Fiscal Federalism Explained Here With the Perfect Examples

In a decentralized form of government, the rights and responsibilities of the government are divided into different levels of government. Instead of concentrating all the power in one government, distribution helps in the smooth allocation of resources up to the grass-root level. The allocation and distribution of the financial decisions may however differ as per case-to-case. There are various ways the central government grants funds to the state/local governments. Accordingly, the respective governments levy taxes on citizens, since the revenue of both the governments is different. Of course, it comes under the ambit of the central government as to how much funds should be granted to the state, and what rights and duties are to be delegated to them.

Let's understand what is fiscal federalism with examples, and its pros and cons.

The term was first used by Richard Musgrave, an eminent economist, considered as a pioneer of public finance. This is a concept of public finance which talks about how the central government allocates and appropriates its funds to state and other local governments, subject to its terms and conditions.

Fiscal Federalism refers to the way financial decisions pertaining to an economy are taken by a decentralized form of government. It explains how resources are allocated between both of them.

Block funds is a type of technique in the federal government, wherein the central government gives blocks of funds to the state government, giving general directives on how to spend it, instead of specific ones. Thus, there is ample flexibility given to the state government.

For example: The Community Development Block Government Program (CDBG) is a development program that was started in 1974. It aims at developing housing facilities, and creating employment opportunities for low-income citizens. As per this program, the United States Department of Housing and Urban Development (HUD) distributes block grants to its state and local government.

In this case, the government gives funds to the state government for a specific purpose, i.e., for a given cause.
For example: The food stamps program provides nutritional assistance, especially for those belonging to the lower economic strata.

In case of revenue-sharing, the taxes earned by the central government are distributed to the state and local governments. This type of fiscal federalism evolved during the tenure of President Richard M. Nixon.

Every state is different, hence, the state government is in a better position to identify the requirements of that particular state. Grass-root-level problems can be identified by them, and it is easier to reach the mass level in case of fiscal federalism. Thus, it considers the regional differences between different states. There cannot be a ready-made solution to every problem faced by different states, and they need to be tailored according to the specific peculiarities of each states. It is easier for the local government to monitor problems and have a sufficient and apt solution for them.

'Laboratories of Democracy': This term was formed by U.S. Supreme Court Justice Louis Brandeis, who stated that the state government should as a 'laboratory' to the central government, thus experimenting with new ideas and projects, and learn new lessons out of them. These lessons will help the central government in formulating policies for the entire nation. They can serve as testing grounds, without impacting or causing any harm to the entire nation.

Stimulates Competition: For better performance, the state and local governments will compete with each other, which will, in the end, be beneficial to the citizens and the nation as a whole. Healthy competition fosters growth.

In case of a decentralized government, there is a possibility of unhealthy competition creeping in. State governments might resort to unfair practices to pull businesses into their states, thus disrupting national harmony. It might lead to unequal distribution of resources and employment opportunities, and create disparities among the states.

Sometimes, it creates chaos due to too many policies and programs. Every state law is different, hence, it becomes difficult for the citizens to comprehend multiple rules. Further, no aid comes free of cost, and with more federal aids to the states, the levy of taxes on the citizens is more.

Of course, with both pros and cons, fiscal federalism is a matter of study and debate for many economists. Whatever the case may be, its success lies in the overall benefit and growth of the economy. When the central and state governments, both work hand-in-hand for the development of their economy, with a degree of freedom that is necessary for the state government, along with a necessary monitoring of the central government, fiscal federalism will definitely succeed in the long run.