Stabilization Function:

Another important function to be assigned in between governments is stabilization function.  Stabilization policy, the process of macro-economic equilibrium, cannot be entrusted to local and regional governments as these unit governments will become ineffective in dealing with certain macro economic issues like unemployment and inflation.  For example, if a sub-central  government say a local government follows a fiscal policy wherein it makes budget proposal to stimulate demand in the local economy. Accordingly it increases its public expenditure and does reduce taxes. Such a fiscal exercise tends to develop several problems. Firstly, it is difficult to finance such a budget deficit.  Secondly, the fiscal multipliers may become very small and close to zero.  Any fiscal policy determined by a single or a group of local governments tend to be impotent.  Moreover, it may lead to unnecessary and avoidable competition among different local governments.  Truly speaking the local governments do not have instruments for macro economic control relating to money supply, interest rates, prices, incomes and imports.  But the Central government is better equipped with several instruments to carry out an effective fiscal policy and also to coordinate with other policies such as Monetary Policy. The sub-central governments are neither efficient nor effective in using the fiscal and monetary instruments with regard to employment and price levels.  So the national government must be entrusted with the responsibility for macro-economic stabilization.

The above analysis explains that certain functions can best be rendered by the Central Government. But the real issue is to  determine which functions can best be performed by the local governments and which one by the federal/central government.  Hence the need and purpose of the discussion so far.  After assigning different functions to different levels of governments in a federal structure, it is necessary to know how and what type of tax powers are to be assigned to different units of governments.