assignment tax powers are
exclusively assigned either to centre or to the
states as is the case in Indian federation
: Stabilizing the economic process in order to
reduce business cycle fluctuations. This entails
to maintain high employment, price level
stability and appropriate level of economic
growth.
: Tax imposed in one state on commodities
when paid by residents of other states while
consuming the exported commodities is called
tax exportation.
: Vertical Fiscal Imbalance occurs when the
revenues of different levels of government do
not match their expenditure responsibilities.
 Fiscal Federalism and
16.9 ANSWER OR HINTS TO CHECK YOUR Fiscal Policy
PROGRESS
Check Your Progress 1
1) Fiscal federalism relates to the division of public sector functions and finances
in a logical way among multiple layers of government. The public sector across
the countries is not organised as a unitary or cenrtralised system. It is instead
stratified into a number of levels of governments, each having its own particular
set of functions and tax-raising powers
2) Fiscal federalism with its inherent structure of decentralization of spending and
revenue sources promotes efficiency and welfare. The decentralisation theorem
propounded by Oates (1972) demonstrates fiscal federalism which ensures
that public services are provided corresponding to the diversified demand
conditions in a federation.
Check Your Progress 2
1) Fiscal policy in federal countries depends on how different functions are devolved
to different levels of government, which level of government has which revenue
sources and how the transfer of resources is carried out.
2) Allocation function, distribution function and stabilization function
3) First, separation between revenue and expenditures of the different federal
levels, and each has its own revenue source as practiced in Switzerland, USA
and India. Second, the German type of federalism in which all major revenue
sources are taken together, and different governmental units receive fixed shares
of total revenue, distributed at state and local levels according to certain criteria.
4) Vertical fiscal imbalance occurs when the revenues of different levels of
government do not match their expenditure responsibilities. Horizontal fiscal
imbalance occurs when different regions of a country have different abilities to
provide services, due to different abilities to raise funds To correct the first,
intergovernmental transfers are required from centre to state governments and
to correct second, weighting transfers payments toward the needier regions is
required.
Check Your Progress 3
1) Intergovernmental transfers target four principal objectives; correcting vertical
fiscalimbalance: reducing horizontal fiscal imbalance and harmonizing tax
burdens, and compensating for jurisdictional spillovers
2) Vertical imbalance results when revenue sources assigned to sub-central
governments do not match the expenditure requirements. Due to weak revenue
base the public services provided by sub-central governments suffer. This vertical
imbalance can be corrected by making inter-governmental transfers from central
to sub-central governments to finance he required level of public services.
3) The revenue raising capacity and expenditure responsibilities of states vary
significantly. The provision of public services, therefore, is lower in poorer states
having weak fiscal base and higher unit cost of providing such services. Thus
inter-governmental transfers are required to offset the fiscal disabilities of the 17
Fiscal Federalism states with lower revenue capacity and expenditure needs. To fulfill the concept
of horizontal equity, it is necessary to give transfers so that each state is enabled
to provide same level of public services at a given tax rate.
4) When public service provided by one state and also enjoyed by the non residents,
it is called spillover of benefits. The particular state while deciding about
theamount of public services to be provided ignores this benefits accruing to
non- residents. If local residents are taxed only according to the benefits they
receive then this will result in allocation of resources to collective consumption
which is below optimum if all benefits were taken into account. The inter-
governmental transfers are designed to handle such spillover of services provided
by the states.
5) To resolve vertical and horizontal imbalances, general purpose transfers from
the central equivalent to the needs and revenue gap. This gap measures the
differencebetween what a state ought to spend to provide specific levels of
public services and the revenue it can raise. Specific Purpose Grants are
transferred for specific purposes at local government level.
Check Your Progress 4
1) Fiscal competition has been considered as wasteful and distorting while some
undesirable actions are taken to enhance tax base. The fiscal competition when
results in multiple tax rates impose high compliance cost on tax payers. Fiscal
competition is considered as fiscal wars or ‘races to the bottom’ when competing
jurisdictions lower their tax rates in an effort to retain their tax bases
2) A competitive relationship among governmental units can be welfare improving
if it is harnessed and monitored properly. In order to be successful, competitive
federalism should have; Clear assignment of functions and sources of finances,
adherence to the set rules based on mutual trust and understanding, and an
independent and just mechanism to conduct and monitor inter-governmental
relationships.

16.10 EXERCISES
1) Explain various features of fiscal management in a federal country relating it to
the issues like functional and revenue power devolution to different levels of
government
2) Explain the requirements of inter governmental transfer of grants and the design
of grants.

18
UNIT 17 EQUITY AND EFFICIENCY ISSUES
Structure
17.0 Objectives
17.1 Introduction
17.2 Rationale and Need for Sub-central Authorities
17.2.1 Need For Decentralization
17.2.2 The Tiebout Model
17.2.3 Welfare Gains of Decentralization
17.2.4 Economic Advantages of Sub-central Governments

17.3 Role of Sub-central Governments

17.3.1 Division of Functional Responsibilities
17.3.1.1 Allocation Function
17.3.1.1.1 Optimal Fiscal Community
17.3.1.1.2 Optimal Community Size
17.3.1.1.3 Optimal Service Level
17.3.1.1.4 The Optimal Size of Local Jurisdiction
17.3.1.2 Distribution Function
17.3.1.3 Stabilization Function
17.3.2 Division of Tax Powers
17.3.2.1 The Non-Correspondence
17.3.2.2 Vertical Federal Fiscal Imbalance
17.3.2.3 Horizontal Federal Fiscal Imbalance

17.4 Issues of Taxation with a Decentralized System

17.4.1 Base and Elasticity of Local Taxes
17.4.2 Tax Competition
17.4.3 Tax Exporting

17.5 Let Us Sum Up

17.6 Key Words

17.7 Some Useful books
17.8 Answer or Hints to Check Your Progress
17.9 Exercises

17.0 OBJECTIVES
After going through this unit, you will be able to:
• understand the important equity and efficiency issues in a federal economy;
• understand the rationale and need for the sub-central governments;
• analyze the role of sub-central governments with regard to the major functions
and tax powers; and
• understand how an optimal size of local jurisdiction for the provision of local
public goods is determined.
23
Fiscal Federalism
17.1 INTRODUCTION
While the fiscal operations are carried out by a single level of government in some
countries, they are carried out by different tiers of government in several other
countries. The number or the levels of governments that deal with the fiscal operations
also differ across nations with federal structure. For instance, USA, India, Australia,
Canada and West Germany have a three tier governments in the federal structure
while Holland and Switzerland have two-tier federal structures. Whether it is a two-
tier or three-tier federal structure or whether a federation is formed by aggregation
or desegregation what is very essential rather inevitable is separation or segregation
of powers and functions. In fact this division is the most crucial and delicate issue
which needs coordination and intervention by the central government to avoid
problems in the federation. One of such problems is the fiscal problem that arises
due to the division of powers and functions which needs federal or central intervention
to ensure efficient solutions in case of less-than-optimum solutions and to bring in
horizontal equity.

Horizontal equity gets added significance in several federal countries, especially in

the developing economies due to the existence of regional disparities. One method
widely accepted across the federal economies around the globe to reduce regional
disparities is federal fiscal transfers to finance regional development. In other words,
federal fiscal transfers has a very important role in bringing down regional disparities
through financing regional development. Of course, there is no unanimity among
economists with regard to the transference of fiscal resources from the federal
government to the backward regions or states. While one approach does favour
the equity aspect, the other opposes it commending the efficiency approach.

Economists like J.M.Buchanan advocated fiscal transfers from the federal government
to the needy poorer regions or states to promote economic development. According
to him, the grants-in-aid or subsidies provided by the federal government encourages
an in-migration of highly skilled labour along with capital and at the same time checks
out-migration of skilled labour and capital from the poorer state, thus helping in
accelerating the development process in the backward States. But this argument
has not been accepted by some economists, the prominent among them being
A.D.Scott. Their argument is mainly based on the fact that the returns to the factors
of production tend to be lower in the poorer regions compared in richer regions.
Thus, it is argued that any transfer of resources by the federal government to the
poor regions would retard the rate of economic growth of the national income and
as such fiscal transfers lead to “subsidizing inefficiency”. He further opines that
poorer states lack adequate natural resources besides capital and entrepreneurs
and mobility of labour from these areas to the developed states would maximize the
production. Thus he favours efficiency objective compared to equalization. But for
Buchanan, B.P.Adarkar, R.N.Bhargava and Mrs.U.K.Hicks who staunchly
supported the equity objective compared to efficiency held that social productivity
of resources transferred from rich to poor states is equally important. But according
to them, Scott took into consideration financial productivity only ignoring the social
productivity angle of fiscal transfers. While arguing that fiscal transference is one of
the main features of federal finance, he opines that welfare is maximized by the
transfer of resources through taxation and public expenditure from the richer states
to poorer states. R.N.Bhargava also favours equity in a federal context on the basis
of the principles of equal marginal sacrifice and marginal benefit. According to him,
24
the marginal sacrifice of taxation in a rich state would be less than that in poor state Equity and Efficiency
Issues
and the marginal benefit of public expenditure is lower in the richer states compared
to the poorer states. Such inequality can be corrected through fiscal transfers to the
poorer regions. Thus the objective of equalization has been upheld especially in a
developing economy like India. It does not necessarily mean that efficiency objective
should be ignored altogether. A balance need to be struck between equity and
efficiency in the federation.

Thus, issues of efficiency and equity assume extra importance in a country with
federal structure. The present unit makes an attempt to explain important aspects of
efficiency and equity in a federal context. Before discussing the efficiency and equity
aspects that arise due to division of powers and functions, it is necessary to know
about the rationale and need for the sub-central governments or authorities
(decentralization). What follows is an explanation of these issues.

17.2 RATIONALE AND NEED FOR SUB-CENTRAL

AUTHORITIES
17.2.1 Need For Decentralization
In a federal context, a decentralized government is one wherein a number of small
autonomous unit governments join together to form a federation of States. The federal
government does coordinate the activities and programmes of the smaller
decentralized governments. On the other hand local governments have the autonomy
with regard to determining the levels of public outputs and fiscal decisions. It is
necessary to note that the degree of centralization varies with the amount of autonomy
these unit governments enjoy over expenditure-public goods output and tax decisions.
For example in the USA the state governments as well as the local governments
enjoy greater freedom with regard to allocation of resources and levying of taxes
and non-tax charges and other related policies. Here the federal government plays a
coordinating role and provides public services of only of national interest. But in the
UK a larger proportion of local government expenditure is financed by the central
government in the form of grants-in-aid. The powers and functions of the local
governments are delegated by the Central Government. For instance, the local
governments need approval from the Centre to take upon capital expenditure
programmes and also borrowing of funds. So the degree of decentralization differs
from country to country as it is in the case of the USA and the UK. The most
important advantage of decentralized governance is that it provides scope for greater
choice between different amounts of public goods and services. As decentralization
facilitates production of different levels of public goods in accordance with the
individuals’ local preferences, resource allocation will be efficient. In this context a
brief explanation of the Tiebout Model is pertinent to have an elaborate understanding
of the issue.

17.2.2 The Tiebout Model

According to Tiebout the level and mix of local public expenditure and taxes are
subjected to wide variations among local political jurisdictions. So people will choose
a particular community or jurisdiction whose public expenditure and tax level best
suits their own preferences for public goods and services on the assumption that
people can be mobile across communities. Thus, if the government expenditure and
25
Fiscal Federalism taxation pattern is fixed, citizens will maximize their well being by choosing a community
or political jurisdiction, which Tiebout states as ‘voting on their own feet’

The most important assumptions of Tiebout Model are as follows. First, all citizens
are fully mobile across local jurisdictions. Secondly, they possess full knowledge of
the government budgets in alternative political jurisdictions. Thirdly, there are many
communities that offer similar employment opportunities to their residents. Fourthly,
there are no inter-jurisdictional externalities. The final assumption is that an optimum
community size is one which corresponds to minimum cost of the public services.
Under these assumptions, a quasi-market equilibrium is achieved when all citizens
are located in that community which best satisfies their economic preferences. This
is subject to the assumption that all communities provide government services at
minimum unit cost. It implies that communities above optimal size discourages new
people to join them and communities, operating at below optimal size try to attract
new people to join them. In this process some people may have to be content with
a “Second – Choice” Community. It is necessary to note that if communities can
supply government services at constant costs, (absence of economies or
diseconomies of scale) then equilibrium will be analogous to a market equilibrium.
Such a situation may lead a one-person community or an infinite number of
communities satisfying the citizen(s)’ preferences. In this way competition among
communities would result in an efficient solution which is just similar to that under
perfectly competitive market economy.
The assumptions on which the basic tenets of the Tiebout hypothesis formed are
extremely restrictive. But still the Tiebout Model is relevant as some households
really respond to differences among government budgets in alternative communities.
The model is not very useful in explaining mobility of citizens across larger geographical
areas like the interstate but strongly advocates decentralized provision of public
goods.

17.2.3 Welfare Gains of Decentralization

Now the welfare gains of citizens from a decentralized public choice will be maximized,
following Tiebout, is shown in Figure. 17.1. For example, the population of a nation
is divided into two groups. For simplicity it may be assumed that the demand curve
for the public good is identical for all individuals in each of the groups. At the same
time it is further assumed that the demand differs between the two groups. So, D1 is
the demand curve of the individuals in group I and D2 is the demand curve of group
II. The other assumption is that constant cost conditions prevail with regard to the
supply of public good. Under these conditions, the preferred levels of public good
for people in group I group II are Q1 and Q2 respectively as shown in the figure. But
in a centralized system of government a single uniform level of public service would
be provided, Qc in the figure. At this level of output, the welfare loss to individuals of
group I equals the shaded area ABC. This shows the excess costs incurred by the
individuals over their valuation of excessive units of consumption of Q1 Qc. Similarly,
the welfare loss to group II is equivalent to the area represented by CDE.

26
 Equity and Efficiency
Issues

Figure 17.1

Of course, there are number of qualifications that are to be observed in this context.
Firstly, the extent of loss of welfare depends upon the degree of homogeneity of
individual preferences. Secondly, the quantum of loss of consumer surplus varies
inversely with the price elasticity of demand. Thirdly, the unit cost becomes lower
to larger communities than for smaller ones if there exists economies of scale in the
production. In essence, the size of welfare losses depends upon the distribution of
preferences of the whole community, the elasticity of demand and the existence of
economies of scale. Undoubtedly, decentralization will bring efficiency gains in a
federation. So let us know more about the economic advantages of decentralization
or of the sub-central governments.

17.2.4 Economic Advantages of Sub-central Governments

It is generally opined that local governments performed more efficiently than a regional
or state government and regional governments are more efficient than the federal or
Central Government. But some people hold an opinion just opposite of it. The fact
is that some functions are more efficiently rendered by the local governments while
some other functions are carried out by the Central or Federal government. Especially
the local governments are more efficient in the provision of local public goods having
a spatial or geographical limitation. This is mainly because the preferences of residents
are likely to vary from one community or group to another. For example, a community
which desires to have an effective police force rather than streetlights can have such
services without an interference of the choice of the preferences of another community
which wants to have an altogether different set of services. It implies that a federal
system with its multi-levels of government contains greater efficiency than a unitary
system where the same level of services are provided to all its citizens. In other
words a federal structure with several sub-central governments will be able to provide
a level of outputs that really corresponds to the preferences among different
communities than a national and centralized government. Such an advantage of
sub-central governments is illustrated in Figure – 17.2. In the diagram output per
person is represented on the x-axis and the number of people are represented on
the y-axis. If there are three different communities A and B and C and a public
good X, the diagram explains the optimal level of output of the public good. A1A2,
27
Fiscal Federalism B1B2 and C1C2 curves show the preferred quantities of the public good X by the
respective communities.
As may be observed from the diagram if a national government were to provide a
uniform level of the public good X to all the existing communities, it would probably
provide a medium level of XB which is very unsatisfactory to the residents of A and
C Communities. On the other hand if there exists three independent governments, it
results into three different levels of output XA, XB and XC. So the range of outputs
provided by local governments is more efficient than a uniform level of output supplied
by a national government. Of course, not all residents would be better off in such a
situation. For example, the residents of communities whose preferences place them
near A2 and C1 in the diagram are put to disadvantage when XA and XC outputs are
provided respectively than XB. So in a federal context, people are free to shop
around for a community whose tax and expenditure polices are best suited to their
needs(Charles Tiebout). To elaborate, residents in Community A who choose XB
more than XA can move from community A to Community B. As a result of consumer
mobility induced by the process of consumers’ choice of communities in response
to differences in governmental services increases the efficiency advantages of sub-
central governments.

Figure 17.2: Provision of Services by Subnational Governments

The second important advantage is that the local governments may be more responsive
to the needs of its citizens. In other words, the political process required in smaller
units of government is more efficient than in larger unit governments. It is widely
believed that local governments are closer to the people and may possess fewer
defects in the decision-making process as the role of pressure groups would be less.
Moreover, the voters are more knowledgeable about how the tax money is spent.
Another advantage attributed to sub-central governments in a federal system is that
scope for innovation and experimentation is larger. The sub-central governments in
large numbers naturally will make experiments with new policies and the
experimentation can be beneficial to other governments. If the policy experimented
is successful, others will emulate and avoid implementation in case of a failure of the
policy or service.
Though decentralization has several economic advantages in a federal economy,
28
what is more important is the division of powers and functions among different levels
of government and how the problems of efficiency and equity are resolved. Especially, Equity and Efficiency
Issues
it is necessary to know the role of the sub-central governments vis-à-vis the federal
government in rendering the functions as well as powers. So let us discuss about the
division of functions of allocation, distribution and stabilization among different layers
of government in a federation.
Check Your Progress 1
1) Write three or four sentences about Tiebout Model.
...................................................................................................................
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...................................................................................................................
2) Write about the Welfare gains of decentralization.
...................................................................................................................
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3) Explain the economic advantages of sub-central governments in three sentences.
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17.3 ROLE OF SUB-CENTRAL GOVERNMENTS

17.3.1 Division of Functional Responsibilities
17.3.1.1 Allocation Function
In a multi-unit system of government which level of government should provide
which type of pure public goods and services in order to ensure efficiency in the
provision of these goods. A largely agreed upon principle of distribution of these
types of goods is the benefit incidence. For example, some public goods are such
that their benefit incidence is nationwide (eg. defence, space exploration, navigation)
while the benefit incidence of some others is spatially limited to regional and local
areas (eg. law and order, streetlight etc). In other words, public goods and services
need to be provided and their costs are to be shared in accordance with the
preferences of the benefit region concerned. In a democratic structure, the chosen
services should be voted and paid for by the resident voters of the region. Thus,
those services whose benefit incidence is nationwide like the defence need to be
provided by the federal government. Services which have regional and local benefit
incidence like law and order and streetlight need to be provided by the sub-central
governments at regional and local level respectively. Of course, the spatial
29
Fiscal Federalism characteristics of public goods and services warrants their provision by multiple
jurisdictions of governments of different sizes at the regional and local level.
17.3.1.1.1 Optimal Fiscal Community
In order to examine the optimum number of fiscal communities and the number of
people within each community, it is assumed that there exists only one public service
and the benefit incidence is confined to all within a geographical area. The benefit
incidence of the service vanishes beyond this geographical region. The second
assumption is that consumers have identical tastes and incomes. Thirdly, service or
good in question is a pure public good so that its quality received by per person is
not affected by the number of participants. It may be understood that the cost to
each person would be less if the number of residents in the region partaking the
service is larger. So, the efficient solution suggests that all consumers congregate in
the same benefit region. It follows that such a cost sharing and the resultant savings
due to large numbers leads to a unitary structure. However, there may be
disadvantages like crowding associated with the saving costs if the number of persons
increases in a geographical size. So the optimal community size need to be decided
by striking a balance between the advantage of sharing in the cost of a given level of
public service and the disadvantages of crowding. The following analysis is based
on the celebrated article “An Economic Theory of Clubs” published in Economica
in 1965 by J.M.Buchanan. It is assumed that people are having same preferences
and income and also that services are pure public goods
17.3.1.1.2 Optimal Community Size
Assuming a given level of public goods and the total cost of the good to the group as
a whole is Z rupees, the optimal size for a given service level is shown in Figure-
17.3. Let us also assume that each member of the local jurisdiction pays a price
equal to the marginal benefits received. In other words, the total cost is shared
equally among all the members. It may be seen in the Figure that various community
sizes are represented on the X-axis while the per capita cost is measured on the Y-
axis. It implies that the cost of service declines as the numbers increase. The AA
Curve in the diagram shows per capita service cost and the slope of the curve is a
rectangular hyperbola with per capita cost equal to Z/N, as the total cost remains
equal to Z throughout. The AA curve resembles a decreasing average fixed cost
with increasing output as drawn in the usual cost-curve for the individual firm. The
curve Am Am which is derived from the AA curve shows a reduction of or a marginal
saving of per capita service as the number increases. It can be stated mathematically
as Am Am is equal to
d ( Z / N) Z
= 2
dN N

In other words, it is the negative of the slope of the AA curve. If such is the situation,
the optimal group size would be the entire community and it can be expanded as
long as Am Am are positive or the AA curve is downward sloping. But the situation
would be changed once the cost of crowding is taken into account.

30
 Equity and Efficiency
Issues

Figure 17.3 : Choice of Optimum Size for given service level

In the diagram the curve OB shows the per capita cost or disutility of crowding for
various sizes of the group while the curve OBm represents the marginal per capita
crowding cost. It may be seen from the diagram that the optimal size of the community
is given by ON2. At this level, the Bm is equal to Am determining a size with N2
members. According to R. A. Musgrave and P.B. Musgrave, the size of the
community will be expanded as long as the per capita savings from cost sharing with
a larger group exceeds the additional per capita costs of crowding. Otherwise, the
total welfare of the residents would be reduced and therefore not rational. So
governmental units of size ON2 would be established with per capita costs for each
unit fixed at OC. If the total population is P and total service cost is Z in each
community, there will be P/N2 jurisdictions, the per capita costs being Z/N2.
Again it may be observed from the diagram that if the service level increases, the
curves AA and AmAm shift upwards and the optimum size of the group increases
further as shown in the diagram. So far a higher level of service wherein the cost is
Z1 , the per capita cost curve shifts up to A’A’ and the marginal cost curve to A1mA1m
the optimal group size being ON4 at a per capita cost of OD. Thus after knowing
about the optimal community size or group size, we now will examine how the
optimal service level is determined.
17.3.1.1.3 Optimal Service Level
In Figure 17.4 various service levels are measured on the x-axis and per capita unit
service cost is measured on the y-axis. The individual demand schedule for the
service of the entire members of the community is represented by DD as the tastes
and income levels of all the members are identical. S1S1 shows the cost of the
service to the entire community as a whole. As the slope of the curve shows, the
unit cost rises as the service level increases. Of course, this depends on the nature
and the related production function of the service S2S2 and S4S4 in the diagram 31
Fiscal Federalism shows different levels of supply schedule to different sizes of communities of N2 and
N4 respectively. As the tax structure is given which divides the total cost equally and
given the SS schedule, the service level purchased by different sizes of the community
will be determined by the intersection of the DD curve with the respective supply
schedules. Likewise, the service level purchased with N1 members corresponding
to the intersection of S1S1 – OQ1 with DD will be N2 members will be OQ2 and the
size required by N4 member community will be OQ4. and so on.

Figure 17.4: Choice of Optimum Service level for given community size

17.3.1.1.4 The Optimal Size of Local Jurisdiction

The optimal solution can be derived from the above two choices of optimum
community size and optimum service level. A combination of these two is shown in
Figure 17.5. In the figure, the size of the community (N) is measured on the x-axis
while the service level (Q) is measured on the vertical axis. The curve N represents
the relationship between the community sizes and the cost of service while Q curve
explains various optimum service levels for various community sizes. As shown in
the diagram, the overall optimal solution is at E, the point of intersection, where the
optimal service level of Q7 and the optimal group size being N7. In this way, multiple
fiscal units which vary in size and scope come into existence in a federal structure.
While some units may be nation-wide like provision of defense while others will be
regional or local (such as law and order and street lighting respectively) Besides the
allocation function, the other two important functions of redistribution of Income
and Wealth and economic stabilization are to be distributed between the governments.
Let us see why and to which level of government these two functions are assigned.
Before discussing this aspect, let us know the limitations that exist in relation to the
determination of optimum community size.

32
 Equity and Efficiency
Issues

Figure 17.5

Limitations
• It is assumed that tastes and preferences to be the same. But in reality tastes
and preferences of the people need not be the same. So the system will contain
multiple units, some similar and some different with regard to size and
composition.
• Assumed that the social goods consumption is non-rival. The government
provided goods and services like fire station, a school of given size, a sewage
disposal plant does not satisfy the consumption characteristics as non-rival. In
all these cases, there will be congestion costs to the previous users.
• Technical economies of scale need to be taken into consideration while
determining the optimal community size.
• Spillover benefits which are very common in between sub-central governments
may result in inefficient provision of social goods output in the absence of any
federal governments intervention by a system of grants-in-aid.
• The voting on their own feet hypothesis may become unrealistic as besides
fiscal factors several non-fiscal factors such as job opportunities and housing.
17.3.1.2 Distribution Function
When this function is to be assigned the question does arise is whether multi units of
government can render this function at different levels in a federal set-up. If the
same logic of decentralized provision of spatially limited public goods is applied to
this function, citizens who are willing for a high degree of redistribution may favour
jurisdiction A while those who will oppose may prefer jurisdiction B. So the unit
government A may adopt a highly progressive income tax coupled with a transfer
system while the other jurisdiction B would use benefit or head taxes for financing
public services. Though it looks sound and logical, there is every chance of its 33
Fiscal Federalism breakdown. For example, high-income people who oppose redistribution of income,
on the assumption of free mobility of citizens would migrate to B while high-income
people who prefer redistribution of income and wealth and poor people would
choose to reside in A. Thus, people with high incomes find that the entire burden of
taxation falls on them at the same time the degree of equalization would become
small as large number of poor people congregate in A. So, the redistributive process
becomes a failure if the local governments render the distribution function.
It is to be noted that the consumer mobility which is beneficial to sub-central
governments as far as the provision of public goods tends to limit the redistributive
function to be given to these governments. So it needs to be carried out by the
Central or federal governments. In other words, a national government appears to
have greater latitude than the sub-national governments in carrying out redistributive
programmes. Though the redistribution by the decentralized government cannot
altogether be ruled out, the Central or national government is more capable and
effective in carrying out the redistributive policies in the absence of the influence of
any non-fiscal factors such as job location, prohibition of in-and- out-migration etc.
17.3.1.3 Stabilization Function
Another important function to be assigned in between governments is stabilization
function. Stabilization policy, the process of macro-economic equilibrium, cannot
be entrusted to local and regional governments as these unit governments will become
ineffective in dealing with certain macro economic issues like unemployment and
inflation. For example, if a sub-central government say a local government follows
a fiscal policy wherein it makes budget proposal to stimulate demand in the local
economy. Accordingly it increases its public expenditure and does reduce taxes.
Such a fiscal exercise tends to develop several problems. Firstly, it is difficult to
finance such a budget deficit. Secondly, the fiscal multipliers may become very
small and close to zero. Any fiscal policy determined by a single or a group of local
governments tend to be impotent. Moreover, it may lead to unnecessary and
avoidable competition among different local governments. Truly speaking the local
governments do not have instruments for macro economic control relating to money
supply, interest rates, prices, incomes and imports. But the Central government is
better equipped with several instruments to carry out an effective fiscal policy and
also to coordinate with other policies such as Monetary Policy. The sub-central
governments are neither efficient nor effective in using the fiscal and monetary
instruments with regard to employment and price levels. So the national government
must be entrusted with the responsibility for macro-economic stabilization.
The above analysis explains that certain functions can best be rendered by the Central
Government . But the real issue is to determine which functions can best be performed
by the local governments and which one by the federal/central government. Hence
the need and purpose of the discussion so far. After assigning different functions to
different levels of governments in a federal structure, it is necessary to know how
and what type of tax powers are to be assigned to different units of governments.
The following section deals with these issues:

17.3.2 Division of Tax Powers

On the basis of ‘voting on their own feet’, members of each benefit region or
jurisdiction should pay for the amount of services that are provided by the respective
34
jurisdiction. This simply suggests that nation-wide taxes to finance nation-wide services
and taxes by the sub-central governments for financing the services provided by the
sub-central governments. The federal or national government can impose broad- Equity and Efficiency
Issues
based taxes like income tax since all the citizens irrespective of their residence get all
the benefits rendered by the national government and so they should contribute.
Similar logic can be applied to the tax structure and instruments to be entrusted to
decentralized governments. For example in India taxes like sales tax, state excises,
motor vehicle tax, land revenue are entrusted to the state governments while property/
house tax, profession tax etc. are levied mostly by the local governments.
For division of tax and non-tax powers between the federal and states, for instance,
E.A.R. Seligman states three important principles for each of the competing tax
jurisdiction. The three principles are (a) efficiency (b) suitability and (c) adequacy.
K.T. Shah says that financial resources placed at different levels of government
should correspond to the functions and obligations assigned to each of them.
B.P.Adarkar states that for an efficient working of the federal financial system three
essential principles of independence, elasticity and administrative economy are
needed. The principles generally agreed upon for the division of resources between
the federal and state governments are the principles of (i) independence and
responsibility (ii) adequacy and elasticity (iii) equity (iv) integration and
coordination. (v) accountability (vi) uniformity and (vii) fiscal access. Of all
these principles the most vital aspect is efficiency and it is related to the administration
of the tax. It may be noted that the base of the tax jurisdiction is the most important
element which has a bearing on administrative efficiency. If the tax base is more and
more extended, a broader tax jurisdiction should be assigned to that tax. For example,
the base of a property tax is narrow, so it is given to the local jurisdiction. Similarly,
a tax on commodities of mass consumption with its broader tax base should be
entrusted to the federal or national government. So is the case with customs duties
, income tax, corporation tax in several federal economies including in India. So
when tax powers are divided on efficiency and administrative economy considerations,
the phenomenon of non-correspondence emerges in almost all federations.
17.3.2.1 The Non-Correspondence
When tax powers are assigned mainly on the basis of efficiency criteria among different
layers of government, it may violate the principle of adequacy. As a result, the
revenue assigned to each government is not adequate to carry out the functions
entrusted to it. One reason for non-correspondence is lack of a clear-cut division of
functions in a federal country. The other reason is that the revenue yield from same
taxes varies among the federating units including the local governments. Another
reason is the wide differences of financial needs of states due to their natural and
economic conditions. The term non-correspondence which was first used by Anthony
D. Scott in 1964 exists universally in almost all federations This non-correspondence
results in vertical and horizontal fiscal imbalances.
17.3.2.2 Vertical Federal Fiscal Imbalance
If there is no adequacy between revenue resources and expenditure responsibilities
of a government is known as fiscal imbalance. Fiscal imbalances are of two types –
Vertical and Horizontal Fiscal Imbalances. In a federation, vertical fiscal imbalance
means the existence of non-correspondence between the revenue resources and
expenditure commitments of the federal governments vis-à-vis the state governments
put together. In almost all federations the central governments are having surplus
fiscal resources compared to their expenditure commitments. They make fiscal
transfers on the basis of constitutional provisions or agreements, in the form of shared
35
Fiscal Federalism tax revenue and grants with a view to reduce vertical fiscal imbalance. Mere increase
in the volume of fiscal transfers to states would reduce this fiscal imbalance. But the
other type of fiscal imbalance is horizontal fiscal imbalance which is more acute in
several federations.
17.3.2.3 Horizontal Federal Fiscal Imbalance
This imbalance refers to the non-correspondence between the fiscal resources and
expenditure commitments across sub-central (State) governments. This arises mainly
due to the differences in the size of geographical area, population, climate, endowment
of natural resources with uniform tax powers and functional responsibilities. Horizontal
equity can be achieved in a federation with a system of fiscal transfers especially of
grants-in-aid provided to states on the basis of an equalizing and rational criteria.
As long as the tax powers are distributed between the Centre and the sub-Central
governments on the basis of efficiency, equity aspects assume importance. Besides
these equity issues, the following aspects are to be noted with regard to taxation in
relation to decentralized system especially of the local governments.
Check Your Progress 2
1) Write four sentences about the Optimal Service Level.
...................................................................................................................
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...................................................................................................................
...................................................................................................................
2) Explain why distribution function be given to the Central Government.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) State the reasons why stabilization function cannot be given to sub-central
authorities.
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...................................................................................................................
...................................................................................................................

17.4 ISSUES OF TAXATION WITH A

DECENTRALIZED SYSTEM
17.4.1 Base and Elasticity of Local Taxes
In a multi-level government structure some taxes with relatively narrow base are to
36 be assigned to enable the local governments to raise the required resources to finance
its public services. In such case, the revenue raising capacity of these governments Equity and Efficiency
Issues
would be limited due to partial migration of the tax bases from one jurisdiction to
another. In several countries the local governments recognized the fact of induced
locational effects as far as their tax bases are concerned. The only exemption in
general, is the property taxation in almost all countries including the USA. However,
unrestrained property taxation results in reduced economic development of a local
jurisdiction which in turn reduces the real property tax base. So the local governments
need to use the tax bases as well as the tax rates very carefully. What is important
is the elasticity of the local tax base with respect to the rate of taxation.
In fact the efficiency of the local tax policy depends upon the knowledge of elasticities
of tax bases of different taxes. It is to be noted that an increase in the tax rate of any
tax base yields increased revenues only if the tax base is inelastic. The elasticity of
the tax base is determined by factors such as the degree of mobility of tax resources,
the rates of similar taxes in the surrounding jurisdictions, the amount of public services
provided by neighboring communities etc. Any extra taxation, as felt by the individual
economic units, would lead to relocation and diversion of business and industry and
even the residents, other things being equal.

17.4.2 Tax Competition

When some taxes are assigned to the decentralized governments, may be states or
local governments, in a federal economy, these governments often develop competition
among themselves to increase their respective tax bases. They often compete to
attract the residents, business, industry etc. whose economic activities increase the
value of the tax bases of the respective jurisdictions. Such competition often leads
to competitive reduction of tax rates, as it happened in the case of Sales Tax of State
governments in India before the implementation of uniform floor rates by all the
states since January, 2000, ultimately acting as a constraint on the size of their
respective budgets. In other words, state or local tax jurisdictions hesitate to increase
the tax rates for fear of loss of business and industry given the levels of public
expenditure and public services. So the possibilities of locational effects of different
tax bases are to be considered before assigning the taxes to lower levels of
governments.

17.4.3 Tax Exporting

Another important issue relating to taxes of decentralized governments is tax exporting.
It is a common feature among state and local governments in several federal
economies including the USA and India. Tax exportation arises in different ways.
Some taxes imposed by a state reduce the income of input-owners of some other
state who employ their inputs in the states’ taxing jurisdiction. It does also occur
when a state raises the taxes of goods manufactured within the state but purchased
by out-of-state residents. The importance of tax exporting is that it has a bearing on
the willingness of the residents of a jurisdiction to pay higher taxes. In other words,
a Re.1/- increase in taxes tend to be valued less than Re.1/- by the local tax payers,
if they know that part of the additional tax will be borne by the people of other
jurisdictions. All these issues discussed above are to be kept in mind while assigning
the tax bases to different levels of government in a federal economy.
Efficiency and equity issues always assume importance in almost all the federal
economies with reference to the division of functional responsibilities as well as
assignment of tax powers among different levels of government. What is required is 37
Fiscal Federalism a rational mix of efficiency and equity with regard to assigning of functions and tax
powers and a continuous adjustment with a view to maximize welfare gains of the
people.
Check your progress 3
1) Write about Vertical Federal Fiscal Imbalance.
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...................................................................................................................
...................................................................................................................
2) Explain the important reasons for the emergence of Horizontal Federal Fiscal
Imbalance.
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...................................................................................................................
...................................................................................................................
3) What do you mean by tax exportation.
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17.5 LET US SUM UP

In an economy with federal structure issues of efficiency and equity assume importance
when powers and functions are to be distributed afresh among different tiers of the
government. The level and mix of local public expenditure and taxes are sujected to
wide variations among local political jurisdictions. So people will choose a particular
community or jurisdiction whose public expenditure and tax level best suits their
own preferences for public services on the assumption that people can be mobile
across communities. In other words, given the pattern of government’s expenditure
and taxation, citizens will maximize their well-being by choosing a community by
“voting on their own feet.” The Tiebout model explains the importance of mobility
of people in a decentralized system of government in a federal structure and concludes
that such mobility improves efficiency. According to Tiebout people are assumed to
‘shop’ around the local jurisdictions to choose to live in just like they shop around
for any consumer good in a market.
As fiscal federalism requires division of powers and functions among different levels
of government, the federal government is best suited to provide services that have a
nation-wide benefit incidence and a large number of other public goods can be
efficiently supplied at the decentralized level by the sub-central authorities.
Stabilization and redistribution of income function can be rendered efficiently by the
Central government. Distribution of tax powers on the criteria of efficiency and
administrative economy leads to vertical federal fiscal imbalance while the differences
38 in natural resources and other economic factors across the states with uniform powers
of taxation leads to horizontal fiscal imbalances which need to be redressed to achieve Equity and Efficiency
Issues
equity through a rational system of fiscal transfers. While assigning taxes to the sub-
central authorities, issues like tax base and elasticity, tax competition and tax
exportation etc., need to be considered as always there exists a trade-off between
equity and efficiency in a federal economy. A balance needs to be maintained between
the two for a healthy functioning of the federation.

17.6 KEY WORDS

Benefit Region : Geographical area wherein the benefit of
public good or service is confined.
Horizontal Federal : Existence of non-correspondence between
Fiscal Imbalance the fiscal resources and expenditure
commitments across State governments.
Pure Public good : A good produced by the government which
is non-rival of its consumption and for which
the quality and quantity is not changed even
to the last consumer.
Sub-Central Authorities : Governments operating at different levels
below the Central government. Sometimes
referred as sub-national governments.
Tax Exporting : If a tax is imposed on goods and services
by State A but paid by non-residents of A
either fully or partly, then it is said that A has
exported the tax to other non-residents.
Vertical Federal : Existence of non-correspondence between
Fiscal Imbalance the revenue resources and expenditure
commitments of the federal overnment vis-à-
vis the state governments put together.

17.7 SOME USEFUL BOOKS

Musgrave R.A. & Musgrave P.B. – (1989) - Public Finance in Theory and
Practice, Mc. Graw Hill, Fifth Ed., New Delhi.
Oates, Wallace E (1972): Fiscal Federalism, Harcourt Brace, New York.
Edgar K. Browning & J.M. Browning (1979) - Public Finance and Price System,
Macmillan, New York, 1979.
David N.Hyman (1987) - Public Finance, A Contemporary Application of Theory
to Policy, Second Ed., New York.
National Institute of Public Finance and Policy (1981) - Trends and Issues in Indian
Federal Finance, Allied, New Delhi.
Singh, S.K. (2004) - Public Finance in Theory and Practice, Sixth Ed., New
Delhi.
Brown, C.V. & Jackson, P.M. (1982) - Public Sector Economics, Second Ed.,
Martin Robertson, Oxford.
39
Fiscal Federalism
17.8 ANSWERS OR HINTS TO CHECK YOUR
PROGRESS
Check Your Progress 1
1) Study Section 17.2.2. carefully and get your answer.
2) See sub-section 17.2.3.
3) Get them from sub-section 17.2.4.
Check Your Progress 2
1) You can get your answer from sub-section 17.3.1.1.3.
2) See sub-section 17.3.1.2. for the answer.
3) The sub-central authorities do not have instruments for macro economic control
relating to money supply, interest rates, prices, incomes and imports. The sub-
central governments are not efficient nor effective in using the fiscal and monetary
instruments with regard to employment and price level.
Check Your Progress 3
1) Study sub-section 17.3.2.2. and get the answer.
2) You can get the answer from sub-section 17.3.2.3.
3) Tax Exportation is a common feature in federal economies. There are different
possibilities for tax exportation. For details study sub-section 17.4.3.

17.9 EXERCISES
1) Explain briefly the Tiebout Model.
2) What are the economic advantages of having sub-central governments?
3) Discuss how the optimal fiscal community is determined?
4) Explain why redistribution and stabilization function should be given to the
Central Government?

40
UNIT 18 STATE AND LOCAL GOODS

Structure
18.0 Objectives
18.1 Introduction
18.2 Public Utility Pricing
18.2.1 Public Utility
18.2.2 Natural Monopoly Pricing
18.2.3 Social Criteria for Utility Pricing
18.2.4 Utility Pricing Rules
18.2.5 Types of Regulation
18.2.6 Public Utility and Decentralization
18.3 Privatization
18.4 Let Us Sum Up
18.5 Key Words
18.6 Some Useful Books
18.7 Answers or Hints to Check Your Progress
18.8 Exercises

18.0 OBJECTIVES

After going through this unit you will be able to:

• understand the advantages and disadvantages of large public utilities.

• understand the problems of designing user charges for these utilities.

• analyze the scope of privatization and the associated problems.

18.1 INTRODUCTION

We discuss in this unit the debates over the issue of public production, especially
public utility pricing, i.e., the ‘user fee’ for public utility services. The questions
of efficiency and equity are discussed in the given context. We have tried to judge
whether regulation is necessary for deconcentration of large public utilities. We
also discuss the issue of privatization as an alternative. The whole analysis has

1
been done with the objective of evaluating the alternative modes of governance of
‘public utility production’ in the context of decentralization.

18.2 PUBLIC UTILITY PRICING

18.2.1 Public Utility

Public Utility is the common term for a firm that provides an important (what
some deem as essential) good or service often through the use of an extensive
distribution network. A key feature of public utilities is that due to huge fixed
capital requirements these tend to be natural monopolies. Thus there is a natural
tendency for concentration / centralization in such cases.
A natural monopoly is able to lower its price when it produces and sells a larger
quantity. This somewhat remarkable ability results because a natural monopoly
uses a great deal of capital. In that capital carries an up-front (sunk) cost that must
be paid regardless of production. A natural monopoly can spread these costs over
larger quantity if it produces more. Consequently, the formal representation of a
natural monopoly starts with falling average and marginal costs with rising output
levels. A single natural monopoly is thus able to produce and supply a good at a
lower cost, and therefore price, than two or more firms.
These big public utilities can generally provide the services at a lower average
cost than the small ones. To exploit this potential and to restrict the public utilities
from practicing monopoly pricing, in many cases, theses firms tend to be either
government owned and operated or heavily regulated by government. Under
government control the firms practise ‘average cost pricing’ rather than ‘marginal
cost pricing’.
To understand the problems with these public utilities we need to discuss their
price-output determination mechanisms. The pricing processes provide vital clues
for our specific analysis.

18.2.2 Natural Monopoly Pricing

First, we show the monopolistic pricing process to ascertain the potential loss of
social surplus in the form of monopoly profits (super-normal profits) for the

2
public utilities behaving as monopolists in absence of any regulation by the
government and in absence of competition in the market. Thus we get the
monopoly equilibrium price E and monopoly equilibrium quantity O” through the
equality between marginal cost and marginal revenue in the following figure. To
avoid the loss in social surplus, i.e. to avoid social cost of monopoly, one option
could be the average cost pricing. Thus the firms could be compelled (regulated
by the government) to charge price P’ and produce output O’. These are derived
by equating average cost and average revenue, so that, market demand at P’ is
met with O’ production and average cost is fully covered by the firms. However,
it is clear that this does not at all satisfy the profit maximizing conditions for the
firms, which is (Marginal Revenue = Marginal Cost). Hence, it is not a feasible
solution.
However, another option could be to induce competition. The government could
encourage competition so that the firms are compelled to practice competitive
pricing or marginal cost pricing. The government could regulate the firms so that
they charge a price like D and produce output O, which is achieved at point C. At
C, [(given) Price = Marginal Revenue = Marginal Cost = Average Revenue or
Demand]. At C, market demand for price D is met with O amount of output and
the ‘first-order condition’ of profit maximization i.e. [(given) Price = Marginal
Revenue = Marginal Cost] is also satisfied. However, this solution is unstable
with falling average and marginal costs. Though Price = Marginal Revenue = P’,
a given value, marginal cost is falling. Hence, at C, the ‘second-order condition’
of profit maximization [d(MR)/dQ < d(MC)/dQ] is violated, which makes the
equilibrium unstable. Moreover, at C, there is operating loss as P < AC. Two
solutions could be proposed for such a problem. First, practicing marginal cost
pricing as above, and subsidizing the operating loss. This is possible if the firms
are directly or indirectly regulated by the government. On the other hand, if
market is allowed to perform its role, the private firms would practice average
cost pricing, where price would be set at A and the corresponding output level at
O. However, under such a situation, the largest firm with maximum capacity
would be able to charge the minimum price and thereby can compete out all other
firms. Consequently, the largest firm emerges as the monopolist. Thus, ultimately
the firms emerge as very large natural monopolies with average cost pricing.
Subsequently, the monopolist may even practice monopoly pricing at E, with
output O”. The figure 1 (below) shows this. To check such tendencies

3
government has to step in. The government has to intervene in the whole process
of pricing and output determination for public utilities. However, where is the
guarantee that the government itself would not behave like a monopolist and
would not practice monopoly pricing? This could be ensured to a large extent by
inducing inter-governmental competition. Such a competition is particularly
possible under the situation of decentralized governance with localized provision
of public goods.

Notes:
a) Marginal Cost Pricing
This is a pricing scheme in which the price received by a firm is set equal to the
marginal cost of production. This is the efficient outcome achieved by
competitive markets. The bad thing about marginal-cost pricing for public utilities
is that normal profit is not guaranteed. The good thing about marginal-cost
pricing is that marginal cost is equal to price, and the public utility is operating
according to the price equals marginal cost (P = MC) rule of efficiency.

b) Average Cost Pricing

The price received by a firm is set equal to the average total cost of production.
The great thing about average-cost pricing is that a regulated public utility is
guaranteed a normal profit. One bad thing about average-cost pricing is that
marginal cost is less than average total cost meaning that price is greater than
marginal cost. As such, the public utility is not operating according to the price
equals marginal cost (P = MC) rule of efficiency.

These two types of pricing are shown simultaneously in the following figure.

4
 Figure 1: Natural Monopoly

Fig.18.1: Natural Monopoly

18.2.3 Social Criteria for Utility Pricing

5
Ideally, utility pricing should maintain the following conditions:
1. Social Efficiency as well as Production Efficiency, i.e. social welfare
maximization along with private profit maximization.
2. Total Cost Recovery.
3. Fairness or Income Equity through price-output decisions.
4. Deconcentration of economic power consistent with decentralization of
decision-making.
5. Natural Resource and Environment Conservation.

Note: Alternative Concepts of Full Cost Recovery:

Fig. 18.2

Here O & M Costs refer to Operating and Maintenance Costs.

18.2.4 Utility Pricing Rules

1. First best solutions: rely on varying forms of lump sum transfers to

achieve full cost recovery. Here, while the production in public utility
is centralized, the financing is done through decentralized resource
mobilization mechanism. Taxes and / or ‘user fees’ are collected from

6
 the different localities in a decentralized manner against the
decentralized distribution of the services produced by the public
utilities.
2. Second best solutions: employ various forms of price discrimination.
Here, price discrimination is practiced as a step consistent with
decentralization. Different localities or categories of users are charged
with differential rates depending on their demand conditions. Equity
considerations also play significant role in this regard.

First Best Solutions

a) Taxation and Subsidization: Prices be set equal to marginal costs.
Consequently, there is revenue short falls from total costs, as both AC and MC
are falling with MC < AC. The ‘operating loss’ would be recovered (subsidized)
through non-distortionary taxes by the government, the total amount of which is
the area ABCD in Figure 1 above.

Criticisms:
(i) an inadvertent redistribution of income due to cross-subsidization,
(ii) income taxes are distortionary, and
(iii) misallocation of resources.

b) The Coasean Two-Part-Tariff: Each consumer would be charged a single

price according to P = MC, but in addition would pay a lump-sum or fixed charge
for the opportunity to be able to buy any unit of the service as ‘entry fee’/ ‘user
charge’.

Criticisms:
Equal entry fee for all violates the equity consideration.
Second Best Solutions

a) Ramsey prices: attempt to maximize social welfare subject to full-cost

recovery, through the use of inverse elasticity rule, i.e. charging consumers with
inelastic demands a higher price relative to consumers with elastic demands. The
use of Ramsey pricing may lead to problems of equity with unequal charges.

7
b) Nonlinear pricing: refers to any case in which the tariff is not strictly
proportional to the quantity purchased. Consumers act as price takers, given
pricing schedules: If offered a menu (series) of prices and corresponding
quantities, each consumer chooses a preferred quantity and pays the associated
charge. In this regard see Figure 18.3.

Fig.18.3

Increasingly this ‘block rate pricing’ method is being adopted by the public
utilities to address the environmental conservation needs. Blocks increases as
consumption level increases. Initial blocks are set with lower prices to provide a
basic level of service to low income households. Design of the blocks is ad-hoc;
determination of blocks frequently involves interest group rent-seeking.
Moreover, concerns about cost recovery remain when conservation rates are
adopted.
18.2.5 Types of Regulation
The alternative to these first and second best solutions is the methods of direct
regulation such as:

8
 1. Rate of Return Regulation: allows monopolies to achieve a specified
rate of return over cost.
2. Price-cap Regulation: a fixed price ceiling.

However, against all these mechanisms privatization has been proposed as a

better alternative by many researchers. It is argued that it ensures deconcentration
of economic power, which complements the process of political decentralization.
However, this issue has generated lot of intense debate.

18.2.6 Public Utility and Decentralization

Let us now discuss some important contributions to the economic literature
relating to the problem of the provision of local public goods, which has been
viewed as problematic by many authors. Paul Samuelson defined public goods as
‘collective consumption goods . ... . which all enjoy in common in the sense that
each individual’s consumption of such a good leads to no subtraction from any
other individual’s consumption of that good’ (Samuelson, 1954, p. 387). In his
well-known paper ‘The pure theory of public expenditures’, he argues that in
some sense, no ‘market-type’, solution exists to achieve the optimal provision of
public goods.
Charles M. Tiebout was the first to point out that most public goods are locally
supplied. In his classic paper, Tiebout (1956) suggests that in an economy of local
public goods, the optimal allocation can be decentralized through competition
among local governments. Tiebout imagines a system of jurisdictions in which
each government offers its own package of public goods/tax structures, and these
compete with one another for consumers. By migrating to the jurisdiction that
respects their tastes in public goods/tax schemes, consumers reveal their
preferences. Competition among jurisdictions and ‘voting with the feet’ may lead
to the efficient provision of local public goods. Tiebout did not specify a complete
model; it was left to later authors to suggest different models in which his
‘competing jurisdictions’ result in the optimal provision of local public goods.
Following these later studies, we can identify the conditions under which
Tiebout’s hypothesis holds.

The first crucial condition is the costless mobility of people among jurisdictions.
Tiebout’s intuition proved correct with respect to the relevance of individuals’

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mobility among jurisdictions to the achievement of the optimal provision of local
public goods. The opportunity to change one’s place of residence and move to
another jurisdiction if a particular local government does not fulfill one’s
expectations frees individuals from becoming ‘captured demand’ for their local
governments. This may motivate local governments to provide the local public
goods preferred by individuals at the lowest possible cost in order to keep these
citizens under their jurisdiction, and thus to provide the public goods efficiently.
Nevertheless, costless mobility of individuals guarantees only that the achievable
utility for identical individuals is equalized across jurisdictions. It cannot
eliminate inefficiencies, which are common to all local governments.
A second crucial assumption required for the Tiebout hypothesis to hold is the
existence of a large number of jurisdictions. This assumption, explicitly made by
Tiebout in his original paper, is crucial in order to ensure competition among
jurisdictions. If there are a large number of local governments (or local service
providers), the impact of the actions chosen by any single local government on
the common utility level is negligible, and thus local governments can be seen as
‘utility takers’ (this would be equivalent to competitive firms that are price
takers). It can be shown that if local governments take the common utility level in
the economy as given, the first best optimum can be sustained as a free-entry
equilibrium among local governments. In the literature, utility-taking local
governments are referred to as ‘perfectly competitive jurisdictions’. Nevertheless,
perfect competition among jurisdictions is extremely unlikely, since perfect
competition requires infinity of jurisdictions, just as perfect competition between
firms requires an infinity of firms. In an economy with a finite number of
jurisdictions, jurisdictions will not be ‘utility takers’. In this case, local
governments may seek to manipulate the utility level of individuals. However,
despite the existence of a limited number of local governments, the equilibrium
allocation will be similar to the optimal one as long as there is free entry and exit
in jurisdiction formation. In this case, the local monopoly power of the incumbent
local governments will be constrained by the threat of an entrant who can steal
their customers. The equilibrium allocation converges to the optimal one as the
optimal jurisdiction size decreases with respect to the economy.
Another relevant assumption is the existence of an appropriate number of people
in the economy. In the literature, this assumption is usually referred to as ‘the
integer problem’. This assumption may appear very technical; however, its

10
implications are important for what follows. If N/n * is not an integer (where N is
the total population and n * the optimal number of individuals in a jurisdiction),
this implies that the population cannot be divided into optimal consumption
groups. If N/n * is not an integer and there are a large number of local
governments (implying that they are utility takers), the utility-taking equilibrium
will not exist. On the other hand, if the optimal jurisdiction size is large with
respect to the population, implying that there are only a few jurisdictions which
will behave strategically with respect to one another, and there is free entry and
exit in jurisdiction formation, the fact that N/n* is not an integer matters because
the jurisdiction sizes will be much bigger than the optimal size. However, it will
still not pay to form a new jurisdiction, and thus the utility of the individuals will
be much lower than at the optimal allocation. The equilibrium allocation
converges to the optimal level as the optimal jurisdiction size decreases with
respect to the economy.
Up to this point, all of the crucial assumptions that we have analyzed in order for
the Tiebout hypothesis to hold are similar to those necessary for a market of
private goods provided by firms with U-shaped average cost curves which are
‘perfectly contestable’, in the sense used by Baumol. They are also similar to the
necessary conditions for the optimal allocation of club goods within a system of
profit-maximizing clubs. Nevertheless, in pointing out the analogy between
private goods and local public goods, Tiebout did not specify the objective
function of the jurisdictions. Much of the debate arising from his work has
focused on this question. The answer to the question of whether the provision of
local public goods by local jurisdictions à la Tiebout will be efficient depends on
the objective pursued by these local governments.
Different authors assume different objectives to be pursued by local governments;
for instance, some presume that jurisdictions will coalesce whenever it is in the
interest of all members of a coalition to do so, that jurisdictions will seek to
maximize the welfare of current residents, or that fiscal policies are decided by
vote. Other authors view local governments as less benevolent to residents, and
thus seeking, for example, to maximize their budgets subject to zero loss
constraint, in a situation where the salaries of the local administrators depend on
the level of expenditures. When the provision of local public goods is cast into the
framework of club theory without regard to geography, each local public good
can be fully financed by the appropriate user charge. The user charges are not

11
only sufficient to cover the costs involved, but they also yield the appropriate
incentive for optimal decision making regarding the supply of local public goods,
as in the standard private-good case. Hence, in this ‘lack of geography’ setting,
the optimal allocation of local public goods can be decentralized through a
Tiebout system of local jurisdictions whose objective is to maximize profits.
However, local public goods are not supplied by flying clubs to flying
individuals. The services are provided at specific locations, and the beneficiaries
of the services reside at other specific locations. This follows from the fact that
residence requires space, and therefore, individual customers are spread out
geographically. Thus, the provision of local public goods is associated with
specific costs, such as transportation to the facility supplying the local public
good, or a decreasing level of service with increasing distance between the public
facility and the beneficiaries’ residential location.
When the club theory setting is modified by assigning locations to local public
goods and their patrons, the optimal allocation can no longer be sustained through
user charges alone. At the optimal allocation, the revenue derived from the user
charge falls short of the provision cost, and the deficit is just equal to the
aggregate land rent generated by the differences in accessibility to the local public
goods experienced by users. In this case, the optimal allocation can be
decentralized if local jurisdictions maximize profits plus land rent.
According to several authors, there is a missing agent in Tiebout’s local public-
good setting, namely, a land developer who capitalizes the benefits of the public
good in the land rent. In such an institutional context, competition among land
developers may lead to the efficient provision of local public goods. Indeed,
jurisdictions which are identified with land developers can profit by respecting
their residents’ tastes when the provision of public goods is capitalized into land
prices. Thus, if capitalized land values are included in profits, jurisdictions have
an incentive to organize their affairs efficiently.
In summary, if (i) there is costless mobility of people between jurisdictions, (ii)
there are a large number of jurisdictions or free entry and exit in jurisdiction
formation, (iii) there are an appropriate number of people in the economy or the
optimal jurisdiction size is small with respect to the economy and (iv) local
governments maximize profits plus land rent, this decentralized mechanism of
competing jurisdictions à la Tiebout will result in the optimal provision of local
public goods. However, these crucial assumptions of Tiebout’s hypothesis are

12
unlikely to materialize in reality, especially in countries with large metropolitan
regions. This makes it problematical to achieve the optimal provision of local
public goods by means of Tiebout’s competing jurisdictions.

Check Your Progress 1

1) Explain, how the monopoly price is determined.

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2) Explain, why the monopoly equilibrium for a public utility is unstable.

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3) What do you mean by AC pricing?

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4) What do you mean by ‘block pricing’?

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18.3 PRIVATIZATION

The above discussion in good measure rehearses some of the ‘set pieces’ of the
public production debate. A majority policy adopted in many countries in recent
years has been ‘privatization’, which basically involves getting the ‘public’ out of
the taxonomy as far as possible. While any shift towards privatization has been
welcomed by some, more cautions observers are less sanguine about the benefits
to be secured. Some of the relevant arguments that suggest caution are considered
below. They relate to objectives, methods and performance measurement.

Objectives
Commentaries on privatisation see it as a cure for everything from an economic
cold to economic cancer plus a few political ailments. Rees evaluates the
argument that privatisation will
(a) reduce public sector borrowing;
(b) lead to decentralization of governance through segmentation of
organization following locational division and specialization;
(c) undermine trade union power;
(d) offer a wide choice of share-owning possibilities;
(e) foster efficiency and innovation;
(f) decrease the extent of political intervention;
(g) stimulate employee co-operation.
However, he doubts that positive advantages can be secured in this way. To
this list could be added that privatisation will
(h) reduce opportunity for cross-subsidization;
(i) increase diversity of institutions;
(j) increase political popularity; etc.
However, some commentators see the very number of objectives as a clear
signal that there is little in the way of a consistent rationale.

Methods
Public provision is usually reserved for goods that come closest to the public
good case. Property rights economists argue that exclusion can always be made

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possible. Non-exclusion means that the property rights over the consumption
benefits of a good or service are not concomitant on payment of the market price.
The ‘light-house’ of the textbook would never be built if this were the case:
historically they were provided privately, but only because a producer was given
a property right over levying charges in local ports (Coase). But getting out of
public production by the deliberate creation of a monopoly is not a priori welfare-
enhancing. Similarly, many privatized enterprises that have been public
production monopolies selling to private consumers e.g. the nationalized
industries discussed above, have become monopolies in the private sector. One
argument is that private monopolies still have an advantage in that they are less
willing to indulge in cross-subsidization to mask inefficiency. This is because of
the influence of capital market discipline.

Final bid Expert valuation

distribution distribution

£(X-A) £X 2 1

Undervaluation Overvaluation

The winner’s curse

Fig. 18. 4

On the other hand, an objective of public monopoly may be to use such cross-
subsidization as a deliberate policy tool to guarantee a given service to all; i.e. it
may reflect not inefficiency but policy. If competition or contestability is not to be
achieved, then bodies regulating both quality and price are required, and these are

15
real resource-users whose success has often been limited and whose criticism has
been vocal.
The franchising of public services to (private) producers whereby competitive
bidding determines who provides specified services and under what
(price/quality) conditions is a popular form of privatisation, but is not without its
difficulties. For example, the sort of franchise we are discussing here is the
‘opportunity’ to sell a service within a public enterprise. The specification,
tendering for and monitoring of the contracts involved are costly activities. Once
a contact has been accepted, the franchise owner is effectively in a monopsony
position for the period of the franchise and predictably may then wish to
renegotiate conditions and performance criteria. Contracting out, though often on
a smaller scale, raises similar problems. Furthermore, auctions in themselves may
be flawed mechanisms. There is the problem of the ‘winner’s curse’. If there is a
franchise up for auction that offers the same profit possibilities to all bidders, the
winning bid tends to exceed the value of the franchise. Assume that each bidding
firm uses its experts to assess the net value of the franchise, and, indeed, that the
mean of these valuations is ‘correct’. This gives the expert valuation distribution
in figure 4. Suppose the firm’s decision-makers are risk-averse and that each
reduces the bid the experts offer. The mean bid will be somewhere below the
mean valuation (and true value), say at £(X − A). The winning bid, however, will
be above that.
The winner will be the one farthest away from the mean of the expected
valuations in the shaded tail at point 2. Here she is cursed in the sense of making a
loss on the franchise. To add insult to injury, even if somehow the mean expert
valuation was below the true valuation, there is a large gap between the winning
expert valuation and the winner’s actual profit. This is the disappointment
distance ‘12’ in Figure 4. Such a mechanism helps explain why contract holders
may be quick to try and renegotiate conditions or renege on quality constrains –
indeed, it could explain the ‘thinness’ of many auctions. The suggestion is that
bidders realize that the only ones they can win without collusion will be ones they
will lose on, and therefore it is best for them not to bid at all.

Measuring Performance
Evidence on the relative efficiency of private and public production is difficult to
establish. In principle there is a cross-section approach (comparing production of
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output in a public and private context either nationally or internationally) and a
time-series approach (assessing comparative efficiency via before-and-after
studies in cases of privatisation or nationalization). Clearly, the weakest point of
both approaches is comparing like with like except for the variable under dispute.
Here we take the variable under dispute to be productive efficiency, so that
maximum outputs should be obtained from units of inputs and the least-cost
combination of inputs chosen. As noted under ‘Objectives’, this may not be an
adequate account of the problem.
Cross-section studies have been employed where private and public enterprises
are found operating side by side. Canadian railways and Australian airways are
two prominent examples. The Canadian Pacific Railway is privately owned and
the Canadian National Railway publicly owned; in Australia the privately owned
Ansett Transport Industries competes with the publicly owned Trans Australia
Airlines (in India, cell phone service provides a similar situation). The general
conclusion on the comparative performance of these enterprises is that there is not
all that much difference, which has led some to conclude that the observation
made above, that it is competition and not ownership that matters, is valid.
Time-series studies are possible as case studies of industries that have moved
from the private to the public sector and vice versa.

Check Your Progress 2

1) Privatization decreases the extent of political intervention. Explain.
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2) Privatization fosters efficiency and innovation. Explain.

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Privatization may even lead to market failure. Explain.
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 ……………………………………………………………………………
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18.4 LET US SUM UP

‘Public production’ has the inherent tendency towards concentration. However,

appropriate designing of policies may ensure decentralization of benefits from
these productions along with decentralization of resource generation for these
units. The resource generation may be efficient as well as inter-locational equity
ensuring depending on the specific price-output determination mechanism
adopted.

18.5 KEY WORDS

Public Utility : is the common term for a firm that provides an

important (what some deem as essential) good
or service often through the use of an
extensive distribution network.
Natural Monopoly : The firm with very high capacity emerges as a
very large entity with average cost pricing. The
largest capacity firm emerges as the sole player in
the market.
Privatization : Transfer of public ownership to private players as
a means to decentralize economic power along with
ensuring efficiency.

18.6 SOME USEFUL BOOKS

Joseph Stglitz,, Public Sector Economics.

Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and

Practice.

Harvey S. Rosen, Public Finance.

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18.7 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

Check Your Progress 1

1) Figure 1.
2) Figure 1.
3) Figure 1.
4) Figure 3.

Check Your Progress 2

1) Market dictates the activities; hence there is very little scope for political
interference.

2) Market, competition.

3) Figure 4.

18.8 EXERCISES

1) Discuss the advantages and disadvantages of large public utilities.

2) Do you think that public production can be regulated in such a way that it
is consistent with decentralization? Critically discuss.

3) Do you think that privatization can always decentralize economic power?

Critically discuss.

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