Cooperative federalism
The objective of cooperative federalism is to guarantee the right to uniform conditions of life across jurisdictions. The peculiarity of this institutional organization is the strong interconnection between the functions and prerogatives of the central government and those of the lower-level governments (the typical examples of which are Germany and, to a lesser extent, Canada).
The objective of social cohesion stressed in the cooperative federalism literature can be analysed with reference to the two equalization principles: horizontal and vertical equity.Under a uniform federal tax rate, disparities in per capita income across jurisdictions make the ‘net fiscal residuum’ (the difference between paid taxes and received benefits) different for individuals with an equal income, the reason being that taxes are a function of each individual income, while benefits depend on the different resource endowments of each jurisdiction. The adoption of the principle of horizontal equity on a federation-wide basis copes with this differential fiscal treatment given to equal-income individuals in lower-level jurisdictions (Buchanan, 1950). The cooperative federalism literature deals with the implementation of the objective of horizontal equalization through horizontal and vertical transfers, the latter going both downward (from the central government towards the ‘poor’ lower-level jurisdictions) and upward (from the ‘rich’ lower-level jurisdictions to the central government). Depending on how large are the disparities in the balance between rich and poor lower-level jurisdictions for both resources and needs of the population, equalizing inter-jurisdictional grants where transfers are decided on per capita income basis may even result in redistribution from the poor of the wealthy jurisdiction to the rich of the backward jurisdiction. Jurisdictions producing public goods also enjoyed by other jurisdictions are entitled to ‘conditional’ matching grants (compensatory subsidies linked to the fulfilment of particular conditions).
In the case of positive externalities, the principle of horizontal equity (equal net fiscal residuum for equal-income individuals) implies that the amount of transfers should correspond to the equalization between marginal cost and marginal benefit.The cooperative federalism literature also deals with the objective of vertical equity. Income disparities across individuals, which are not provoked by their market decisions (their leisure/work or effort choices) but by the conditions of the jurisdiction they live in, should be compensated. Widespread interdependencies inside a federation make the Pareto improvements relevant from both the equity and efficiency points of view. Under a uniform federal tax rate, Pareto suboptimal equilibrium position on the utility possibility frontier may be due to the differential public and merit goods enjoyed by equal-talented individuals. The larger the disparities across lower-level jurisdictions in terms of resource endowments and public responsibilities stemming from the different needs of the population (infrastructures, education, health care and so on), the more fiscal equalization by matching grants is justified on the basis that with an equal federal tax rate the same level of public services should be provided federation-wide. An improvement in social cohesion and efficiency can be expected by the correction of resource imbalances across jurisdictions.
The equalization of fiscal capacity and public services is implemented by differentiating the receiving from the contributing jurisdictions. The computation is made according to the ratio between the index of fiscal capacity and the index of equalization for each jurisdiction (in order to annul the bias of different tax rates across jurisdictions). For the equalization objective pursued by the federation to prevail on the subsidiarity principle, the main state functions should be an exclusive prerogative of the central government, whereas the functions shared with the lower-level jurisdictions should be exerted within the limits determined by the central government’s legislation.
Adding the vertical dimension to inter-jurisdictional transfers required by horizontal equity may substantially change the interpersonal income distribution that was reached within each jurisdiction. In fact, two unwelcome consequences may result. First, equalization grants aimed at increasing the benefits for individuals living in poor jurisdictions might require much wider federal transfers than those aimed at achieving equal net fiscal residuals for equal-income individuals living in different jurisdictions. This may start an inter-jurisdictional conflict. Second, the implementation by the federal government of a principle of vertical equity through the compensation of disparities in fiscal treatment caused by per capita income divergences across jurisdictions jeopardizes the horizontal equity obtained through the transfers aimed at annulling differences in the net fiscal residuum of equal-income individuals. This may cause a clash between the two principles. Moreover, the principle of vertical equity entails that the central government implements a principle of vertical equity evenly shared by all communities belonging to the federation. Hence, local governments are not allowed to implement their own preferred degree of vertical equity. The local communities, if net contributors, will complain that they should not be forced to assume financial responsibility with the other jurisdictions for the implementation of whatever degree of vertical equity at the federal level. In fact, the objective of social cohesion endorsed by cooperative federalism could be rejected, as ‘freedom of choice’ claims that each jurisdiction has the right to set up its own degree of vertical equity (Boadway and Flatters, 1982).The crucial problem undermining the implementation of cooperative federalism concerns the system of incentives. To what extent the redistributive effort implied by horizontal and vertical equity is carried out heavily depends on the tax rate which a society is keen to afford.
In a multi-layer constitutional organization, centralization entails the integration of the jurisdictional programmes of public policies and the aggregation of the two electorates. Suppose two jurisdictions of equal size and income distribution. In the case of social insurance programmes the kernel of income distribution is right- skewed, so that the federal majority voting will favour a lower federal tax rate than it was in the jurisdictions (Persson and Tabellini, 1994). In the case of unemployment insurance programmes, the kernel of income distribution is left-skewed, which reverses the result. In fact, a too high federal tax rate would be decided by constituencies formed by the electorates of two jurisdictions with a high and a low probability of being hit by a negative asymmetric shock, respectively. The wider is the gap between the two jurisdictions in the probability to be hit by a negative shock, the more the risk-averse poor in the ‘low-risk-of-unemployment ‘ jurisdictions voting in favour of a larger unemployment insurance will exceed in number the risk-averse rich of the ‘high-risk-of-unemployment’ jurisdiction voting against (Persson and Tabellini, 1996a, 1996b).