Fiscal Federalism: How Taxes Are Shared Between Central and Regional Governments
Fiscal federalism: how taxes are distributed between the center and regions
Fiscal federalism is the system that decides which level of government raises money, which level spends it, and how fiscal gaps between richer and poorer places are corrected. The subject covers central governments, states, provinces, regions, municipalities and other subnational public authorities.
This evidence brief explains fiscal federalism as an institutional framework rather than as a country comparison. It focuses on tax assignment, tax sharing, own-source revenue, intergovernmental transfers, equalisation and fiscal rules. Country examples are excluded to keep the framework comparable across different constitutional and budget systems.
Source type: official and institutional methodology sources from OECD, IMF and World Bank. Coverage: fiscal federalism framework. Unit: qualitative institutional evidence. Direction: stronger subnational tax autonomy can improve accountability, but only when spending duties, revenue authority, transfers and borrowing limits are aligned.
Direct answer
Central governments usually keep the broadest and most mobile tax bases because they are better placed to manage redistribution, macroeconomic stability and nationwide tax administration. Regional and local governments are usually better suited to taxes linked to immobile bases or local services, such as property taxes, user charges and some local fees. When subnational spending duties exceed their own revenue capacity, the gap is closed through shared taxes, unconditional grants, conditional grants or equalisation transfers.
Key concepts in fiscal federalism
Expenditure assignment defines which level of government is responsible for schools, roads, health services, water, public safety or social programmes.
Revenue assignment defines who controls tax bases, rates, reliefs, administration and final use of the revenue.
A vertical fiscal imbalance appears when subnational expenditure responsibilities are larger than subnational own-source revenue.
A horizontal imbalance appears when regions at the same government level have different tax capacity or different service-cost pressures.
Overview: from tax base to public service
A workable fiscal federal system links four decisions. Expenditure assignment says which level of government must deliver a service. Revenue assignment says which level can raise money. Intergovernmental transfers move money across levels of government to close fiscal gaps. Borrowing and debt rules decide when subnational governments may finance investment and how fiscal risk is controlled.
The most important distinction is between tax autonomy and tax revenue share. A region may receive a large share of a centrally collected tax without controlling the tax base, the rate or the collection system. That gives funding but not autonomy. By contrast, a smaller local tax can create stronger accountability if voters can connect the tax bill to local service quality.
Tax distribution should therefore be read as an institutional chain. A centrally administered VAT can be partly shared with regions. A personal income tax can have a national base with a regional surcharge. A property tax can be local in principle, but weak valuation, low collection capacity or political resistance can make it less effective in practice.
Conceptual evidence table: tax distribution mechanisms
The table below explains the main mechanisms used to distribute tax powers and public revenue between central and subnational governments. Each row names the source that supports the concept and explains what the source is used for.
| Evidence item | Mechanism | How the money is distributed | Source note |
|---|---|---|---|
| Expenditure assignment | Assignment | Spending duties are assigned to the level of government expected to deliver the service effectively, such as central, regional or local government. | World Bank Primer, 2023: confirms expenditure assignment as one of the four pillars of fiscal decentralization. |
| Revenue assignment | Assignment | Tax powers are divided by who controls the tax base, rate, reliefs, administration and final claim on revenue. | World Bank Primer, 2023; IMF Chapter 3, 1997; OECD Tax Autonomy Indicators, 1995 to 2024. |
| Tax autonomy | Assignment | Subnational governments have stronger autonomy when they can set rates, adjust reliefs or influence the tax base, not merely receive a fixed share. | OECD Fiscal Decentralisation Database, Tax Autonomy Indicators, table series 1995, 2000 to 2024. |
| Personal income tax surcharge | Assignment | The center may define the national base while regions set an additional surcharge or receive limited rate-setting authority. | OECD tax autonomy typology and IMF tax-assignment framework: used to distinguish rate control from revenue receipt. |
| Corporate income tax | Assignment | Often assigned mainly to the central level because corporate profits are mobile and can create tax competition or base allocation disputes. | IMF Fiscal Federalism in Theory and Practice, Chapter 3, 1997: tax assignment and mobile tax bases. |
| VAT or broad consumption tax | Sharing | The center commonly administers the tax, while a formula can distribute part of the revenue to regions. | IMF Chapter 3, 1997 and World Bank Primer, 2023: used for tax assignment and shared-revenue distinction. |
| Derivation-based sharing | Sharing | Revenue is distributed according to where it is collected, even when subnational governments do not control the base, rate or sharing rule. | World Bank Primer, 2023: describes centrally collected revenue shared by derivation without local control. |
| Property tax | Own-source | Usually fits local or regional governments because land and buildings are immobile and connected to local infrastructure and services. | World Bank Primer, 2023; OECD sub-central tax autonomy work: used for local revenue assignment. |
| User fees and charges | Own-source | Local governments may charge for identifiable services such as permits, water, waste, transit facilities or local amenities. | World Bank Primer, 2023: connects fees and user charges to local service assignment and collection capacity. |
| Unconditional grants | Transfer | The center transfers funds with broad discretion for the recipient government, often to reduce vertical fiscal imbalance. | World Bank Primer, 2023 and IMF transfer framework, 1997: used for grant and vertical-gap concepts. |
| Conditional grants | Transfer | Funds are transferred for a defined purpose, such as health, education or infrastructure, to protect national standards or policy priorities. | World Bank intergovernmental transfer guidance and IMF transfer framework: conditional versus unconditional transfers. |
| Equalisation transfers | Transfer | Resources are transferred to reduce differences in fiscal capacity or expenditure needs across subnational governments. | OECD Working Papers on Fiscal Federalism No. 36, 2021: defines fiscal equalisation and compares equalisation modes. |
| Borrowing and debt rules | Rule | Regions may borrow for investment, but rules limit deficits, guarantees, debt stock or central bailout expectations. | World Bank Primer, 2023: local borrowing and capital finance as the fourth pillar; IMF work covers macro-fiscal risk. |
| Soft budget constraint | Rule | Fiscal discipline weakens when subnational governments expect the center to rescue them after overspending or excessive borrowing. | IMF fiscal federalism literature and World Bank Primer, 2023: used for subnational fiscal sustainability risk. |
Table note: the rows explain fiscal mechanisms rather than measured country values. The table does not use projections, rankings or numeric fiscal shares. Source snapshot checked on June 18, 2026.
Framework chart: where fiscal tools usually fit
This chart is a qualitative placement map, not a measured score. Longer bars mean the tool is usually closer to central-government control; shorter bars mean the tool is usually closer to regional or local control. The widths are visual positions only and are not percentages, index values or statistical estimates.
Methodology: how to read this fiscal federalism brief
The article uses a framework approach because fiscal federalism is defined by legal powers, tax control and transfer rules, not by one universal score. A numeric country comparison would need consistent country-year data on tax categories, government levels, revenue values, tax autonomy and transfer formulas.
Metric
The subject is institutional tax distribution: who controls tax bases, tax rates, tax collection, shared revenue, transfers and borrowing rules.
Tax autonomy vs tax share
Tax autonomy means control over the instrument. Tax share means receiving revenue. A region can receive money without controlling the tax.
Vertical imbalance
This occurs when subnational spending responsibilities exceed subnational own-source revenue before transfers are counted.
Horizontal imbalance
This occurs when regions at the same level have different revenue capacity or expenditure needs.
Equalisation
Equalisation transfers reduce differences in fiscal capacity or spending needs, but their design can affect incentives and perceived fairness.
Soft budget constraint
A soft budget constraint appears when subnational governments expect the center to rescue them from overspending or debt stress.
The source hierarchy gives priority to institutional methodology sources from OECD, IMF and World Bank. OECD is used for tax autonomy, fiscal decentralisation indicators and equalisation concepts. IMF is used for tax assignment, tax administration and macro-fiscal risk. World Bank is used for the four pillars of fiscal decentralisation, local public finance, intergovernmental transfers and local borrowing.
The brief does not measure tax burden, tax rates, public-sector size, government quality, service outcomes, corruption, redistribution or living standards. It explains how public money powers can be assigned across levels of government and why the same tax can mean different things depending on who controls the base, rate, collection and final use.
Insights from the framework
Key insight
Fiscal federalism works best when spending responsibility and financing responsibility point in the same direction. Unfunded mandates weaken service delivery and blur accountability.
Notable pattern
Broad, mobile and redistributive taxes usually stay closer to the center. Immobile and benefit-linked revenues fit better at the regional or local level.
Transfer dependence
Transfers are not a temporary flaw. They are a normal part of fiscal federalism because service responsibilities are often more decentralised than revenue capacity.
Interpretation risk
A system can look decentralised because regions receive money, yet remain centralised if they cannot set rates, define bases or decide how funds are used.
The practical test is not whether a country is labelled federal or unitary. The test is whether the fiscal architecture gives each government level enough authority, enough resources and enough discipline to deliver its assigned functions. A shared tax can provide stable funding, but it may not create local accountability. A local tax can create accountability, but it may not raise enough money in poorer jurisdictions.
What this means for readers
For taxpayers, fiscal federalism affects which public services feel local and which feel national. Property taxes, local fees and regional surcharges are more visible because residents can often connect them to roads, schools, waste collection, permits, transit or local infrastructure. Shared taxes and transfers are less visible, but they often finance the same services behind the scenes.
For businesses, the design of tax distribution affects compliance complexity. A single national VAT may be easier to administer than multiple local sales taxes. At the same time, regional surcharges, local property taxation, business permits and subnational fees can influence where firms invest, hire and locate facilities.
For public policy, the main question is not whether decentralisation is automatically good or bad. The question is whether the rules connect authority, funding and accountability. A region with spending duties but no revenue tools becomes dependent. A region with revenue autonomy but weak debt rules can create fiscal risk. A region with both authority and discipline can make service trade-offs clearer to voters.
FAQ: fiscal federalism and tax distribution
Who decides which taxes belong to the central government and which belong to regions?
That decision is made through a country’s constitution, fiscal laws, intergovernmental agreements and budget institutions. The technical question is which level can best manage the tax base, rate, administration and accountability link.
What is the difference between tax assignment and tax sharing?
Tax assignment is about control over a tax instrument. Tax sharing is about dividing the revenue after collection. A regional government can receive a share of VAT without controlling the VAT rate or base.
Why are broad taxes like VAT often centralised?
Broad consumption taxes require consistent rules, input-credit administration and compliance systems. Central administration can reduce fragmentation, tax competition and enforcement problems, while revenue can still be shared by formula.
Why is property tax often local?
Property is fixed in place and connected to local services, land use and infrastructure. This makes it more suitable for local accountability than taxes on mobile profits or high-income taxpayers.
What is vertical fiscal imbalance?
Vertical fiscal imbalance occurs when subnational governments are responsible for more spending than they can finance from their own revenue. Transfers or shared taxes are used to close the gap.
What is horizontal fiscal imbalance?
Horizontal fiscal imbalance occurs when regions at the same government level have different tax capacity or different spending needs. Equalisation transfers are designed to reduce these differences.
Do transfers reduce regional autonomy?
It depends on the transfer design. Unconditional grants give more discretion. Conditional grants protect national priorities but can limit local choice. Formula-based transfers are usually more predictable than ad hoc bargaining.
Can fiscal federalism create debt problems?
Yes. If subnational governments borrow heavily and expect central bailouts, fiscal discipline can weaken. Debt limits, transparent reporting and credible no-bailout rules are used to reduce that risk.
Sources
The sources below define the fiscal federalism concepts used in the article: tax autonomy, revenue assignment, transfers, equalisation and subnational borrowing.
OECD Fiscal Decentralisation Database
Used for tax autonomy indicators, revenue/spending shares and the distinction between tax control and revenue receipt.
OECD Working Papers on Fiscal Federalism No. 36
Used for the definition and interpretation of fiscal equalisation, fiscal capacity and expenditure needs.
World Bank Fiscal Decentralization Primer
Used for the four pillars: expenditure assignment, revenue assignment, intergovernmental transfers and local borrowing.
World Bank Intergovernmental Fiscal Transfers
Used for transfer principles, grant design and the role of fiscal transfers in local public finance.
IMF Fiscal Federalism in Theory and Practice
Used for tax assignment, tax administration, revenue sharing, transfers and macro-fiscal risk in fiscal federal systems.
OECD/UCLG WOFI
Used as a global reference for subnational government finance, decentralisation frameworks, subnational revenue, expenditure and debt context.
World Observatory on Subnational Government Finance and Investment
