This monograph is a study of economic decision making by governments in a federation. A federation is simply a multilevel system of government in which different levels of government exist, each of which has some independent authority to make economic decisions within its jurisdiction. By economic decisions, we include a variety of things. Governments can acquire resources to provide public goods and services. Expenditures for these purposes can be of a current nature (e.g., hiring employees, purchasing materials) and a capital nature (e.g., buildings, infrastructure). Governments can raise revenues in order to finance services provided by the private or nonprofit sectors, such as hospitals, universities, or insurance. They can arrange to have resources redistributed among households in the economy. They can introduce regulations in the markets of the private sector so as to influence resource allocation there; or they can interfere with the pricing mechanism as an alternative way of achieving resource allocation or redistributive effects, such as through subsidizing or taxing certain activities. They can also attempt to influence the aggregate amount of activity that occurs in the economy both through budgetary actions and through changes in the amount of money and credit circulating in the economy.
Constitutional divisions of powers among various orders of government fall into three categories: unitary, federal, and confederal.
A unitary country has a single or multitiered government in which effective control of all government functions rests with the central government.
A federal form of government has a multiorder structure, with all orders of government having some independent as well as shared decision-making responsibilities.1 Federalism represents either a “coming together” or a “holding together” of constituent geographic units to take advantage of the greatness and smallness of nations. In a flat (globalized) world, it is increasingly apparent that “nation states are too small to tackle large things in life and too large to address small things” (Bell, 1987: 13–14). Subscribing to the “coming together” view of federalism, Daniel J. Elazar (1980) pointed out and elaborated that the word “federalism” has its roots in the Latin foedus, meaning “league,” “treaty,” or “compact.” More recently, Robert Inman (2007: 530) noted that “the word ‘federal’ has come to represent any form of government that brings together, in an alliance, constituent governments each of which recognizes the legitimacy of an overarching central government to make decisions on some matters once exclusively the responsibility of individual member states.” “Coming together” has been the guiding framework for mature federations such as the United States, Canada, and, more recently, the European Union.
A federal form of government promotes decentralized decision making and, therefore, is conducive to greater freedom of choice, diversity of preferences in public services, political participation, innovation, and accountability.2 It is also better adapted to handle regional conflicts. Such a system, however, is open to a great deal of duplication and confusion in areas of shared rule and requires special institutional arrangements to secure national unity, ensure regional equity, and preserve an internal common market.
Federal countries broadly conform to one of two models: dual federalism or cooperative federalism. Under dual federalism, the responsibilities of the federal and state governments are separate and distinct. According to William H. Riker (1964: 11), under such a system, (1) “two levels of government rule the same land and the people, (2) each level has at least one area of action in which it is autonomous, and (3) there is some guarantee . . . of the autonomy of each government in its own sphere.” Under cooperative federalism, the responsibilities of various orders are mostly interlinked. Under both models, fiscal tiers are organized so that the national and state governments have independent authority in their areas of responsibility and act as equal partners. National and state governments often assume competitive, noncooperative roles under such an arrangement. Dual federalism takes either the layer cake or coordinate-authority approach. Under the layer cake model practiced in Mexico, Malaysia, and Russia, there is a hierarchical (unitary) type of relationship among the various orders of government. The national government is at the apex, and it has the option to deal with local governments either through state governments or more directly. Local governments do not have any constitutional status: they are simply extensions of state governments and derive their authority from state governments. In the
The cooperative federalism model has, in practice, taken three forms: interdependent spheres, marble cake, and independent spheres. In the interdependent spheres variety as practiced in Germany and South Africa (a unitary country with federal features), the federal government determines policy, and the state and local governments act as implementation agents for federally determined policies. In view of federal domination of policy making, state or provincial governments in this model have a voice in federal policy making through a second chamber (the upper house of the parliament). In Germany and South Africa, the second-order (state) governments are represented in the upper house of the national parliament (the Bundesrat and the Council of the Provinces, respectively). In the marble cake model of cooperative federalism, various orders of government have overlapping and shared responsibilities, and all constituent governments are treated as equal partners in the federation. Belgium, with its three territorial and four linguistic jurisdictions, has a strong affinity with this approach. Finally, in a model of cooperative federalism with independent spheres of government, all orders of government enjoy autonomous and equal status and coordinate their policies horizontally and vertically. Brazil is the only federation practicing this form of federalism.
The competitive federalism model is a theoretical construct advanced by the fiscal federalism literature (Salmon, 2006; Breton, 2006; Kenyon and Kincaid, 1991) and not yet practiced anywhere in its pure form. According to this construct, all orders of government should have overlapping responsibilities, and they should compete both vertically and horizontally to establish their clientele of services. Some analysts argue that such a competitive framework would create leaner and more efficient governments that would be more responsive and accountable to people.
Countries with a federal form of government vary considerably in terms of federal influence on subnational governments. Such influence is very strong in Australia, Germany, India, Malaysia, Mexico, and Pakistan; moderately strong in Nigeria and the United States; and weak in Brazil, Canada, and Switzerland. In the last group of countries, national control over subnational expenditures is quite limited, and subnational governments have considerable authority to determine their own tax bases and tax rates.
Federal countries also vary according to subnational influence on national policies. In some countries, there is a clear separation of national and subnational institutions (“executive” or “interstate” federalism), and the two orders interact through meetings of officials and ministers, as in Australia and Canada. In Germany and South Africa, state or provincial governments have a direct voice in national institutions (“intrastate” federalism). In the United States, regional and local coalitions play an important role in the Congress. In some federal countries, constitutional provisions require all legislation to recognize that ultimate power rests with the people. For example, all legislation in Canada must conform to the Canadian Charter of Rights and Freedoms. In Switzerland, a confederation by law but a federal country in practice, major legislative changes require approval by referendum. Such direct-democracy provisions indirectly reinforce the decentralized provisions of public services. In all federal countries, local government influences on the federal and state governments remain uninstitutionalized and weak.
Countries with a federal form of governance do not necessarily treat second orders of government in a uniform manner. They often offer flexibility in accommodating the special needs or demands of constituent units or impose a federal will in certain jurisdictions. This adaptability may take the form of treating some members as less equal than others. For example, Chechnya in Russia and Kashmir in India enjoy lesser autonomy than do other oblasts and states; or the federation may treat some members as more equal than others by giving them wider powers, as is the case with Sabah and Sarawak in Malaysia and Quebec in Canada. Some federations offer constituent units freedom of choice to be unequal or more equal than others through opting in or out of federal arrangements. Such options are part of the arrangements offered by Canada, Spanish agreements, and the European Union’s treaty exceptions for the United Kingdom and Denmark (see Watts, 1999).
Barry Weingast (2006) has advanced a theoretical concept for comparative analyses of federal systems. Market-preserving federalism is put forth as an ideal form of federal system in which (1) multiple governments have
In a confederal system, the general government serves as the agent of the member units, usually without independent taxing and spending powers. The United States had a confederal system from 1781 to 1787. The United Nations, the European Union, and the Commonwealth of Independent States (CIS), which now consists of eleven of the former republics of the Union of Soviet Socialist Republics (USSR), approximate the confederal form of government. A confederal system suits communities that are internally homogeneous but, as a group, completely heterogeneous. The European Union, however, over time has consistently moved to assume a federal role.
The instruments that governments use to undertake their economic activities include, broadly speaking, the following:
Expenditures on goods and services. Governments may purchase labor, capital, goods, and services from the private sector in order to provide goods and services to their constituents. Such major expenditure categories as defense spending, transportation, schools, and hospitals are included in their menu of goods and services expenditures. In some cases, the public sector actually produces the goods or services. In others, it merely finances their provision by private producers or the nonprofit sector.
Transfers to individuals or households. Government spending also includes transfer payments. These can be provided to households in the economy, for example, in the form of welfare payments, payments for disability, and payments to the elderly. These transfers might be administered through the tax system or through an agency responsible for delivering them to their intended recipients.
Subsidies to firms. A particular form of transfer is a subsidy to firms in the private sector, whose purpose is typically to assist the firm’s participation in the private sector in ways that facilitate government objectives.