Chapter Two

Fiscal Federalism and Power of Taxation

Dr. Messele G.

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 Learning Objectives
• Define the concept of fiscal federalism, and discuss
issues relating to the supply of public goods in a
multilevel system of government.
• Discuss the Fiscal Decentralization Theory
• Use the Tiebout model of supply for local public goods
in a system of decentralized governments to analyze
the relationship between local government finance and
location decisions.
• Understand the Taxation and Decentralization in
Ethiopia
• Identify and discuss the Power of Taxation in Ethiopia
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 Fiscal Decentralization Theory

• Fiscal Decentralization :
– The distribution of powers,
– functions and finances among different tiers of government is
‘Fiscal Decentralization and
– in recent years, the subject of fiscal decentralization has received
enthusiastic attention.
– This Decentralization is seen as a remedy for most problems and a
means to good governance.
• According to Richard Bird (2008) Recent years have seen a
worldwide trend toward fiscal decentralization. In particular,
many developing countries are turning to various forms of
fiscal decentralization as an escape from inefficient and
ineffective governance, macroeconomic instability, and
inadequate growth. 3
 Fiscal Decentralization Theory…

• The more decentralized is the ability to tax; the

greater will be the autonomy of state and local
governments to carry out their own policies.
• On the other hand, a more centralized fiscal
regime may be recommended for
macroeconomic reasons related to the
coordination of fiscal policies.
• To keep an adequate balance between autonomy
and coordination is a matter of great concern.
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 Fiscal Decentralization Theory…

• Of the three broad bases for taxation – property,

consumption and income -, the first, that is the
real state property, is more commonly assigned
to local authorities, given its adherence to the
local boundaries.
• By the same token, incomes, which are of a
national character, should be taxed at the federal
level; consumption, being neither local nor truly
national, should fall within.
• This simple rule, however, is not applicable in
practice. 5
 Fiscal Decentralization Theory…

• Regional disparities with respect to population size, per

capita income, administrative capacity and social needs,
do not allow for simple solutions.
• When production and income are highly concentrated in
a small area, the fiscal balance can be achieved only by
means of an efficient regime of compensatory transfers.
• Thus, some centralization is required to meet the
financial needs of the less developed states through a
redistribution of federal tax receipts.
• Centralization may be enhanced when the tax
administration at the state and local levels is not
prepared to deal with modern taxes, so as to avoid a loss
in the quality of the fiscal system. 6
 Fiscal Decentralization Theory…

• Recourse to multiple forms of collecting taxes

from the production and consumption of goods
and services has been widely made to achieve a
better balance in the distribution of fiscal
revenues.
• Turnover taxes, more easily collected, grow in
line with modern value added taxes, provoking
economic inefficiencies and reducing the
competitiveness of domestic production in the
external and internal markets.

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 Fiscal Decentralization Theory…

• Globalization of financial and commercial

activities, together with the advance of free trade
areas and economic unions, poses new challenges
for achieving fiscal balance in federal regimes.
• With the removal of barriers to trade,
disadvantages due to higher tax burdens should
be removed to avoid economic and social losses.
Pressures for tax harmonization will, thus,
produce a positive effect on the quality of the
fiscal regime contributing for a successful regional
and international integration.
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 Fiscal federalism and intergovernmental fiscal relations

• Does the allocation of taxing powers matter for economic

growth, for the ability to achieve the desired level of
redistribution, or for the efficient allocation of public services?
If so, is a Federal system to be preferred?
• Fiscal federalism, financial relations between units of
governments in a federal government system.
• Fiscal federalism is part of broader public finance discipline.

• The term was introduced by the German-born American

economist Richard Musgrave in 1959.
• Fiscal federalism deals with the division of governmental
functions and financial relations among levels of government.
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 Fiscal federalism and…
• As nation states evolve and new nations are born, it
is natural to ask three fundamental design
questions.
– First, how many local and state governments should
there be?
– Second, how will they be represented in the central
government?
– Third, how should taxing and spending responsibilities be
allocated among the central and lower tiers?
• With respect to taxation in particular, our answer
depends crucially on whether the nation is a mature
or a developing economy.
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 Fiscal federalism and…
• Within the confines of a mature nation state, the
constitutional planner has greater flexibility in the
choice of feasible policy instruments and in many
cases fewer fundamental objectives (e.g.,
macroeconomic goals may have been achieved or will
be seen as manageable).
• However, in a developing economy, redistribution is
likely to be at least as important as efficiency in taxing
and spending. Moreover, local units of government
may not have the training or sophistication to manage
substantial tax revenues and to organize the provision
of locally-provided public goods.
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 Governance Structures
• distinguish among four forms of federal governance
1) Constitutionally Federal
Under this regime, there are two or more constitutionally created provinces,
there is constitutionally required representation for those provinces in the
central legislature, and there are significant policy responsibilities for the
states or provinces that operate at the sub national level.
Examples of constitutionally federal countries are the United States, Canada,
Germany, Mexico, Nigeria, and Pakistan,
2) De Facto Federal
Under this regime, there are two or more constitutionally created provinces
and significant policy responsibilities at the sub national level (usually among
only a few provinces). However, there is no constitutionally guaranteed
representation for the provinces in the central legislature and consequently
little or no political or economy power for the sub national units.
Examples of de facto federal countries are China, Italy, Japan, and the
Netherlands
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 Governance Structures
3) Administrative Federalism
Under this regime, there is significant policy
decentralization of taxation and spending functions to
regional and large local governments, but there are no
constitutionally created provinces and, by definition, no
representation of provinces in the central legislature.
Example of administrative federal countries are
Denmark, France, Norway, Sweden, and Uruguay.
4) Unitary.
Under this regime, there is a single nation state and
significant policy centralization. There are no provinces,
and by definition no provincial representation to the
central legislature 13
 Governance Structures

• Unitary governments have a single state, no

provincial representation, and centralized policy-
making.
Examples include Chile, Peru, New Zealand, the
United Kingdom, Korea, Thailand, Sierra Leone,
and Zimbabwe.

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 Principles of Fiscal federalism
• It does not mean that all forms of governments are
'fiscally' federal, only that 'fiscal federalism' is a set of
principles that can be applied to all countries
attempting 'fiscal decentralization'.
• In fact, fiscal federalism is a general normative
framework for assignment of functions to the different
levels of government and appropriate fiscal instruments
for carrying out these functions
• These questions arise: (a) how are federal and non-
federal countries different with respect to 'fiscal
federalism' or 'fiscal decentralization', and (b) how are
fiscal federalism and fiscal decentralization related
(similar or different)? 15
• The theory of fiscal federalism assumes that a federal system of
government can be efficient and effective at solving problems
governments face today, such as just distribution of income,
efficient and effective allocation of resources, and economic
stability.
• Economic stability and just distribution of income can be done by
federal government because of its flexibility in dealing with these
problems.
• Because states and localities are not equal in their income, federal
government intervention is needed. Allocation of resources can be
done effectively by states and local governments.
• Musgrave argued that the federal or central government should
be responsible for the economic stabilization and income
redistribution but the allocation of resources should be the
responsibility of state and local governments. 16
 Principles of Fiscal federalism…
• As concept, fiscal federalism is often related to fiscal
decentralization and sometimes even considered similar to it,
although the two notions appear as different due to their own
formulation.
• Thus, decentralization would mean, as its name itself suggests, the
fact that power naturally belongs to the centre, which decides to
transfer it to the lower levels, for reasons related to a better
management of local interests or at least more adequate to the
preferences of the members of the local community.
• On the other hand, fiscal federalism would imply the pre-existence
of competence sharing in what concerns the mobilization of public
revenue, (fiscal) decentralization not being necessary any longer, at
least at first sight. In other words, the federal system of power
structuring is intrinsically based on a larger decentralization than
the unitary state system of organization. 17
 Principles of Fiscal federalism…
• In the case of federal system of finance, the
following main principles must be applied:
i. Principle of Independence
ii. Principle of Equity:
iii. Principle of Uniformity
iv. Principle of Adequacy of Resources
v. Principle of Fiscal Access:
vi. Principle of Integration and Co-ordination:
vii. Principle of Efficiency:
viii. Principle of Administrative Economy
ix. Principle of Accountability

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 The Tiebout Model
• Developed by Charles M. Tiebout.
• Level and mix of local expenditures and taxes are likely to
show wide variations among local political jurisdictions.
• Citizens who have mobility will choose to live where
government budget best satisfies their preferences for
public services.
• Government expenditure and revenue patterns tend to be
set on the local level.
• Quasi-market equilibrium attained when all residents
located in the community that best satisfies their political
preferences.
• Useful in explaining movements within a constrained
geographic area.
 The Tiebout Model
• The Tiebout model examines the consequences of
mobility in a decentralized system of government
and concludes that mobility improves efficiency.
• In the Tiebout model, citizens are assumed to
“shop” for local jurisdictions in which to reside in
much the same way that they shop for any
consumer good.
• The Tiebout hypothesis indicates that people have
two methods of "voting" on government activity.
i. At the Ballot Box
ii. With the Feet

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 Fiscal Decentralization in Ethiopia

• Political decentralization created the basis for fiscal

decentralization and thereby a tax and expenditure
assignment for federal and regional govts.
• Accordingly, federal government undertakes functions
such as formulation of macroeconomic policies and
strategies, provision of defense, formulation and execution
of financial and foreign investment policies, regulation of
communication network, foreign trade and foreign affairs.
• Regional governments are responsible for executing
policies, strategies, and plans for their economic and social
developments.

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 Fiscal Decentralization in Ethiopia

Generally federal fiscal structure embraces

• (1) The assignment of tax instrument;
• (2) The alignment of expenditure responsibilities;
• (3) A system of intergovernmental transfers; and
• (4) Procedures for borrowing.

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 Fiscal Decentralization in Ethiopia
• The Constitution of the country (Ethiopia) establishes
two levels of government namely Federal and Regional
local governments.
• The country is divided into ten regional states and two
special city administrations.
• The government reorganized its structure to deepen
and broaden the decentralization process to
Kifleketema and kebeles by transferring a number of
responsibilities accompanied by fiscal empowerment.

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 Expenditure Assignment
• One of the basic arguments for fiscal decentralization is
the assignment of fiscal responsibilities so as to :
 improve local govt’s capacity to effectively identify
and
 address the needs of people.
• The Constitution of Ethiopia provides the following
guidelines regarding expenditure

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 Expenditure Assignment

1. The central government and the regional governments

bear all financial expenditure necessary to carry out
responsibilities and functions assigned to them by law
2. The central govt might grant the regions in emergency,
rehabilitation, and development assistance and loans,
provided that such assistance and loans do not hinder
the proportionate development of regions, and
3. The central govt has the power to audit and inspect the
proper utilization of subsidies it grants to the regions.

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 Expenditure Assignment

• The first guideline gives the regional government the

duty and the right to plan and implement their own
development policies.
• while the last two indicate the responsibility of the
federal government to support and monitor regions

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 Revenue Assignment

• Assignment of taxes is related to the respective

responsibilities of central and lower layers of
government.
• For instance taxes on international transactions and a
considerable portion of income and sales taxes should
be assigned to federal government for the purpose of
macro economic stabilization. However, local
governments have to rely on taxes that are relatively
stable.

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 Revenue Assignment
The Government of Ethiopia issued Proclamation 33/1992,
which defines the sharing of revenue between the central
and regional self-government.
The sharing of revenue aims at the following objectives.
– To enable the government to carryout their duties and
responsibilities efficiently.
– To help regional governments for developing their
regions by taking initiatives by themselves.
– To remove the gap between regional governments in
all sorts of development and economic growth.
– To encourage those activities towards which the
regions have a common interest.
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 Revenue Assignment
• The proclamation also states the basic factors, which are
taken into account for revenue sharing. Thus the following
principles are considered for sharing of revenue between
the central & regional governments.
– The ownership of the source of revenue;
– The national or regional character of the source of revenue;
– The convenience of levying and collection of tax;
– The population of regions, distribution of wealth in the
region, & the standard of development of the region;
and
– Any other factor that may be taken as a basis for integrated and
balanced economy.
•   29
 Revenue Assignment

• Uniformity in tax system, specifically in the tax base and

tax rate, is an indispensable factor to be taken into
account in the assignment of tax among different layers
of government.
• Uniformity eliminates administrative problems through
simplifying tax coordination and increases efficiency.
• Working with one tax code rather than many is less
burdensome.
• Uniformity aims at regional fairness and equity. It avoids
competition among regions with distorting effects on the
flow of capital, on migration, and cross boarder
shopping.
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• As per Proclamation No 33/2002 revenue bases are classified as
federal, regional, and joint (or shared).
Federal: The following are the revenues assigned to federal
• Duties, taxes and other charges levied on the importation and
exportation of goods;
• personal income tax collected from employees of the central
government and international organizations
• profit tax, personal income tax, and sales tax collected from
enterprises owned by the central govt
• taxes collected from national lotteries and other chance winnings
• taxes collected on income from air, train, and marine transport
services
• taxes collected from rent of houses and properties owned by the
central government
• charges &fees on license and services issued or rendered by the
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central government
Regional
• personal income tax collected from employees of the regional
government and employees other than those mentioned
• rural land use fee
• agricultural income tax collected from farmers not incorporated in an
organization
• profit and sales tax collected from individual traders
• tax on income from inland water transportation
• taxes collected from rent of houses and properties owned by the regional
governments
• profit tax, personal income tax, sales tax collected from enterprises
owned by the regional governments
• income tax, royalty and rent of land collected from mining activities; and
• charges and fees and licenses and services issued or rendered by the
regional government
•  
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Shared Revenue
These include:
• profit tax, personal income tax and sales tax
collected from enterprises jointly owned by the
central govt and regional govt
• profit tax dividend tax and sales tax collected
from organizations that carry out business
activities
• profit tax royalty and rent of land from large scale
mining, any petroleum and gas operations, and
• forest royalty
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No Type of joint revenue Revenue sharing formula
Federal Regional
1. Jointly established companies
Profit tax As per capital share As per capital share

Employment income tax 50% 50%

Indirect tax 70% 30%

2 Private companies
Profit tax 50% 50%

Indirect tax 70% 30%

Dividend 50% 50%
Mineral and Petroleum
Profit tax 50% 50%
3 Royalty 60% 40% 34
 Grants for Regions
• Differences in the level of economic development and
natural resources endowment lead to a widely different
level of fiscal capacity among themselves.
• This means that the underlying rationale for a system of
intergovernmental transfer is the existence of a fiscal
gap at the sub national government level emanating
from lack of locally generated own revenue to finance
own expenditure.
• Different types of budgetary grants are provided
by central government to sub national govts.

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 Grants for Regions
• The grants (financial transfer) are made:
- To narrow the vertical imbalance, mismatch between
revenue and expenditure arising from relations
between center and state
- To narrow the horizontal fiscal imbalance, arising from
fiscal relations between sub national govts
• In Ethiopia, the grant is predominantly
unconditional/general purpose grant. As per article 62
of the Constitution, federal grant has been given to
regions since 1995, based on sets of formula
developed by MoFED. The variables used in this
formula were revised periodically.
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Thank You!!!

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