The pursuit of ‘fiscal’ federalism

What is fiscal federalism? In economics, it is a subfield of public finance that studies the financial relations — revenue and expenditure — between the different levels of government in a federation. In his 1959 seminal book, The Theory of Public Finance, the German-born American economist, Richard Musgrave, propounded the theory of fiscal federalism, arguing that to address the inequality in the distribution of wealth among the states and achieve economic stability as well as efficient and effective allocation of resources, the federal government should play the lead role of “redistributing” resources — while the states should handle the “allocation”.

In simpler words, Musgrave proposed that the federal government is better placed to play the role of “mother hen” by taking a panoramic view of the economic health of the federation and using the instruments of revenue to even things up. Imbalances can be disruptive to the overall wellbeing of the federation since every part of the country is not equal in geography, demography, natural endowments and economies. Therefore, the federal government should redistribute the revenue to the states according to their needs and circumstances. This is usually done through equalisation payments, federation grants/allocations and distribution of the tax handles.

In my previous article, “The Pursuit of ‘True’ Federalism”, I did explain that countries practise federalism differently. I implied that true federalism would basically mean that powers to make laws and impose taxes are shared between at least two “equal” levels of government, namely the national and the sub-national. The powers of each tier are defined by a country’s laws. The “irreducible minimum” powers exclusive to the centre are: foreign affairs, defence and monetary policy. I concluded that while I’m not opposed to restructuring, we miss the point by thinking our problem is the structure of the federation rather than the tragically inept and corrupt leadership.

Another point we keep missing is the way we define “fiscal federalism”. I have been hearing agitations for “fiscal federalism” since 1999 or thereabouts. As I have explained already, fiscal federalism seeks to “even things up” in the federation because of unequal resources in the states. The federal government therefore plays the role of robbing Peter to pay Paul. While the centre has extensive machinery to raise tax revenue across the federation, it is the states that have to provide most public services, such as roads, water, health care and education. Hence, Musgrave proposed “redistribution” by the centre and “allocation” by the states to these essential services.

I will now give examples. Fiscal federalism in the US was conceived to prevent further bankruptcies of states. Although American states are in control of the natural resources in their territories, they do not operate as islands. They are compelled to have balanced state budget because of the overall health of the federation. The federal government “redistributes” the tax revenue through two types of transfers: one for balancing the state budget, and the other for “public interests” or for reducing shocks caused by natural disasters and economic crisis. It must be noted that while tax handles are fairly distributed, the federal government still holds the ace.

Australia, in 1933, introduced “horizontal fiscal equalisation” to compensate states with lower capacity to raise revenue. It remains so till today. The goods and services tax (GST), about $50 billion a year, is collected by the Commonwealth (that’s their federal government) and distributed among the states based on the advice of the Commonwealth Grants Commission (GCC). GST is like our VAT in Nigeria. In Belgium, there is the “national solidarity intervention” under which regions, where the average per capita yield of personal income tax falls below the national average, get an unconditional transfer from the federal government.

Germany’s 1919 Weimar Constitution vests all taxation powers in the federal government. A “state tax law” was passed in 1920 to ensure that every state gets at least 80% of the average tax revenue accruing to states. In other words, if the average tax revenue generated per state is $100 million, no state will get less than $80 million from the federal purse — even if the tax is not derived from its territory. The centre robs Peter to pay Paul by taking money from the richer states to compensate the poorer states for “fiscal balance”. If tax revenue is $120 million in State A and $60 million in State B, the centre will allocate $80 million to State B by reducing State A’s share.

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In oil-producing federations, “balancing” differs from country to country. In Canada, oil provinces are in total control of their resources. They collect the petroleum taxes and royalties. Because only very few provinces have oil (Alberta and Saskatchewan), the federal government has an equalisation fund from where grants are given to other provinces for balance. Conversely, in Mexico, the federal government is in charge of all the oil revenue. States receive a flat 20% as allocation, whether or not they have oil. However, municipalities where oil-production and shipping take place receive an extra 3.17 per cent as compensation for the environmental damage.

So what am I driving at? When people demand “fiscal federalism” in Nigeria, I am convinced that there is a conceptual fallacy — which is not uncommon with us. After all, we say “zoning” when we mean “power rotation”. In truth, we are already practising “fiscal federalism” as evident in the use of revenue-sharing principles such as population, landmass and terrain in the horizontal federation allocation formula (among the states, that is) to try and even things up. This is the “fiscal federalism” proposed by Musgrave and practised across many federations. I believe it is important to get this conceptual error out of sight so that we can be clear about what we really want.

I suspect that when agitators demand “fiscal federalism”, they mean either “resource control” or “increased derivation”. There is a glaring lack of clarity. What exactly is resource control? Does it mean every state should keep 100% of the revenue accruing from its territory? In the United Arab Emirates (UAE), every emirate is 100% in control of its natural resources and only contributes to the federal purse. That was the pre-nuptial agreement in 1971. But with the global crisis in 2009, oil-rich Abu Dhabi still had to bail out Dubai with $20 billion. That is common sense, right? A bankrupt Dubai can pull down the UAE economy. The notion of “on your own” federalism is Utopian.

Could “resource control” also mean every state should take charge of its natural resources by awarding the mining licences and collecting the taxes on behalf of the federation — and then remitting a certain percentage to the central pot for redistribution? Under this variant, it does not necessarily mean oil-rich states will take more than 13% as it currently obtains, but it means they are the ones that will decide who mines the oil. They are therefore in a better position to properly negotiate their interests with oil companies before allowing exploration activities. It means the federal government can still “redistribute” for a fiscally balanced federation. Is this an option?

Perhaps, by “fiscal federalism”, the agitators mean “increased derivation” for states that provide the revenue. In the first republic, before oil boom hit us, derivation was as high as 50% for the regions. But with the flood of petrodollars, the military government changed the law and took virtually all the income to the centre, from where it began to spend. At some point, oil-rich states did not get one kobo for derivation. Such cruelty! I call it man’s inhumanity to man. Mercifully, the 1995 Constitutional Conference recommended that oil-producing states should receive at least 13% of the revenue as derivation. This was incorporated into the 1999 Constitution.

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In sum, what do we mean by fiscal federalism, resource control and restructuring? We cannot begin to have a meaningful, intelligent conversation if we do not clearly define the concepts. My conclusion all along is that many campaigners do not even know what they are agitating for — they just echo what they hear from the star agitators. And that is why even though I am all for restructuring, my understanding is somewhat different from the dominant notions. We need to get on the same page first on what we are talking about. We can then proceed to have an engaging and stimulating debate on the costs and the benefits. Let’s keep the conversation alive!



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