Fiscal federalism: how taxes are distributed between the center and regions
Disclaimer: This article is for educational purposes only. It describes how public revenues and responsibilities may be allocated across levels of government and is not legal, tax, or financial advice.
Fiscal federalism is the rulebook that determines who taxes, who spends, and who compensates whom inside a country with multiple layers of government. In practice it answers three hard questions: (1) which level of government has access to stable tax bases, (2) which level is responsible for big-ticket services (health, education, infrastructure), and (3) how transfers correct mismatches between regional spending needs and regional revenue capacity.
The core tension is structural: centralisation can improve uniformity and redistribution, while decentralisation can improve tailoring, accountability, and policy experimentation. Most real-world systems sit between these poles, using grants, shared taxes (like VAT), and equalisation formulas to keep the system workable.
What “fiscal federalism” includes in practice
Who controls tax bases and rates (personal income tax, VAT/sales tax, corporate tax, property tax), and who administers collection. Tax assignment shapes incentives and determines how sensitive regions are to local economic cycles.
Which services regions must provide (schools, local roads, hospitals) versus which services the center funds nationally (defense, pensions, macro-stabilisation). Spending responsibilities are often “sticky” even when revenue capacity is uneven.
Grants from the center to states/regions to finance national priorities (e.g., co-funded healthcare), smooth recessions, or correct under-provision of key services.
Mechanisms that reduce gaps between rich and poor regions. They can be explicit (equalisation payments) or implicit (shared taxes + spending norms).
Limits and safeguards for subnational debt (hard budget constraints, fiscal rules). Borrowing rules can protect national stability but also constrain regional investment.
Table 1. Tax revenue distribution snapshot (latest comparable year)
Percent shares show how tax revenues are split between the central and regional level. “Transfer share” approximates how much of regional budgets is financed via intergovernmental transfers. Values are shown as a compact cross-country illustration and should be interpreted together with country-specific definitions.
| Country | Central tax share | Regional tax share | Transfers as share of regional budget |
|---|---|---|---|
| USA | 55% | 45% | 30% |
| Canada | 60% | 35% | 25% |
| Germany | 50% | 48% | 15% |
| Switzerland | 60% | 40% | 20% |
Reading tip: a higher regional tax share usually means more subnational autonomy, but it does not automatically mean higher overall efficiency. The transfer share matters because it indicates how strongly regions depend on centrally financed grants and equalisation.
Figure 1. Central vs regional tax shares (illustrative cross-country comparison)
This stacked bar chart visualises the split shown in Table 1. It is useful for quickly comparing how “centralised” the revenue side of the public sector is across systems.
Chart fallback: Your browser blocked the chart script. Here is the same data as a table.
| Country | Central share | Regional share |
|---|---|---|
| USA | 55% | 45% |
| Canada | 60% | 35% |
| Germany | 50% | 48% |
| Switzerland | 60% | 40% |
Note: “central” and “regional” can be defined differently across datasets (e.g., treatment of social security funds or shared taxes). Use the chart to understand relative patterns, not to prove a precise accounting identity.
How fiscal federalism works: mechanisms, incentives, and real trade-offs
The United States: decentralised taxation + big federal grant system
The U.S. is often described as a decentralised system because states and localities rely heavily on their own taxes (property, sales, and state income taxes) and make many service-delivery decisions locally. At the same time, the federal government shapes outcomes through grants, matching funds, eligibility rules, and program standards.
In practical terms, U.S. fiscal federalism works because each level specialises:
- Federal level: broad-based revenue (especially personal income tax) and nationwide programs (defense, pensions, health insurance for seniors), plus grants to states.
- State level: large service responsibilities (education, transportation, health programs) and tax instruments that vary by state.
- Local level: property-tax-based financing of schools and local services, often with strong reliance on the local tax base.
Why it matters: decentralised revenue authority can foster responsiveness, but it also makes outcomes sensitive to regional tax bases — and pushes the system to rely on transfers to keep minimum standards.
International models: three common architectures
Across advanced economies, fiscal federalism usually fits one of three broad architectures. The key difference is not only “who collects”, but also how strongly transfers and shared taxes enforce national solidarity.
- Cooperative / shared-tax model (e.g., Germany): major taxes are collected under harmonised rules, then shared by formula across federal, state, and municipal levels. This reduces tax competition but also narrows room for independent tax-rate experimentation.
- Decentralised autonomy with equalisation (e.g., Switzerland): subnational units have meaningful tax-rate autonomy. The system relies on equalisation and transfers to limit divergence — while still allowing competition.
- Mixed decentralisation + explicit transfers (e.g., Canada): provinces operate major taxes and services, while the federal level uses large transfers (including equalisation and health/social transfers) to sustain comparability across provinces.
Why intergovernmental transfers are unavoidable
In almost every federation, regional governments face a structural gap: their responsibilities (schools, hospitals, local transport) are expensive and politically sensitive, while their tax bases can be volatile or unequal. Transfers solve four problems at once:
- Vertical imbalance: regions spend more than they can reliably raise with their own taxes.
- Equity: richer regions can fund better services unless equalisation offsets fiscal capacity gaps.
- Externalities: services like public health or education generate national benefits, justifying national funding conditions.
- Stabilisation: central budgets can smooth recessions by sustaining transfers when regional revenues fall.
The controversy is about design: formula transparency, conditionality, and whether transfers preserve incentives to develop the local tax base.
Conceptual flow: who collects, who spends, who transfers
The diagram below shows a simplified “flow” that is common to most federations. Exact institutions differ by country, but the logic of collection → pooling → allocation → transfers is consistent.
Central taxes (e.g., income / VAT / payroll) + regional/local taxes (e.g., sales, property, regional income taxes). Administration may be centralised even when revenues are shared.
The center finances national public goods and redistribution; regions/localities deliver proximity services (schools, clinics, roads) — often with mandated standards.
Grants (conditional or block) + equalisation formulas reduce fiscal-capacity gaps, co-fund national priorities, and stabilise regional budgets in downturns.
More autonomy can improve tailoring and accountability; more centralisation can improve equity and coordination. Hybrid designs aim to keep both — but require clear rules and credible enforcement.
Practical check: if regions depend heavily on transfers, they may have limited autonomy even if they “exist” as constitutional entities — because the center can shape outcomes through funding conditions.
Figure 2. Transfer dependence of regional budgets (illustrative)
A second lens is not “who collects” but “who pays for regional spending.” Transfer dependence can be a sign of strong national equalisation — or a sign that regional revenue instruments are weak relative to responsibilities.
Interpretation hint: “low transfer share” does not automatically mean “better system.” It can also mean regions finance spending locally — which may increase disparities if tax bases differ sharply.
Methodology, insights, and practical interpretation
Methodology
This article is an explanatory overview supported by a compact cross-country snapshot (USA, Canada, Germany, Switzerland). The table and charts summarise tax revenue shares by level of government and a simplified indicator of transfer dependence of regional budgets.
How the indicator is interpreted:
- Central tax share = proportion of tax revenues attributed to central government (definitions can differ by dataset, especially for social security).
- Regional tax share = proportion attributed to state/provincial/local government.
- Transfer share of regional budget = an illustrative proxy for how much regional spending relies on intergovernmental transfers.
Limitations: cross-country comparability is constrained by institutional differences (shared taxes, consolidation rules, treatment of social security). Values are best used to compare broad patterns, not to produce fine-grained rankings.
Insights: what the comparison reveals
Even among advanced economies, fiscal federalism is not a single “model” but a set of design choices that reflect history and politics. The comparison suggests four high-level insights:
- Revenue autonomy and service delivery do not always match. Regions can have strong responsibilities but weaker tax bases, making grants structurally necessary.
- Transfers are not a bug — they are the stabilising glue. Without transfers or shared taxes, large differences in tax capacity translate into unequal public services.
- Tax competition is a real incentive channel. When regions set rates, they may attract investment — but the “price” can be underfunded services or shifting the burden to property/consumption taxes.
- Centralisation buys equity and coordination, decentralisation buys tailoring. Sustainable systems usually combine both through transparent formulas and credible fiscal rules.
The policy question is rarely “centralise or decentralise.” It is usually: what should be local, what should be national, and what should be jointly financed — and which level is accountable when outcomes disappoint.
What this means for readers
If you use fiscal federalism to understand real-world policy debates, focus on three practical checks:
- Responsibility map: which level is actually responsible for schools, hospitals, and roads in your country?
- Funding map: how much of that spending is financed locally vs via transfers? High transfer dependence often means that “local autonomy” is partly limited by funding conditions.
- Incentives: do regions keep the benefits of growth (tax base expansion), or do equalisation rules claw it back? The answer shapes local economic-development incentives.
In short: look beyond constitutional labels. Real decentralisation is a combination of revenue autonomy, spending discretion, and predictable transfer rules.
FAQ: fiscal federalism in plain language
Is a higher regional tax share always “better”?
Not necessarily. A higher regional tax share can increase accountability and policy innovation, but it can also widen service gaps if regions have very unequal tax bases. Systems with high decentralisation often need strong, transparent equalisation.
Why do conditional (earmarked) grants cause controversy?
Conditional grants can improve national standards (e.g., healthcare access), but they may also force regions to spend on priorities that do not match local needs — especially when the grant does not cover full costs or when administrative requirements are heavy.
What is the “vertical fiscal imbalance” people talk about?
It means one level of government has the “easy” revenue sources while another level has costly responsibilities. The gap is then closed by transfers. Many federations are built this way because central taxes are broader and easier to administer.
How does equalisation avoid becoming a “punishment for success”?
Good equalisation formulas usually smooth extreme gaps without removing the incentive to grow the local tax base. In practice that means partial, not full, equalisation — and clear rules that limit abrupt changes.
Why do small, rich regions sometimes prefer more decentralisation?
Regions with strong tax capacity may prefer decentralisation because they can keep more of their revenue locally and tailor policies to their electorate. That preference often increases political pressure for explicit national standards or stronger equalisation from poorer regions.
Sources (official / international)
These sources are useful for verifying definitions, understanding transfer design, and cross-checking country statistics.
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OECD — Fiscal Decentralisation Database
Comparative data on revenue and spending shares by level of government (national accounts-based definitions and consolidation notes).
https://www.oecd.org/en/data/datasets/oecd-fiscal-decentralisation-database.html -
OECD Public Finance Data Portal — Fiscal decentralisation theme page
A structured portal view of decentralisation indicators and related public finance datasets.
https://publicfinance.oecd.org/themes/http%3A%2F%2Fpublicfinance.oecd.org%2Ftaxonomy%2Fthemes%23TH44 -
U.S. Census Bureau — Government finances (state & local finance programs)
Primary entry point for nationwide state/local finance statistics (revenues, expenditures, debt).
https://www.census.gov/programs-surveys/gov-finances.html -
Medicaid.gov (CMS) — Medicaid & CHIP enrollment highlights
Official monthly enrollment snapshots that help contextualise scale in shared-responsibility programs.
https://www.medicaid.gov/medicaid/national-medicaid-chip-program-information/medicaid-chip-enrollment-data/september-2025-medicaid-chip-enrollment-data-highlights -
Department of Finance Canada — Major federal transfers
Official breakdown of major transfers to provinces and territories, including Equalization and health/social transfers.
https://www.canada.ca/en/department-finance/programs/federal-transfers/major-federal-transfers.html -
Library of Parliament (Canada) — Equalization formula note
Clear explanation of the equalization mechanism and published totals for specific fiscal years.
https://lop.parl.ca/sites/PublicWebsite/default/en_CA/ResearchPublications/200820E
Reminder: for precise country accounting, always check the methodological notes (consolidation, social security, shared taxes, and treatment of intergovernmental flows).
Download the data & charts archive
ZIP bundle with the article assets: tables (CSV/XLSX) and chart images (PNG) for the fiscal federalism overview.
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