Vertical and Horizontal Fiscal Imbalance:

Vertical fiscal imbalance occurs when the revenues of different levels of government do not match their expenditure responsibilities. As discussed earlier, the assignment of tax and expenditure between the centre and sub-national levels is often not coordinated and lower level governments have revenues that do not match their needs. This will necessitate intergovernmental transfers from the over endowed central government to the under endowed sub-national governments.  This is known as vertical fiscal equalization.

Horizontal fiscal imbalance occurs when different regions of a country have different abilities to provide services, due to different abilities to raise funds. This can occur if some regions are able to raise more funds through their tax bases than other regions and/or the cost of provision of services is higher in some regions than in others. This is usually rectified by weighting transfers payments toward the needier regions, referred to as horizontal fiscal equalization.