PUBLIC FINANCE
FISCAL FEDERALISM
4. lecture
Ing. Veronika Volfová
veronika.volfova@mvso.cz

Fiscal Federalism
•Fiscal federalism represents a system enabling different groups living in various regions to
express diverse preferences regarding public goods. It examines the roles of different government
levels and relationships between them.
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•This system exists in both federal and unitary arrangements, addressing the allocation of fiscal
responsibilities across multiple tiers of government.
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Theory of Fiscal Federalism
•Multi-level Budgetary System
•Fiscal federalism creates a multi-level system of public budgets, where financial responsibilities
are distributed among different levels of government – typically central, regional, and local
governments.
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•Each level performs different functions:
•central government handles macroeconomic stability, defence, or national policies,
•regional governments coordinate development and infrastructure,
•local governments provide services closest to citizens, such as schools, waste management, or
local transport.
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•The purpose of this system is to increase efficiency and responsiveness, because local governments
understand local needs better than the central authority.

Theory of Fiscal Federalism
•The theoretical basis of fiscal federalism comes from the allocative function of public finance,
which deals with the efficient provision of public goods.
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•Different regions often have different preferences for public services. For example:
•urban regions may prioritise public transport and infrastructure,
•rural areas may prioritise agricultural support or road maintenance.
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•Decentralisation allows these services to be adapted to local preferences, improving the
efficiency of public spending.

Theory of Fiscal Federalism
•Regional differences arise due to:
•economic development levels,
•demographic structure,
•geographic conditions,
•and local policy priorities.
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•For example:
•richer regions can collect higher tax revenues,
•poorer regions may depend more on intergovernmental transfers.
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•Because of these differences, fiscal federalism must also include equalisation mechanisms to
reduce regional disparities.

Theory of Fiscal Federalism
•It addresses vertical and horizontal budget structures, fiscal centralisation degree, and
distribution of fiscal powers.
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•Vertical budget structure
•Refers to the relationship between different levels of government budgets (central, regional,
local).
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•The key question is:
•Which level of government should be responsible for specific taxes and expenditures?
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Theory of Fiscal Federalism
•Horizontal budget structure
•Deals with relationships between governments at the same level, for example between regions or
municipalities.
•The main issue is regional inequality, because some regions have stronger tax bases than others.
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•Degree of fiscal centralisation
•Refers to how much financial power is concentrated at the central government level.
•Countries differ significantly:
•high centralisation → most taxes collected by central government
•higher decentralisation → local governments collect and manage more revenue.
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Theory of Fiscal Federalism
•Distribution of fiscal powers includes:
•tax authority (who collects which taxes),
•expenditure responsibility (who pays for which services),
•transfer mechanisms (grants or shared taxes).
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Principles of Fiscal Federalism
•Fiscal federalism is based on several principles that help determine which level of government
should perform specific public finance functions.
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•These principles are closely connected to the main functions of public finance, especially:
•allocation,
•redistribution,
•and economic stabilisation.
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Principles of Fiscal Federalism
•The goal is to organise the multi-level public finance system in a way that ensures:
•efficient provision of public services
•fair distribution of resources
•and macroeconomic stability.
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•The following principles explain how these responsibilities should be divided between central,
regional, and local governments.
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Principles of Fiscal Federalism
•1. Diversity Principle
•The diversity principle states that fiscal arrangements should reflect the different preferences
and needs of citizens in various regions.
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•Different regions may require different types of public services depending on their economic
structure, population, or geographic conditions.
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•Local governments are usually better able to respond to these differences because they are closer
to the citizens.
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Principles of Fiscal Federalism
•Examples:
•large cities may invest more in public transport and cultural institutions
•rural areas may prioritise road infrastructure or agricultural support
•tourist regions may spend more on tourism infrastructure and environmental protection
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•In the Czech Republic, for example, Prague invests significantly in cultural services, while
smaller municipalities often prioritise basic infrastructure and local services.
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Principles of Fiscal Federalism
•2. Equivalence Principle
•The equivalence principle suggests that those who benefit from public services should also
participate in decisions about their provision and financing.
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•This principle improves the efficiency of public spending because the people who pay for the
services are also those who use them.
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•Local governments therefore often manage services that mainly benefit local residents.
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Principles of Fiscal Federalism
•Examples:
•municipalities finance local roads, street lighting, and waste collection
•these services are funded by local taxes and fees
•residents influence these decisions through local elections and municipal councils
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•This creates a stronger connection between taxpayers, decision-makers, and beneficiaries.
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Principles of Fiscal Federalism
•3. Centralised Redistribution
•Redistribution of income should generally be handled by the central government.
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•If redistribution policies were implemented at the regional level, individuals might move to
regions with more generous social benefits, which could create regional imbalances.
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•Centralised redistribution helps ensure equal living standards and social protection across the
entire country.
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Principles of Fiscal Federalism
•Examples:
•national social security systems
•pensions
•unemployment benefits
•income support programmes
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•In the Czech Republic, these programmes are primarily financed and administered by the central
government.
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Principles of Fiscal Federalism
•4. Centralised Stabilisation
•Macroeconomic stabilisation policies should also be managed at the central government level.
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•Stabilisation policies aim to reduce economic fluctuations, control inflation, and support
economic growth.
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•Regional or local governments usually do not have sufficient fiscal capacity to influence the
national economy.
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Principles of Fiscal Federalism
•Examples:
•state budget deficits or surpluses used to influence economic activity
•national fiscal stimulus programmes
•coordination with monetary policy conducted by the central bank
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•Regional governments may support these policies through regional development programmes, but the
main responsibility remains with the central government.
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Models of Fiscal Federalism
•Fiscal federalism studies how public finances are divided and managed between different levels of
government.
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•Countries organise these relationships differently depending on their political structure, level
of decentralisation, and economic disparities between regions – they use vertical and horizontal
model.
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Models of Fiscal Federalism
•Vertical Model
•The vertical model of fiscal federalism focuses on the distribution of financial resources and
responsibilities between different levels of government (central → regional → local).
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•It answers questions such as:
•Which level of government collects taxes?
•Which level provides public services?
•How are revenues redistributed between levels?
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•In this model, each level of government typically has defined competencies and sources of revenue.
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Models of Fiscal Federalism
•Example: Czech Republic
•The Czech Republic uses elements of the vertical model through the tax revenue sharing system.
ØMajor taxes (VAT, income taxes) are collected centrally.
ØRevenues are then redistributed between the state, regions, and municipalities according to
predetermined formulas.
ØMunicipalities and regions receive a fixed share of national tax revenues.
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•For example:
ØMunicipalities receive a portion of VAT and income taxes
ØRegions receive a share mainly to finance education, transport, and healthcare infrastructure
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Models of Fiscal Federalism
This system ensures that lower levels of government have funding even if they cannot collect large
taxes themselves.

Models of Fiscal Federalism
•Horizontal Model
•The horizontal model of fiscal federalism focuses on financial relationships between governments
at the same level.
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•Its main goal is to reduce economic disparities between richer and poorer regions.
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•Without such mechanisms, wealthier regions with strong economies could provide much better public
services, while poorer regions would struggle.
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Models of Fiscal Federalism
•Common tools  used in the horizontal model include:
oEqualisation transfers
oIntergovernmental grants
oRedistribution mechanisms
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•These mechanisms redistribute resources so that all regions can provide comparable levels of
public services.
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Models of Fiscal Federalism
•Example: Germany
•Germany uses a well-known horizontal fiscal equalisation system (Länderfinanzausgleich).
oWealthier federal states (e.g., Bavaria, Baden-Württemberg) contribute more to the system.
oLess wealthy states (e.g., Saxony-Anhalt, Mecklenburg-Vorpommern) receive transfers.
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•This helps maintain similar living standards across the country.
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Implementation Types
•The vertical model can be implemented in several different ways depending on how much fiscal power
is given to lower levels of government.
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•Vertical model subdivides into:
1.centralised,
2.decentralised,
3.and combined approaches.
4.
•Each offers distinct advantages.
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Centralised model
Central Government
Controls majority of revenue
Regional Governments
Limited financial autonomy
Local Autorities
Minimal self-sffuciency
This model concentrates revenues in the central budget. Lower governments receive redistributed
funds through vertical transfers, primarily grants. Czechoslovakia operated this system until 1990.
Advantages include unified tax policy. Disadvantages include limited autonomy for municipalities.

Deccentralised model
•Complete Financial Independence
•Lower government levels achieve full self-sufficiency. This remains theoretical and doesn't exist
in practice.
•Direct Revenue-Expenditure Link
•Clear connection between collected revenues and spending responsibilities creates accountability.
•Extensive Tax Authority
•Local governments possess significant taxation powers. This increases administrative demands
substantially.
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Combined model
•Hybrid Approach
•Merges centralised and decentralised models. Most democratic states implement this pragmatic
solution, including the Czech Republic.
•Multiple Revenue Sources
•Government levels maintain own revenue streams. For example, Prague collects property taxes and
receives shared taxes.
•Supplementary Funding
•Higher budgets augment lower-level revenues. Czech municipalities receive redistributed VAT and
income tax portions.
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Fiscal Federalism in the Czech Republic
The Czech Republic employs a combined model with decentralising elements. Prior to 1990,
Czechoslovakia used a centralised system.
Neither municipalities nor regions achieve financial self-sufficiency. Tax revenue allocation
provides essential funding for local governments.

Fiscal Federalism Framework
•Fundamental Concept
•Fiscal federalism organises multi-level budgetary systems. It allows regional differences based on
local preferences and needs.
•Model Types
•Vertical models include centralised, decentralised, and combined approaches. Horizontal models
address inter-regional relationships.
•Czech Implementation
•Czech Republic employs a combined model with decentralising elements. Tax sharing provides
essential municipal funding.
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