The Fiscal Interest Approach: The Design of Tax and Transfer Systems

Abstract

The design of the fiscal system vitally shapes subnational government institutions, policy choices, and economic performance. In this chapter we focus on the fiscal interest approach, the idea that the specific arrangements of tax and transfer systems directly affect the interests and incentives of subnational political officials. These incentives therefore affect these governments’ policy choices and, consequently, the performance of their jurisdictions. This chapter reviews several ideas in the literature that show how precisely this occurs. When the taxation and transfer system has subnational governments rely on own revenue generation from broad based taxes, subnational governments tend to be responsive to their residents’ needs, the overall health of their economies, and more willing to provide market-enhancing public goods. An excessive reliance on central government transfers, on the other hand, has a detrimental effect on subnational incentives to assist the production of wealth. We provide and overview of how the type of tax that is assigned and the specific formula used to divide central government funds among subnational governments either rewards or punishes subnational government efforts at promoting growth and prosperity; and, similarly, whether it encourages subnational government spending beyond their means or promotes prudent fiscal management.