Fiscal Federalism: Who Taxes and Who Spends

Dividing power means dividing money. In many systems, the national government collects most taxes while regional and local governments deliver many expensive services such as schools, hospitals and policing. This mismatch, called 'vertical fiscal imbalance', is bridged by transfers from the centre.

Because regions differ in wealth, many federations also use equalization payments to ensure poorer regions can offer comparable services. Canada's equalization programme dates from 1957 and was written into its constitution in 1982; Germany redistributes revenue among its Länder; Australia shares goods and services tax revenue among states.

These arrangements are frequently controversial: richer regions may resent subsidizing poorer ones, and grants with conditions let central governments steer policies in areas formally controlled by regions. Economists such as Wallace Oates argued that services should be provided by the level of government closest to the people who benefit, but politics often shapes the outcome more than theory.