Fiscal Competition:

While more emphasis has been given 'cooperative federalism' in the fiscal federalism literature, it is necessary to note that the relationship between government units is essentially competitive.  Cooperation means conformity to a centralized policy regime and this could imply negation of concept of federalism altogether.

Fiscal competition has been considered as wasteful and distorting while some undesirable actions are taken to enhance tax base. The fiscal competition when results in multiple tax rates impose high compliance cost on tax payers. Fiscal competition is considered as fiscal wars or 'races to the bottom' when competing jurisdictions lower their tax rates in an effort to retain their tax bases. The reasons for inter jurisdictional fiscal competition is that the states compete to lure business into their areas in order to create economic activity that can ultimately increase tax revenues and expenditures which go into improving quality of life. This is based on the presumption that tax rates influence the business decisions and ultimately, economic growth.

The use of tax instruments to attract trade and business alter relative prices in unintended ways and can bring in various types of barriers - fiscal as well as physical - to the free movement of factors and products, and thus distort the pattern of resource  allocation.  As jurisdictions are not homogenous, the ability from jurisdiction to jurisdiction to attract trade and business will differ.

It can give rise to exploitation of the weak by the strong. In developing country federations, the inter-state inequities are acute in the levels of development. There is no link between tax and expenditure decisions wherein costs and benefits of public decisions are not clearly perceived. When the states attempt to indulge in fiscal competition and pass the burden of financing public services to other states, it results in a very inefficient system.

In most developing countries, consumption taxes predominate in the aggregate revenues.  Administrative apparatus in these  countries tend to be weak and often, origin based indirect taxes are used over destination based ones as soft options for revenue raising.  The tax system is not transparent and a cascading type of tax system is adopted wherein inputs and capital goods are taxed, cross boarder purchases are taxed at low rates to attract business, and exports to other jurisdictions are taxed at the highest rate possible.  The implications of such a policy are as follows:

• The strategy of choosing different tax rates on residents and non-residents increases rate differentiation.
• The tax exportation and provision of tax incentives to attract capital complicates the tax structure and makes it open to abuse.
• The tax competition can cause significant unfavourable impact on equity andefficiency.

Thus the gains from autonomy in choosing their preferred public services and tax rates can come into conflict with the welfare loss arising from inter-state fiscal competition.  It has the potential to increase regional inequalities and in some circumstances affect the sustainability of the public sector in general. This problem can be tacked with the scheme of tax harmonization with the  cooperation of jurisdictions and the central government.

A competitive relationship among governmental units can be welfare improving if it is harnessed and monitored properly.  As in the market, it is necessary to satisfy certain pre-conditions to ensure that competition among jurisdictions leads to welfare gain. Ensuring competitive equality among government units and the appropriate application of principle of cost-benefit analysis are conditions that results in welfare gain from inter-jurisdictional fiscal competition. The efficient organization of a federation will depend upon the way competitive relationships are harnessed productively.  Fiscal policy can be effective when the policies of  different levels of government are coordinated.  Similarly, satisfactory resolution of tax and expenditure conflicts between different levels of government and jurisdictions can be achieved only when there is a certain degree of coordinated behaviour among  government units.  In order to be successful, competitive federalism should have:

• Clearly enforceable property rights or the assignment of functions and sources of finances
• Adherence to the set rules by each of the government units and effective
• mechanism to foster interactions based on mutual trust and understanding, and

An independent and just mechanism to conduct and monitor inter-governmental relationships.  The mechanism should ensure that no governmental unit is able to exploit, free ride and dominate other units so as to ensure competitive equality and application of appropriate cost benefit principles.