30 January, 2013
Fiscal Federalism for a new Europe
Alexander Hamilton was the first federalist to face in theory and practice the constitutional problem of establishing a multilevel system of public finance.

Guido Montani is a Vice-President of the UEF and professor of International Political Economy (University of Pavia). This note is written in view of the joint initiative of UEF and the Spinelli Group for the constitutional reform of the European Union.


Hamilton’s Problem

Alexander Hamilton was the first federalist to face in theory and practice the constitutional problem of establishing a multilevel system of public finance. In modern times we can restate the Hamilton’s problem on the basis of the classic wording of Kenneth Wheare: “The federal principle requires that the general and regional governments of a country shall be independent each of the other within its sphere, shall be not subordinate one to another but co-ordinate with each other. Now if this principle is to operate not merely as a matter of strict law but also in practice, it follows that both general and regional governments must each have under its own independent control financial resources sufficient to perform its exclusive functions”. This principle is the cornerstone of fiscal federalism because the other face of the Hamilton’s problem is federal democracy: each government should be accountable to its citizens (or their representatives in parliament) and that is possible only if the government’s budget shows clearly where the money comes from and how it is spent (principles of financial transparency).

Now, let’s restate the Hamilton’s problem in a little more technical way. In practice, in a multilevel system of government, it can happen that some government – at the federal level or at the regional/state level – is unable to have sufficient fiscal revenues to finance its expenditures. In such a case there is some imbalance. Two kinds of imbalances are possible: a vertical fiscal imbalance (VFI) and a horizontal fiscal imbalance (HFI). If, for instance, the federal government is able to collect more taxes than regional/state governments and the regional/state governments are responsible for more expenditures than the revenues they can collect there is a VFI (this is the general case in present federations, where federalism is considered a decentralized system of the central government because most of the fiscal power and monetary policy are located at the federal level).  At the same time, among sub-federal governments it can happen that some regions/states are able to finance with own resources their expenses, while some other regions/states are unable to do the same: in such a case there is a HFI.

The experience of existing federations shows that it is very difficult to remove these two kinds of imbalances, most of all because they are interlinked. Let’s consider a federation including rich and poor regions/states. It can happen that federal regions/states find an agreement to remove the VFI. But the agreement is shaped in such a way that rich regions/states achieve easily a balance while poor regions/states will find that their fiscal revenue is not sufficient to provide the same per-capita services the other citizens receive. The lesson is that, in practice, in a multilevel system of public finance some form of vertical transfer from the federal government towards regions/states and some form of horizontal transfer from rich to poor regions/states is unavoidable.

However these transfers of revenue between governments should be conceived as a transitory measure in view of attaining the ideal state without fiscal imbalances as depicted by Wheare. Transfer of funds between governments is a transitory policy to avoid major social, economic and political problems, which can put in danger the cohesion of the federal union. Usually transfers of funds are a cause of quarrels and complaints. Cohesion policies are necessary only to attain a more perfect union, where every government can be fully accountable for the utilization of the taxes paid by its citizens and for the quantity and quality of the services it provides.

The European fiscal problem

If we consider the problem of VFI it is possible to say that all existing federations suffer from an excess of centralization: some fiscal transfer from the federal government to region/state government is necessary to allow them to provide the services and public goods required by their citizens. Sub-federal governments undergo a fiscal gap. The existing situation of the European Union is exactly the opposite: there is a European fiscal gap and an excess of decentralization of revenues and expenditures at the national level. Let’s consider the proposal of the Commission for the next MFF 2014-2020, A Budget for Europe 2020. According to the Commission, the Union budget (1% of GDP) should provide “programmes which can deliver results that individual Member States cannot deliver on their own”. But when you consider the crucial programme “Connecting Europe” the Commission says that the total amount of investment could be up to 2 trillion of investments: nevertheless the Union budget provides funds for less than half this amount. Moreover, the Commission admits that 85% of European own resources stem from national budgets. Wheare would say that the European government is not independent, but subordinate to national governments.

The European fiscal deficit (or gap) is one of the features of the European democratic deficit. It is impossible to get rid of the first deficit without getting rid of the second and the other way around. This means that to overcome the European fiscal deficit a specific political struggle is required. The fiscal deficit is not a novelty: it blew up during the last two decades but the European Parliament and the European parties consent to it as an unfortunate destiny. Even the recent report on the shortcomings of the Union budget of Haug, Lamassoure and Verhofstadt, Europe for Growth, deals openly only with the own resources problem but postpones the debate on the crucial issue of the size of the Union budget. The Union will have a federal budget only if the European parties and their leaders are able to convince the citizens that some public goods (a balanced growth, full employment, a green economy, security) can be provided by the federal government at a lower cost than what they pay for the same public goods (or the illusion of these public goods) to their national government. Such a fiscal federal system, without imbalances, can cut down the average fiscal burden of the citizens.

Aware that a real federal reform of the Union cannot result only from some articles in a new treaty, a judicious treaty amendment would remove the main bottlenecks on the way of a substantial increase of European own resources. A European federal budget cannot be but the result of a European struggle of political parties and European citizens for a better future.


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