2005. Fiscal Federalism and Macroeconomic Governance: For Better or For Worse?

Anwar Shah
(November 1998)

Shah concludes that, contrary to a common misconception, decentralized fiscal systems offer more potential for improved macroeconomic governance than do centralized fiscal systems, because they require greater clarity about the roles of various players and decisionmakers and—to ensure fair play—greater transparency in rules governing interactions.

In analyzing the institutional environment for macroeconomic management, Shah discusses monetary policy, fiscal policy, and subnational borrowing. In analyzing the macroeconomic dimensions of securing an economic union, he discusses the regulatory environment, tax coordination, transfer payments and social insurance, intergovernmental fiscal transfers, and regional equity. Finally, he discusses the challenges of globalization and draws lessons from experience about fiscal reform in developing countries: Among them:

• Monetary policy is best entrusted to an independent central bank with a mandate for price stability.
• Fiscal rules accompanied by "gatekeeper" intergovernmental councils or committees provide a useful framework for fiscal discipline and coordination of fiscal policy.
• The integrity and independence of the financial sector contribute to fiscal prudence in the public sector.
• To ensure fiscal discipline, governments at all levels must be made to face the financial consequences of their decisions.
• Societal norms and consensus about the roles of various levels of government and limits to their authority are vital to the success of decentralized decisionmaking.
• Tax decentralization is a prerequisite for subnational access to credit markets.
• Higher-level institutional assistance may be needed to finance local capital projects.
• An internal common market is best preserved by constitutional guarantees.
• Intergovernmental transfers in developing countries undermine fiscal discipline and accountability while building transfer dependencies that cause a slow economic strangulation of fiscally disadvantaged regions.
• Periodic review of jurisdictional assignments is essential to realign responsibilities with changing economic and political realities.
• Finally, and contrary to a common misconception, decentralized fiscal systems offer more potential for improved macroeconomic governance than do centralized fiscal systems.

This paper—a product of the Country and Regional Relations Division, Operations Evaluation Department—is part of a larger effort in the department to learn lessons of experience in improving public sector performance in developing countries. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Silvana Valle, room G6-079, telephone 202-458-4493, fax 202-522-3124, Internet address svalle@worldbank.org. The author may be contacted at ashah@worldbank.org. (46 pages)

The full report is available in PDF format.