Fiscal Federalism and Fiscal Policy:

Countries are found to have unitary or federal governments. Federal countries as distinct from unitary governments are organised at different levels - central, state and/or local governments and have constitutional powers in the spheres of functions and finances. Fiscal policy of the governments in a federal set-up refers to the management of the government finances based upon assigned functions and revenue sources.  Intergovernmental transfers or devolution of resources in the form of grants and tax shares to the lower level of government are considered an important element of fiscal policy in a federal structure.  In this unit we shall discuss the concept of fiscal federalism, fiscal policy management in a federal structure, need and forms of grants flowing from higher level to lower level of government and the issues relating to fiscal competition.

In the federal countries the government functions are devolved, based on the suitability of different levels of government. The local governments due to their nearness to the people have the best capability to provide wide ranging public services responding to taste and preferences of their people. The revenue sources are also devolved to different levels of government to carry out their functions smoothly. The devolution of tax powers differ across the federations and in most cases the central government has the most buoyant and important sources of revenue.  Due to their weak fiscal capacity, the sub-central governments depend heavily on the transfer of grants from central government to carry their responsibilities.