On the Design of Economic Constitutions

Author(s): Anwar Shah

Source: The Canadian Journal of Economics / Revue canadienne d'Economique , Apr.,
1996, Vol. 29, Special Issue: Part 2 (Apr., 1996), pp. S614-S618
Published by: Wiley on behalf of the Canadian Economics Association

Stable URL: https://www.jstor.org/stable/136118

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 On the design of economic constitutions

ANWAR SHAH World Bank

Constitutional divisions of powers among various levels of governments are

of three types: unitary, federal and confederal. A unitary country has a
single or multi-tiered government in which effective control rests with the
national government. A unitary form facilitates centralized decision making
to further national unity objectives. A large majority of countries have
adopted this form. A federal form has a multi-tiered structure with decision
making shared by all levels of government. It is more conducive to
decentralized decision making. In a confederal form, central authority
merely coordinates the decisions of sovereign members. Economic theory
suggests that decision making should occur at the lowest level of government
consistent with allocational efficiency. Thus optimal size jurisdiction would
vary with specific instances of economies of scale and benefit/cost
spillovers. Achieving the optimal number and size of jurisdictions requires
voting with feet, voting by ballots or other community formation processes,
and redrawing jurisdictional boundaries.
Developing and transitional economies are more centralized than industrial
countries were in their early stages. Strong emphasis on central planning in
developing countries has contributed to the centralization of authority and
worked as an impediment to innovative responses to local issues by local
governments. Further, it has stymied private sector development.
Experiences of industrial countries suggest that decentralization of aut
should be the guiding principle (the so called "subsidiarity principle") unless
a convincing case can be made for centralization of a specific responsibility.
Fiscal decentralization can contribute to more efficient provision of local
public services by allowing a better matching of expenditures with local
priorities. Accountability is promoted through a clearer and closer linkage
of the benefits of local public services with their costs. These considerations
are especially relevant for large and diverse countries. Increased fiscal
autonomy could also be instrumental in mobilizing more revenues from local
sources, thus contributing to a country's overall fiscal position. More

Canadian Journal of Economics Revue canadienne d'Economique, XXIX, Special Issue

April avril 1996. Printed in Canada Imprime au Canada

0008-4085 / 96 / S614-618 $1.50 ? Canadian Economics Association

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 Design of economic constitutions S615

broadly, decentralized decision making enlarges possibilities for increased

local level participation in development. In a decentralized environment,
national objectives can be served through conditional grants, interstate
agreements and regulation. Constitutional responsibilities should be clearly
stated to avoid overlap and duplication of authority as well as to ward off
court challenges. Political process in developing countries too often favours
narrow regional interests to the neglect of national concerns. It is desirable
to determine tax and expenditure assignment simultaneously so that revenue
means can be matched as closely as possible to expenditure needs of various
levels of governments to enhance accountability. This will also contribute
to a reduction in the role of fiscal transfers, thereby minimizing their
distortionary effects. Revenue decentralization without a corresponding
decrease in expenditure responsibilities can constrain the federal government
as happened in Brazil in 1988. In transition economies, for example in the
Russian Federation, expenditure decentralization has taken place without
concomitant increases in revenues for subnational governments. Thus the
deficits of the federal governments are simply passed on to the subnational
level (see Shah 1994).

Expenditure assignment issues: In expenditure assignment, some countries

recognize that decentralization efforts in the past may have circumvented the
role of the federal governmenit in stabilization and redistribution. In such
situations, a conscious effort is needed to restore to the federal government
its rightful role. In most countries, however, the pervasive, intrusive role of
national government is coming under increasing scrutiny. The role of
national government in national defense and security is clear but its
involvement in purely local functions is being questioned.
It is desirable for the national government to assume responsibility for
national public services, international affairs, monetary policy, regulation,
transfers to persons and businesses, fiscal policy coordination, regional
equity, redistribution, and preservation of an internal common market.
Global economic integration would require a re-examination of constitutional
federalism. For example, federal authority to enter into international
agreements in the areas of trade that embody social policy provisions -- an
area of state responsibility -- raises new avenues of conflict among national
and subnational governments. Further, some federal functions such as
regulation of the financial sector, environment, etc., could no longer be
effectively performed by national governments. State governments should
be responsible for education, health, social insurance, intermunicipal issues,

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S616 Anwar Shah

and oversight of local governments. All local services must be assigned to

local governments. In areas of shared responsibilities, the roles should be
clarified. Generally, the federal government should be involved with overall
policy, setting standards, and auditing; state governments should have an
oversight function; and local governments should be involved with the
provision of infrastructure and services.
Assignment of public services to local or regional governments can be
based on various considerations such as economies of scale, economies of
scope (appropriate bundling of public services to improve efficiency through
information and coordination economies and enhanced accountability through
voter participation and cost recovery), cost/benefit spillovers, proximity to
beneficiaries, consumer preferences, and flexibility in budgetary choices on
composition of public spending. Assignment of responsibilities to various
local governments could be asymmetric based on population size, rural/
urban classification and fiscal capacity criteria. Assigning responsibility for
the provision of service to a specific level does not imply that the same
government should be directly engaged in its production. Such a decision
should be based on evaluation of public versus private sector production
alternatives using efficiency and equity criteria. In some countries, state
enterprises engaged in production of private goods also carry out local
service delivery responsibilities. This should be discouraged as it
complicates evaluating the economic performance of these enterprises.

Issues in tax assignment: A number of issues arise in assigning taxes.

First, in most developing countries, subnational governments have limited
access to own tax bases and depend upon higher level transfers. This
undermines accountability. In transition economies this situation is reversed
and the central government may not have full control over its tax bases due
to local administration of these. For example, in China and Russia, revenues
were collected at the local level and shared upwards. This created local level
incentives to make better collection efforts for taxes fully retained at that
level and less effort for taxes that were largely transferred upwards. Local
governments in these countries also liked to receive transfers in kind or
contributions from own enterprises rather than collect higher corporate
taxes. Thus revenue sharing on a tax by tax basis is not desirable. Further,
in a country with conflict among levels of government, subnational
administration of national taxes is not advisable. China is strengthening
central tax administration to collect revenues from central and shared taxes.
Second, problems are also caused by overlapping, uncoordinated

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 Design of economic constitutions S617

administration, especially for sales and excise taxes. There are problems of
overlap in Brazil for the federal manufacturer level sales tax, the state level
VAT and local services taxes, and in Argentina, for the federal VAT and
provincial turnover taxes. Experiences of Brazil, the European Union
(Community), Russia and the state of Michigan suggest that a multi-stage
sales tax such as the VAT is unsuitable for assignment to subnational
governments.
Third, corporate income taxes and resource rent taxes are unsuitable for
assignment to subnational governments as the tax base of the former can be
eroded as a result of interjurisdictional tax competition and the latter due to
instability in revenues and a geographically uneven distribution of tax bases
across a nation. Both these taxes should be assigned to the national
government. Subnational governments could be compensated through a
revenue sharing pool. It would also be desirable to establish a revenue
stabilization pool for resource rents and other widely fluctuating revenues.
In general, tax assignment could be undertaken using two broad principles:
namely efficiency in tax administration and fiscal need. Efficiency in tax
administration suggests that taxes on mobile factors such as corporate and
personal income and multi-stage sales taxes such as on value-added sales
should be assigned to the federal government. Of course, with globalization,
national governments will face increasing difficulties in taxing capital
income. Fiscal need criteria suggest that tax policy instruments for financing
national policy objectives should also be assigned to the federal government.
Thus, progressive redistributive taxes such as taxes on personal incomes,
wealth and inheritances; taxes on highly unequally distributed tax bases such
as resource rent taxes; stabilization tools; taxes on international trade;
excises on national and global "bads" such as carbon, alcohol and tobacco;
and user charges and benefit taxes for national public services could be
assigned to the federal government. Tax harmonization and coordination to
preserve an internal common market should also be a federal responsibility.
Efficiency dictates that state governments levy residence based taxes; for
example, single stage consumption taxes (manufacturer/wholesale/retail level
sales taxes and excises). State and local governments may levy
supplementary rates on the federal personal income tax base. Fiscal need
criterion suggest that state governments can also levy sin taxes (excises on
alcohol, effluent charges, motor fuels, energy taxes, betting, lotteries,
racetracks and congestion tolls on provincial roads) and benefit charges such
as payroll taxes, vehicle taxes, business registrations, court fees, stamps,
resource royalties, poll taxes and user charges.

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S618 Anwar Shah

Efficiency in tax administration suggests that local governments should

levy taxes on immobile factors (e.g. property taxes) and fiscal need criteria
suggest that they should also levy cost recovery/user charges such as
frontage taxes, tolls on local roads, and poll taxes.

Issues in intergovernmental transfers: If properly structured, specific

purpose transfers can support important policy objectives in a federation:
* To deal with specific fiscal deficiencies, non-matching transfers, changes
in taxing and/or spending responsibilities, or tax base and/or revenue
sharing mechanisms are needed.
* To address differential net fiscal benefits across jurisdictions or horizontal
fiscal imbalances, general non-matching equalization transfers are needed.
* To compensate for benefit spillover, open-ended matching transfers are
needed with the matching rate determined by benefit-spillout ratio.
* To ensure minimum standards of services across the nation, conditional
non-matching (block) transfers are needed.
* To stimulate public expenditures on areas with high national but low local
priority, conditional open-ended matching transfers are needed.

Institutional considerations: Reform of intergovernmental fiscal relations

requires complementary adaptations in the institutional arrangements for
intergovernmental coordination, planning, budgeting and implementation.
Intergovernmental coordination and consultation is critical. This could be
accomplished through regular meetings of officials. The structure of
transfers should be periodically reviewed either by intergovernmental
committees or by autonomous grant commissions. For decentralized
institutions to succeed, it is important to loosen the grip of central planning
over subnational governments. Such planning imposes a central view of
public investment requirements at the local level and often works as an
impediment to innovative responses by local governments. It is best to avoid
detailed central control over local government use of funds and financial
management. Instead, there is a need to strengthen higher level monitoring
and audit of lower level government performance. These functions are often
conducted by several agencies in an uncoordinated fashion. Consolidation
of these tasks in a single agency would improve effectiveness.

REFERENCES

Shah, Anwar (1994) The Reform of Intergovernmental Fiscal Relations

in Developing and Emerging Market Economies. (Washington, D.C.:
World Bank)

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