Mind the Gap: Reflections on Fiscal Balance in Decentralized Federations Robin Boadway, Queen’s University Prepared for The Federal Idea: A Conference in Honour of Ronald L. Watts IIGR, October 18-20, 2007

Outline Introduction Introduction Caveats Caveats Evolving views of the fiscal gap Evolving views of the fiscal gap Fiscal imbalance vs. Fiscal Gap Fiscal imbalance vs. Fiscal Gap Fiscal imbalance I: The soft budget constraint Fiscal imbalance I: The soft budget constraint Fiscal imbalance II: Tightening the budget constraint Fiscal imbalance II: Tightening the budget constraint Seeking some balance Seeking some balance

Introduction Fiscal gap—transfers from higher to lower level—is a feature of multi-level governments Fiscal gap—transfers from higher to lower level—is a feature of multi-level governments Applies to both federal-provincial abnd provincial-local levels Applies to both federal-provincial abnd provincial-local levels Fiscal gap varies widely across countries, mainly due to differences in revenue-raising Fiscal gap varies widely across countries, mainly due to differences in revenue-raising Gradual tendency for growing expenditure decentralization; revenue side mixed Gradual tendency for growing expenditure decentralization; revenue side mixed

Introduction, cont’d No consensus about the most suitable fiscal gap for any given nation, but some common mantras No consensus about the most suitable fiscal gap for any given nation, but some common mantras Changing circumstances (scope of government policy) and changing views about decentralization have fed into changes in ideals about the fiscal gap Changing circumstances (scope of government policy) and changing views about decentralization have fed into changes in ideals about the fiscal gap Among economists, decentralists have taken center stage, and to some extent among policy makers and advisors as well Among economists, decentralists have taken center stage, and to some extent among policy makers and advisors as well

Introduction, cont’d Recently, concept of fiscal imbalance has entered the lexicon Recently, concept of fiscal imbalance has entered the lexicon In Canada, distinction between fiscal gap and fiscal imbalance made by S éguin Commission In Canada, distinction between fiscal gap and fiscal imbalance made by S éguin Commission Some suggestion that the two are related Some suggestion that the two are related This talk: exploration of the evolution of thinking about fiscal gap and its relation with fiscal imbalance This talk: exploration of the evolution of thinking about fiscal gap and its relation with fiscal imbalance

Caveats Draw heavily on Canadian experience Draw heavily on Canadian experience Economists’ perspective vs. broader ones Economists’ perspective vs. broader ones Economic dimension of policy choices Economic dimension of policy choices Relevance of incentives Relevance of incentives Importance of one’s view of benevolence of government, or quality of governance Importance of one’s view of benevolence of government, or quality of governance Importance of value judgments: solidarity/social citizenship vs. efficiency Importance of value judgments: solidarity/social citizenship vs. efficiency

Evolving Views of the Fiscal Gap Arguments determining the size of fiscal gap Arguments determining the size of fiscal gap Decentralization of spending versus revenues Decentralization of spending versus revenues Accountability Accountability Equalization Equalization Exercise of the spending power Exercise of the spending power Fiscal harmonization Fiscal harmonization Potential for federal-provincial-local cooperation Potential for federal-provincial-local cooperation Importance of fiscal competition? Importance of fiscal competition? The fiscal gap versus the responsibility gap The fiscal gap versus the responsibility gap

Evolving Views, cont’d Evolution of expenditure decentralization Evolution of expenditure decentralization Spending now dominated by services to people, transfers and social insurance: decentralized provision efficient but national interests at stake Spending now dominated by services to people, transfers and social insurance: decentralized provision efficient but national interests at stake Infrastructure: potential conflict between provincial responsibility and national interest, especially if highly decentralized (lessons from econ geography) Infrastructure: potential conflict between provincial responsibility and national interest, especially if highly decentralized (lessons from econ geography) Reconciliation of benefits of decentralized delivery with national interest is a key issue Reconciliation of benefits of decentralized delivery with national interest is a key issue

Evolving Views, cont’d Case for revenue decentralization weakened Case for revenue decentralization weakened More reliance on VAT More reliance on VAT Evolution toward schedular (dual) income taxes Evolution toward schedular (dual) income taxes Globalization and mobility of tax bases Globalization and mobility of tax bases Competitiveness Competitiveness Importance of harmonized tax bases Importance of harmonized tax bases Increase in horizontal disparities Increase in horizontal disparities Growing importance of cities Growing importance of cities

Evolving Views, cont’d The elusive concept of accountability The elusive concept of accountability Economists argue fiscal gap deters accountability Economists argue fiscal gap deters accountability In fact, revenues from major tax bases little different from transfers in terms of accountability In fact, revenues from major tax bases little different from transfers in terms of accountability Effect of incentives on gov’t vastly overstated Effect of incentives on gov’t vastly overstated Watertight division of responsibilities misconceived Watertight division of responsibilities misconceived Accountability argument overstated Accountability argument overstated Has decentralization mantra gone too far? Has decentralization mantra gone too far?

Fiscal Imbalance vs. Fiscal Gap The existence or otherwise of a fiscal imbalance has been a highly charged issue in Canada The existence or otherwise of a fiscal imbalance has been a highly charged issue in Canada Séguin argument: Given expenditure responsibilities and division of tax room, transfers inadequate, given major cutbacks Séguin argument: Given expenditure responsibilities and division of tax room, transfers inadequate, given major cutbacks Also, they suggested fiscal gap too large Also, they suggested fiscal gap too large Horizontal imbalance also pronounced Horizontal imbalance also pronounced Some observers deny possibility of fiscal imbalance Some observers deny possibility of fiscal imbalance

Fiscal Imbalance vs. Fiscal Gap, cont’d Distinction conceptually meaningful, but ambiguous Distinction conceptually meaningful, but ambiguous Concept of fiscal imbalance judgmental: relies on views about optimal fiscal gap Concept of fiscal imbalance judgmental: relies on views about optimal fiscal gap Large fiscal gap not inconsistent with fiscal balance Large fiscal gap not inconsistent with fiscal balance In the long run, imbalance should not persist, assuming provinces have fiscal discretion In the long run, imbalance should not persist, assuming provinces have fiscal discretion In the short run, sudden changes can cause imbalance: can go either way  In the short run, sudden changes can cause imbalance: can go either way 

Fiscal Imbalance I: The Soft Budget Constraint Excessive lower-level spending and debts leading to higher transfers: negative imbalance Excessive lower-level spending and debts leading to higher transfers: negative imbalance Some causes/symptoms Some causes/symptoms Lack of commitment (bailouts: Nwfld?) Lack of commitment (bailouts: Nwfld?) Lack of lower-level accountability Lack of lower-level accountability Lack of lower-level policy-making discretion Lack of lower-level policy-making discretion Use of central discretionary funding Use of central discretionary funding Excessive central controls Excessive central controls Fiscal gap too high? Fiscal gap too high?

Fiscal Imbalance II: Tightening the Budget Constraint Restriction on higher-level transfers starting from a situation of fiscal balance Restriction on higher-level transfers starting from a situation of fiscal balance Some causes/symptoms Some causes/symptoms Debt imbalance Debt imbalance Discretionary central transfers Discretionary central transfers Horizontal imbalance increasingly expensive Horizontal imbalance increasingly expensive Sub-national governments able to raise revenues Sub-national governments able to raise revenues Responsibilities for spending programs ill-defined Responsibilities for spending programs ill-defined Fiscal gap too low? Fiscal gap too low?

Seeking Some Balance How to combine benefit of decentralized public services and targeted transfers with efficient harmonized tax system, horizontal balance and balanced response to fiscal shocks? 1. Significant fiscal gap: federal control of VAT, environmental tax, and income tax 2. Constraint on federal government: revenue sharing (Australian/German system)

Seeking Some Balance, cont’d 3. Provincial revenue-raising discretion: access to harmonized income tax and narrow taxes 4. Reduced discretion on year-to-year transfers 5. More cooperative decision-making 6. Institutional cooperation: federal provincial advisory fiscal commission 7. Use of the spending power an open question