Every federal system faces a deceptively simple question: who should do what? Should your local council fund primary schools, or should the national treasury? Who's responsible for highways that cross three provinces? And critically, who gets to levy which taxes to pay for it all?

These aren't just administrative puzzles. The allocation of spending responsibilities and taxing powers shapes everything from local service quality to regional inequality to macroeconomic stability. Get it wrong, and you end up with underfunded mandates, destructive tax competition, or services that nobody feels accountable for delivering well.

Fiscal federalism offers frameworks for thinking through these assignments systematically. The goal isn't a universal blueprint—different countries with different histories and institutions will reach different answers. But the underlying economic logic helps clarify trade-offs and identify when decentralization serves citizens well versus when it creates more problems than it solves.

The default presumption in fiscal federalism is that services should be provided at the lowest level of government capable of delivering them efficiently. This isn't ideological preference for small government—it's recognition that local provision has genuine advantages that centralization sacrifices.

Local governments understand local preferences better. Communities differ in what they want from public services: some prioritize school funding, others want better parks, still others focus on policing. When services are provided locally, citizens can express these preferences through voting, voice, and ultimately by moving to jurisdictions that match their priorities. This 'voting with feet' mechanism—what economist Charles Tiebout formalized decades ago—creates a form of market discipline for public services.

Local provision also enables experimentation. When dozens of municipalities try different approaches to service delivery, successful innovations can spread while failures remain contained. Centralized systems lose this laboratory function.

But subsidiarity has limits. Small jurisdictions may lack administrative capacity for complex services. They may be unable to achieve economies of scale in specialized functions. And when the benefits of a service extend beyond jurisdictional boundaries—or when equity concerns demand uniform standards—the case for centralization strengthens. The principle isn't 'always local.' It's 'local unless there's a good reason otherwise.'

Takeaway

Decentralization's value lies in matching services to local preferences and enabling policy experimentation—advantages that should only be sacrificed when specific conditions demand broader coordination.

The strongest economic argument for centralizing a function is the presence of significant spillovers—benefits or costs that cross jurisdictional boundaries. When one jurisdiction's investment helps (or harms) residents elsewhere, decentralized decision-making systematically gets the quantity wrong.

Consider pollution control. A factory upstream affects water quality downstream. If the upstream jurisdiction makes pollution decisions based only on local costs and benefits, it will tolerate more pollution than is socially optimal because it doesn't bear the full costs. Similarly, a city that invests heavily in higher education may see many graduates move elsewhere, enjoying the productivity benefits without contributing to the investment. Both scenarios create under-provision problems.

The logic works in reverse too. Jurisdictions may over-provide services that shift costs to neighbors—classic 'beggar thy neighbor' dynamics in tax policy, where aggressive corporate tax cuts attract business at other jurisdictions' expense without creating net economic value.

The policy response depends on spillover magnitude. Minor spillovers might be addressed through intergovernmental grants that incentivize beneficial activities. Moderate spillovers may call for coordination mechanisms or minimum standards set by higher levels. Only when spillovers are truly national in scope—defense, macroeconomic stabilization, fundamental rights—does full centralization become the efficient answer. The key is matching the scale of decision-making to the scale of the impact.

Takeaway

When benefits or costs leak across boundaries, local decision-makers lack incentive to account for the full social impact—creating a systematic case for coordination or centralization proportional to the spillover's reach.

Assigning spending responsibilities without assigning adequate revenue sources creates unfunded mandates—a recipe for fiscal stress and blame-shifting. But not all taxes work equally well at all government levels. The optimal assignment depends on three key factors: mobility, administrative capacity, and cyclical sensitivity.

Mobility matters most. Taxes on highly mobile bases work poorly at local levels because they invite destructive competition. If one city cuts corporate taxes, businesses relocate, forcing neighbors to match the cut, ultimately leaving everyone with less revenue and no competitive advantage. This is why most fiscal federalism frameworks assign corporate income taxes and mobile capital taxes to national governments. Property taxes, by contrast, work well locally—land can't flee to a neighboring jurisdiction.

Administrative capacity argues for centralizing taxes that require sophisticated systems. Value-added taxes demand consistent treatment across supply chains, making national administration far more practical than having each municipality run its own VAT. Sales taxes can work subnationally but require coordination to prevent cascading or gaps.

Cyclical stability matters because local governments typically can't run deficits during downturns the way national governments can. Assigning highly cyclical revenue sources—like income taxes that plunge during recessions—to local governments creates budget crises precisely when services are most needed. Property taxes, with their relatively stable base, provide more predictable local revenue.

Takeaway

Tax assignment should match base mobility to jurisdictional level—mobile bases to higher governments, immobile bases locally—while ensuring local governments have revenue sources stable enough to maintain services through economic cycles.

Fiscal federalism isn't about finding the one right answer to 'who does what.' It's about systematically thinking through trade-offs that every multi-tiered system must navigate. Local knowledge and preference-matching pull toward decentralization. Spillovers, scale economies, and equity concerns pull toward centralization.

The frameworks matter because misalignment has real costs. Services assigned to governments lacking capacity or appropriate revenue sources will be underprovided. Taxes assigned to levels where bases are mobile will erode through competition. Spending decisions made at scales that don't match benefit boundaries will be systematically wrong.

Good fiscal federalism design isn't permanent either. As economies integrate and populations become more mobile, the optimal assignment shifts. The goal is building systems flexible enough to adapt while stable enough to provide accountability.