The Centralization-Decentralization Issue

Fiscal Federalism Principles: A Simple Summary

Dating back to Oates (1972), a large theoretical and empirical literature examines how to assign spending and taxation powers in a federal system. The literature also includes the issue of fiscal discipline, as discussed in von Hagen and Wyplosz (2008). The driving elements of this literature are the presence of externalities and of returns to scale, which favor the federal level, and information asymmetries as well as heterogeneous preferences, which favor sub-federal levels. This immediately alerts us to the fact that any centralization or decentralization choice should result from the balancing of various trade-offs.

The literature has been further refined to take into account the existence of economic and political failures. The existence of such failures means that each choice of the degree of centralization is inevitably in the nature of a second best (in fact a nth best) and depends on both local specific economic conditions and governance aspects. Tommasi and Weinschelbaum (2007) focus on political failures. Governance issues at both the central and sub- central levels lead to a preference for decentralization, largely because it introduces an element of (political) competition meant to provide incentives to improve local dysfuntions. This result comes on top of the usual argument, initially developed by Olson (1971), that smaller constituencies are more homogeneous and, mostly, provide for better control of their politicians than larger ones where voter power is diluted.

The important message is that there is no universally best way of building a federal system. However, this does not mean that "anything goes". Federal institutions must be compatible with the theory's general principles complemented by a careful consideration of specific local and historical circumstances.

European integration is a unique historical experiment inasmuch as it does not explicitly aim at forging a federal state, only at an "ever closer union". The implication is that there are no simple, off-the-shelf, prescriptions coming from an already ambiguous literature. Because a large number of cases imply finely balanced trade-offs, a decision rule is needed. This is the role of the subsidiarity principle. Simply stated, it holds that decision power should be located at the decentralized level unless there is a strong case for centralization. Put differently, decentralization is the default option. However, as written into the Treaty on the Functioning of the European Union (TFEU), Art. 5(3) provides a less clear-cut definition. It recognizes the presence of trade-offs and does not really sets decentralization as the default option. The Court of Justice of the European Union, which has the last word on the matter, has generally taken a pro-centralization view of ambiguous cases.