Tax Devolution in a Federal System:

The determination of vertical structure of taxes - taxes assigned to central government and to state government, is referred as tax assignment or devolution of tax powers in a federal structure. The basic issue here is a normative question as to which taxes are best suited for use at different level of governments. There are basically two models available in fiscal federals structures that address the assignment of revenue sources.

First, there is a separation between revenue and expenditures of the different federal levels, and each has its own revenue source as practiced in Switzerland and USA. This gives different governmental units and local and central level considerable flexibility in designing their tasks and fulfilling their responsibilities. Second, the German type of federalism in which all major revenue sources are taken together, and different governmental units receive fixed shares of total revenue, distributed at state and local levels according to certain criteria. The flexibility of sub-central governments to collect taxes is strictly limited and this makes it difficult for them to follow the correspondence principle.

In reality, all federal systems are located somewhere between these two extremes and the question of which tax should be devolved to which level of government remains pertinent.  According to conventional criteria, the only revenues clearly suitable to sub-national governments are those they can administer efficiently, and which fall primarily on their own residents.  Sub-national governments should not for example, be allowed to impose taxes that are shifted to other jurisdictions. At decentralised level, economic agents, goods and resources have significant movement as reflected in the nation wide market. The difference of mobility of taxed units has significant implicatons for design of vertical structure of taxation .

The decentralised levels of government should avoid the taxation of highly mobile economic agents (be they households , capital or final good) The tax devolution based on the principle of separation need more elaboration.  In this type of tax assignment tax handles are exclusively assigned either to centre or to the states as is the case in Indian federation.  Under this arrangement most of the broad based and productive tax handles have been assigned to the centre, perhaps for reasons of stabilisation and redistribution stated earlier.  These include taxes on income and wealth from non-agricultural sources, corporation tax, excise duty on manufactures (excludes liquor and narcotics), and customs duty. A number of tax handles have been assigned to the states as well, but, from the point of view of revenue productivity , only tax on sale and purchase of goods is a broad based tax assigned to states.  The clear demarcation of tax handles of the central and state governments has been prescribed to avoid tax overlapping and concurrency.

The tax devolution across the federal countries show that many problems arise because sub-national governments are commonly assigned revenue sources that are inadequate to finance the expenditures for which they are responsible. Traditionally central governments have claimed as their own most of the major revenue sources notably, income tax, payroll, and customs and so on, leaving little room for sub- national governments to levy their own taxes on these bases and hence rendering them dependent on federal transfers.