What is Fiscal Federalism?

Fiscal federalism is an area of study in public economics that focuses on the allocation of fiscal rights and responsibilities across different levels of government. There are many different theories of fiscal federalism, with some suggesting that greater allocation of funds should go to decentralized governments, while others suggest that a strong central government is more important. The goal of analyzing this area is to improve the efficiency of governing by improving the allocation of funding and expenditures.

The traditional theory of fiscal federalism focuses on the economic role of government in the existence of the nation. In a free-market based system or a broadly capitalist society, government is generally meant to interfere only as much as is necessary to maintain stability in the system. This may include allocating goods, employment levels, and income rates on a broad level, so that all citizens have relatively equal access to the same wages, economic opportunities, and consumer goods. Other provisions may include correcting vast market failures through economic stimulus.

In this traditional model, the role of the decentralized or regional government is much more specific to the needs of the jurisdiction. People in Arkansas, for instance, will probably have different needs than those in Oregon. A strong system of regional governments can help ensure that the individual needs of each jurisdiction are met, while the central government tends to manage issues on a much broader, macroeconomic level.

Based on this simplified general theory of fiscal federalism, the major issue becomes dividing economic responsibilities and allocations so that both the federal government and the regional governments can best manage their duties. For instance, a federal minimum wage may help the central government in the duty of ensuring a basic equity in wages across all regions. A state minimum wage may be higher, depending on the cost of living and economy of a localized area. If housing, food, and other costs are far lower in Montana than in New York, fiscal federalism suggests that it makes sense for these state governments to set minimum wages that are no lower than the mandated federal minimum, but can be adjusted to the independent economies of the states.

Taxation rights are a major issue in the study and concern in fiscal federalism. People in the United States are often confused by the fact that they must pay both federal and state taxes each year. Dual taxation is a function of fiscal federalism, since the regional and federal governments each maintain the right to tax for the services they provide. With more and more countries tending toward a decentralized government system, it becomes more difficult for citizens all over the world to understand their complicated tax systems.