Economic Basis of Fiscal Federalism:

Public Goods & Services Argument: Market cannot provide public goods efficiently. The services like defence and law and order are the classic examples of the public goods which makes the existence of government inevitable. Because pure public goods can be provided efficiently only by the government. What about the mixed goods? Non excludable and rival, Non rival but excludable. Some goods are non rival and non exclusive only up to a point. So we can divide them into local and national public goods. Hence the case for national and sub national governments. Benevolent & Omniscient government argument: A single benevolent and well informed govt. can provide both local and national public goods. What about the information when it is not perfect? Then how a benevolent govt will achieve the objective of welfare maximization. The information about the preferences for local public goods can better be available to the local governments. So sub national or local governments can better handle the provision of local public goods. So federal government would better handle it than a unitary govt. Incomplete information is not yet a solid argument in favour of decentralisation. This argument might have hold good in the period before the modern means of communication. Assumption of automatic benevolence of government decision makers is also not perfect. If they have their self interests then there must be some incentives to keep them on right track. The electoral process. Better provision of public goods means better chances of re election. Case 1. A national politician being judged on the basis of the provision of local and national performance. Case 2. A local politician is judged on the basis of local performance will have more incentives. Than in the other case. Thus decentralisation refines the incentives available to the politicians. Competition among localities and movements of people will ensure better performance under federal structure than under unitary structure. Positive and negative spillovers also favour national and sub national governments. Coasean solution to externalities also supports the idea of federal structure. Pigovian tax and subsidy solution to externalities can be applied to sub national governments. Under unitary government taxes can be set at a higher rate than optimal rate. Under federal structure competition among governments will lead to a race to the bottom in the taxes. This is like monopoly and competitive market structures. Compeition among governments creates incentives for the decision makers that are beneficial to the people. Financing of public goods under imperfect information and benevolent government. 1. Taxes not explicitly linked to benefits derived.

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Whether to provide or not a public good? Non rivalry will cause free rider problem. Understating of benefits will lead to less than efficient provision. Poll tax will lead to overstating of benefits.

Finance Commissions: Twelfth finance commission envisaged a rule based fiscal control by recommending the enactment of the FRBM Act by the central and state governments. It mandated uniform deficit reduction targets across the states without discriminating on the basis of different fiscal needs of different states. This has the potential for regional inequality in the delivery of public services across the states in the reform period.