The Dilemma of Fiscal Federalism: Grants and Fiscal Performance around the World

This article uses cross-national data to examine the effects of fiscal and political institutions on the fiscal performance of subnational governments. Long-term balanced budgets among subnational governments are found when either (1) the center imposes borrowing restrictions or (2) subnational governments have both wide-ranging taxing and borrowing autonomy. Large and persistent aggregate deficits occur when subnational governments are simultaneously dependent on intergovernmental transfers and free to borrow-a combination found most frequently among constituent units in federations. Time-series cross-section analysis reveals that as countries increase their reliance on intergovernmental transfers over time, subnational and overall fiscal performance decline, especially when subnational governments have easy access to credit. These findings illuminate a key dilemma of fiscal federalism and a more precise notion of its dangers: When constitutionally or politically constrained central governments take on heavy cofinancing obligations, they often cannot credibly commit to ignore the fiscal problems of lower-level governments.