The role of intergovernmental fiscal institutions: The case of tax sharing

Abstract

In the literature on fiscal decentralisation – both the first generation and second generation theories – a critical assumption made is that local governments have taxing power over local taxes. Another assumption is that a clear distinction exists between local taxes and intergovernmental grants. Tax sharing, which is widely adopted in the world except in a few countries such as the United States and Canada, makes such assumptions invalid. Tax sharing links the budgets of the central and local governments in a complicated way and creates conflicts of interest among different levels of government. It also may lead to an inefficient tax mix and higher national debt. Compared with the cases where the assignment of tax and expenditure responsibilities are clear cut, understanding the interrelationship between tax sharing, fiscal institutions, and the political system is critical for the success of fiscal decentralisation.