Issues in intergovernmental fiscal transfers: public finance and political economy considerations

The design of intergovernmental transfers has a huge bearing on the efficiency and equity of public service provision as they play a prominent role in financing subnational governments across the world. In the first-generation theory (FGT) of fiscal federalism, they are viewed as economic policy tools to correct imperfections. The FGT assumed that decision makers are benevolent actors who would intervene to provide public goods efficiently. On the other hand, the recently emerged second generation theory (SGT) of fiscal federalism focuses on the political economy implications of transfers and pays attention to the institutional and political incentives that induce or constrain the behaviour of politicians. The SGT sees intergovernmental transfers as a potential tempting target for rent-seeking politics. This chapter summarizes the main arguments of both theories and provides examples from federations.