Rethinking the division of tax room and revenue in fiscal federalism

Abstract

The division of tax room for shared tax bases, such as income taxes in Canada, the United States, Australia, and Switzerland, is a frequent cause of political conflict between national and sub-national governments. Economists and legal scholars have developed a theory that sets out an optimal division of tax room, but federal nations often substantially depart from this prescription by allocating too much or too little tax room to national governments. This article argues that the divergence between theory and actual practice can be partially explained by a ‘credit assignment problem’ that affects the political economy of government decision making. To illustrate, the article develops a model to identify the incentives governments face when dividing tax room. The model’s central observations are that (a) the optimal division of tax room requires robust intergovernmental contracting, but (b) the necessary contracts are difficult or impossible to perform due to problems in allocating political credit – electoral rewards and punishments – between the two levels of government. The result is political conflict and, frequently, a sub-optimal division of tax room and the revenue that results. This article argues that law can perform two functions in responding to the credit assignment problem: (a) it can facilitate credit assignment, so that the necessary contracts over tax room and revenue are politically feasible, and (b), failing perfect credit assignment, it can mitigate the welfare effects of a sub-optimal division of tax room. The article shows how a credit assignment perspective should lead to reconsideration of constitutional law doctrines, such as the federal spending power and various doctrines that enable or limit concurrent expenditure jurisdiction. While these doctrines are the subject of long-running debates in legal scholarship, the credit assignment perspective offers new insights and new doctrinal prescriptions.