Our previous blog captured the First Generation Theory (FGT) on Fiscal Federalism. In this blog we will cover ground on the Second Generation Theory (SGT) on Fiscal Federalism which incorporates the learnings from FGT and builds on it by adding on to the growing experiences on decentralisation along with the evolution of public sector and fiscal institutions.

The primary difference between the approaches by scholars and practitioners between the two phases was that the first generation thought was rule based and disregarded the fundamental notions of human behaviour and public choice. Whereas, the second generation questions these assumptions and approaches decentralisation by borrowing from literature outside public economics. Such as, principal-agent approach, incentive-driven approach, information asymmetry, economics, organizational theory etc. A detailed comparative view has been discussed below:

Trade-off between the Centralisation and Decentralisation argument:

FGT regarded the government as the custodian of public interest. It sets a positive role for the government in terms of correcting various forms of market failure, establishing an equitable distribution of income and stabilising the macro-economy. Similarly, in a multi-level government setting, each level will fundamentally work towards maximising the social welfare of its respective constituencies. Mancur Olson envisioned its outcome as a ‘perfect mapping’ (technically referred as fiscal equivalence) of functions and finance of governments at different levels that deliver efficient levels of outcome. To manage the spill-over benefits and disadvantages, it simply applied the Pigouvian theory of subsidies where the Central government would provide matching grants to decentralised governments.

SGT, on the other hand questions the efficiency argument of governments by questioning if there can be uniform levels of output. This is because there exists fundamental information asymmetry which leads to perverse incentives and free-riding at the cost of the different tiers of the government (also known popularly as the prisoner’s dilemma). Further, Wallace Oates questions that if the argument for decentralisation is the lack of understanding of local preferences by the Central government, then how can it determine Pigouvian subsidies for local governments?

Going further, SGT included in its framework the political processes through two different ways: as Robert Inman’s setting of ‘de-concentration’ or ‘administrative federalism’ with the traditional principal-agent approach where regional and local governments are largely agencies that respond to Central directives and also, exclusively, the electorate as the principal and elected officials as its agents as studied by Mariano Tommasi.

Structure of the Public Sector and Fiscal Institutions

In the FGT approach, the Central government was responsible for managing the macroeconomic impacts that may arise.  It has stressed on the need for hard budget constraints in local governments so spending can be controlled and managed. This scenario however ignores what is called soft budget constraints as put forward by Janos Kornai i.e. an expectation of rescue by decentralised units from the Centre in times of fiscal stress.

These kind of expectations can set several difficulties as local governments find an irresistible incentive to expand their programs and spend beyond their means. Expectations are the basis of inefficiencies and goes against the Pigouvian spirit which identifies matching grants as solutions for fiscal rescue. On the other hand, Wallace Oates mentions that the SGT approach stresses that such claims cannot be ignored by the Central government because:

1. Welfare of the locality may fall below desired levels due to low output levels in that jurisdiction and
2. There may be electoral consequences for the Central government authorities.

In countries like Argentina and Brazil, local government fiscal behaviour had almost led to the destabilisation of the entire fiscal system and economy.  Wallace Oates explains that similar conflicts have arisen in the European Monetary Union where it was assumed that following a set of rules will prevent undermining the credibility of the European Central Bank by the member nation policies. But this was just in principal, as in reality there involved fundamental ‘common pool’ problems which came in conflict with the redistributive objectives of the European Union. Thus, SGT took into consideration the incongruity between the structure of public sector and fiscal institutions. It identifies that there exists a real conflict of objectives that presents a difficult trade-off in the design of fiscal institutions and budgetary procedures.

It recommends three important features that will make sure that the purpose of hard budgets are served well: 

1. Establishing balanced budget constraints through the legislature
2. Constrain borrowing limits for financing capital projects and
3. Designing clear public bankruptcy laws that specifies clearly how fiscal crises will be handled

Role of the Central Government

FGT simply assumed federal structures to be stable and self-enforcing entities. As mentioned by De Figueirdo and Weingast, it doesn’t take into consideration that federal structures have two very inherent incentives for destructive behaviour i.e.:

1. Central intrusion that leads to destruction of an effective federal structure
2. Local capture undermining the federal structure that raids fiscal commons through opportunistic efforts that leads to local benefits incurred at the expense of other jurisdictions
3. SGT attempts to find the delicate balance between the Centre and the local governments. By applying game theoretic analysis of soft budget constraints and fiscal bailouts.

But the larger point to drive home is that political and hence fiscal institutions are endogenous to the system they subsist in and hence solutions will have to be context dependent.

To summarise, where FGT followed a technocratic rule based approach, SGT builds a pragmatic way for measuring decentralisation. In spite of the outcomes being so country specific and adept with contradictions, broad rules of decentralisation has been framed. Follow our next blog to unravel the basic tenets and contextualization of decentralisation as put forward by Roy Bahl.