Fiscal Federalism: Theory, Issues And Perspectives

culled from DAILY INDEPENDENT, August 29, 2005 

As originally defined by Musgrave (1959) and Oats (l972), "fiscal federalism" concerns the division of public sector functions and finances among different tiers of government.  In undertaking this division, Economics emphasizes the need to focus on the necessity for improving the performance of the public sector and the provision of their services by ensuring a proper alignment of responsibilities and fiscal instruments. While economic analysis, as encapsulated in the theory of fiscal federalism, seeks to guide this division by focussing on efficiency and welfare maximisation in determining optimal jurisdictional authority, it needs to be recognised that the construction of optimal jurisdictional authority in practice goes beyond purely economic considerations. Political considerations, as well as historical events and exigencies, have in practice, played major roles in shaping the inter-governmental fiscal relations in most federations.

Even in non-federal states, there has been a growing movement towards greater fiscal decentralisation in recent years. Some analysts have attributed this to globalisation and deepening democratisation the world over on the one hand and increasing incomes on the other (Vito Tanzi, 2000). Other specific reasons for increasing demand for decentralisation are:

• Central governments increasingly are finding that it is impossible for them to meet all of the competing needs of their various constituencies, and are attempting to build local capacity by delegating responsibilities downward to their regional governments.

• Central governments are looking to local and regional governments to assist them on national economic development strategies.

• Regional and local political leaders are demanding more autonomy and want the taxation powers that go along with their expenditure responsibility (Kee, undated).

Moreover, in recent years, decentralisation has become a feature of reform agenda promoted and supported by the World Bank and other multilateral institutions. The rationale for this has been in part that decentralisation promotes accountability. It is not therefore surprising that by 1997, 62 of 75 developing nations had embarked on one form of decentralisation or another (World Bank, 1997).

In the context of Nigeria, however, given the historical commitment to federalism as the basis for coexistence and unity, fiscal federalism has long been an important and central feature of inter-governmental relations. Even though the construction of a stable and acceptable intergovernmental fiscal arrangement has been the subject of various commissions, committees and other efforts since the amalgamation of Southern and Northern Nigeria in 1914, the issue remains on the front burner today, still evoking a great deal of passion and virulent contestation. The recent stalemate over this matter in the Political Reform Conference and the subsequent walk-out by delegates from the South-South attest to this. I believe that is why the organisers of this event have found it appropriate to choose this topic.

What we seek to do in this presentation is to link the domestic debate to the received theoretical framework as well as the historical experiences of some other older federations. The remaining part of the lecture will be organised as follows: Section II will review theories of fiscal federalism and the ways these have evolved over time. In Section III, we look at the history of fiscal federalism in Nigeria and the state of the contestations today. This is followed in Section IV by an attempt to relate the Nigerian debate to received theory and experiences in other federations with a view to redirecting some of the debate. Section V concludes the presentation.

Theories of Fiscal Federalism

The basic foundations for the initial theory of Fiscal Federalism were laid by Kenneth Arrow, Richard Musgrave and Paul Sadweh Samuelson's two important papers (1954, 1955) on the theory of public goods, Arrow's discourse (1970) on the roles of the public and private sectors and Musgrave's book (1959) on public finance provided the framework for what became accepted as the proper role of the state in the economy.

Within its framework, three roles were identified for the government sector. These were the roles of government in correcting for various forms of market failure, ensuring an equitable distribution of income and seeking to maintain stability in the macro-economy at full employment and stable prices.

The theoretical framework in question was basically a Keynesian one which canvassed for an activist role of the state in economic affairs. Thus the government was expected to step in where the market mechanism failed due to various types of public goods characteristics. Economics teaches us that public goods will be under-provided if left to private market mechanisms since the private provider would under invest in their provision because the benefits accruable to her or him would be far lower than the total benefit to society. Governments and their officials were seen as the custodians of public interest who would seek to maximise social welfare based on their benevolence or the need to ensure electoral success in democracies.

Once we allow for a multi-level government setting, this role of the state in maximising social welfare then provides the basic ingredients for the theory of fiscal federalism. Each tier of government is then seen as seeking to maximise the social welfare of the citizens within its jurisdiction. This multi-layered quest becomes very important where public goods exist, the consumption of which is not national in character, but localised. In such circumstances, local outputs targeted at local demands by respective local jurisdictions clearly provide higher social welfare than central provision. This principle, which Oats (1972) has formalised into the "Decentralisation Theorem" constitutes the basic foundation for what may be referred to as the first generation theory of fiscal decentralisation (Oats, 2004). The theory focussed on situations where different levels of government provided efficient levels of outputs of public goods "for those goods whose special patterns of benefits were encompassed by the geographical scope of their jurisdictions" (Oats, 2004: 5). Such situation came to be known as "perfect mapping" or "fiscal equivalence" (Olson 1969).

Nevertheless, it was also recognised that, given the multiplicity of local public goods with varying geographical patterns of consumption, there was hardly any level of government that could produce a perfect mapping for all public goods. Thus, it was recognised that there would be local public goods with inter-jurisdictional spill-overs. For example, a road may confer public goods characteristics, the benefits of which are enjoyed beyond the local jurisdiction. The local authority may then under-provide for such a good. To avoid this, the theory then resorts to traditional Pigouvian subsidies, requiring the central government to provide matching grants to the lower level government so that it can internalise the full benefits.

Based on the following, the role of government in maximising social welfare through public goods provision came to be assigned to the lower tiers of government. The other two roles of income distribution and stabilisation were, however, regarded as suitable for the central government.

To understand the rationale for the assignment of the redistribution function to the central government, we need to examine what the implications of assigning this responsibility to the lower tier would imply. Given that citizens are freely mobile across local or regional jurisdictions, a lower level jurisdiction that embarks on a programme of redistribution from the rich to the poor would be faced with the out-migration of the rich to non-redistributing jurisdictions and in-migration of the poor from such jurisdictions to the redistributing one. If on the other hand, the powers to redistribute were vested in the central government, a redistribution policy would apply equally to citizens resident in all jurisdictions. There would therefore be no induced migration.

The assignment of the stabilisation function also follows from the chaos that would ensue if sub-central governments were assigned the responsibility. Beggar-thy-neighbour policies will lead to sub-optimal policies from the point of view of national welfare. Moreover, given the openness that characterises the relationship between the regional governments, they are grossly constrained in carrying out effective stabilisation policies. This is because these lower tiers of government have very limited capacity to influence local employment levels and inflation.

From the foregoing, we can summarise the role assignment which flows from the basic theory of fiscal federalism. The central government is expected to ensure equitable distribution of income, maintain macroeconomic stability and provide public goods that are national in character. Decentralised levels of government on the other hand are expected to concentrate on the provision of local public goods with the central government providing targeted grants in cases where there are jurisdictional spill-overs associated with local public goods.

Once the assignment of roles had been carried out, the e next step in the theoretical framework was to determine the appropriate taxing framework. In addressing this tax assignment problem, attention was paid to the need to avoid distortions resulting from decentralised taxation of mobile tax bases. Gordon (1983) emphasised that the extensive application of non-benefit taxes on mobile factors at decentralised levels of government could result in distortions in the location of economic activity.

Following the assignment of functions, taxes that matched more effectively the assigned functions were also assigned to the relevant tier or level of government. For example, progressive income tax is suited to the functions of income redistribution and macro-economic stabilisation and is therefore assigned to the central government. On the other hand, property taxes and user fees were deemed more appropriate for the local governments. Benefit taxes are also prescribed for decentralised governments based on the conclusion that such taxes promote economic efficiency when dealing with mobile economic units, be they individuals or firms.

The final element of this basic theory that we wish to note is the need for fiscal equalisation. This is in the form of lump sum transfers from the central government to decentralised governments. The arguments for equalisation were mainly two. The first which is on efficiency grounds saw equalisation as a way of correcting for distorted migration patterns. The second is to provide assistance to poorer regions or jurisdictions. Equalisation has been important in a number of federations.  For example, Canada has an elaborate equalisation scheme built into her inter-governmental fiscal arrangements.

It should be pointed out however, that recent literature emphasises the importance of reliance on own revenues for financing local budgets. A number of authors (Weingast, 1995; McKinon, 1997) have drawn attention to the dangers of decentralised levels of government relying too heavily on intergovernmental transfers for financing their budgets.

Fiscal federalism in Nigeria

The issue of Fiscal Federalism has engaged various commissions and committees since the colonial days. Yet, even today, this issue continues to be in the front burner of national discourse. The calls or demands for resource control clearly demonstrate that this is still an unsettled issue. Yet, it is an issue we must find a way to resolve if we are to continue as a federation. I believe we have all committed ourselves to remaining as a federation.

Historical background to where we are:

It is important that we take a historical view of how we arrived at the present situation. Between 1948 and today, nine commissions, six military decrees, one Act of the legislature and two Supreme Court judgements have been resorted to in defining and modifying fiscal interrelationships among the component parts of the federation (Egwaikhide and Isumonah, 2001).  The inconclusive discussion of the issue at the recent Political Reform Conference is the latest attempt at engaging this issue.

These attempts sought to define or redefine or interpret the framework for revenue sharing both between the Regions and the Centre (vertical sharing) and among the Regions themselves (horizontal sharing).

Pre-Independence developments: 

The first phase of the development of fiscal federalism in Nigeria occurred during the 1948-1952 period. This phase was marked by a centralised financial arrangement in which the excess in the budget of the central government was allocated to regional governments on the principle of derivation. The expenditure needs of the central government thus took precedence.

In the second phase (1952-54) autonomous revenue and tax jurisdiction for the regional governments was introduced in addition to the operation of the principle of derivation for the sharing of federally collected revenue.

The basic elements of the second phase were carried over to the third phase (1954-59). A major distinguishing factor of this phase was the emphasis on the derivation principle in the sharing of federally collected revenue.

This pleased the Northern and Western Regions given the boom in their export commodities: cotton and groundnut the North and cocoa in the West. The Eastern Region, whose main export crop; palm oil, was facing difficult times in the global market, was unhappy with its application (Egwaikhide and Isumonah, 2001).

In general, this was the period of state-centred fiscal federalism. It has remained the reference point by present day proponents of either higher emphasis on derivation or resource control, especially minorities of the oil-producing areas. Some advocates of resource control actually equate it with a 100 per cent derivation.

Our view is that there is a difference between 100 per cent derivation and resource control. The difference may be subtle, but it is nevertheless significant. Resource control confers on the lower level government the authority to legislate on the conditions and terms of the extraction  of the resource. This would most likely result in more concession terms. The issue of how much of the royalties and taxes collected would be paid to the central government or the federation account is a separate matter.

Post-Independence phases of the development of fiscal federalism

Back to the historically phased development of fiscal federalism in Nigeria, the fourth phase (1960-66), which remains the main pillars of fiscal federalism to date was the product of post independence politics.

This phase sought to reduce the earlier emphasis on regional financial independence based on the principle of derivation. It was argued that the financial stability of the federal government was necessary for the stability of the regions. Following from this, the 1960/63 constitutions provided for 50 percent derivation in respect of revenues from all minerals.

It was in this phase that the Distributable Pool Account (the forerunner of today’s Federation Account) was instituted. Specified tax proceeds collected by the federal government was paid into this account and then distributed to the regions based on the following criteria: (1) continuity in government services; (2) minimum responsibilities of each government; (3) need based on population size of the region; and (4) the balanced development of the federation.

The fifth phase, beginning from 1966 has been characterized by increasing centralization as the states have become increasingly mole dependent on the centre. This period has coincided largely with the military's stranglehold on Nigerian politics. The centrist command structure of the military was brought to bear on inter government fiscal relationships. A number of historical occurrences and events were exploited to promote the centrist preference of military rulers. Of these, the civil war and state creation were the most important. The rally around the need for national unity as a result of the civil war was exploited to strengthen the centre at the expense of the states. The creation of states from the regions and continuous fragmentation of the states became instruments for promoting a concentration of fiscal authority at the centre. In addition to these, various decrees were promulgated expropriating tax authorities and jurisdictions from the states. The concept of a predatory centre is apt in describing this period. The centrist philosophy has found its way into the 1999 Constitution handed down by the military.

Even under democracy, fiscal centralisation has been too attractive for democratically elected governments at the centre to resist. Calls by lower tiers of government for a more decentralised fiscal arrangement have continued to fall on deaf ears. Fiscal mobilisation commissions appointed by the central government and the National Assembly have continued to formulate revenue allocation formulas which maintain fiscal centralism.

Relating the Nigerian experience to theory and comparative experience:

It  is interesting to note that the Nigerian discourse hardly relates to the underlying theory of fiscal federalism. In the debate that goes on, we are not usually guided by this theory. How should we restructure our fiscal federalism so as to maximise the reaping of economic efficiency and the stimulation of national development? Does theory for example have anything to tell us about the implications of the present centralised control over resources? It is my view that the failure to grant control of resources to the lower tiers of government is impeding overall national growth and development. Every region, every state of our county is richly endowed with resources, be they oil, solid minerals, forest resources, arable land, etc. The centralisation of oil wealth and the resultant over-dependence of all states on the revenues therefrom has accelerated the national degeneration into the resource curse and Dutch disease conundrum. What we have done by this process is that we have shielded the states from a hard budget constraint, thus encouraging them to merely 'raid the commons'. Incentives for developing own tax bases and resources are thus stultified to the detriment of overall growth and development. Recent studies provide evidence on the growth impact of decentralisation and enhanced regional autonomy (Kee, undated; Desai et.al, 2003).

Likewise we can turn to underlying theory to re-examine the existing vertical revenue sharing. The concentration of revenues at the centre as well as the assignment of responsibilities to the different levels of government as contained in the 1999 constitution would appear to us to be excessively skewed in favour of the centre. This is understandable given that the l999 Constitution was crafted under the military. We need to revisit the assignment of responsibilities and revenues among the three tiers of government with an eye on enhancing the overall performance of the economy.

The wav forward:

Because of the role politics has played in the evolution of the present situation, care needs to be taken to carry all parts of the nation along in fashioning out a new position. This needs to be based on the principles of give and take.