Fiscal Federalism: Lessons from Five Federations

Fiscal federalism is the question every federation must settle first: which level of government raises which taxes, and which level pays for which services. Get the answer right and the union grows stronger with time. Get it wrong and the provinces or states spend their energy bargaining for handouts instead of governing. Mian Ashiq Hussain, writing in How Constitutions Flourish or Fail, reads the history of the world's leading federations through this single lens.

His conclusion is consistent across countries. Federations hold together when each tier can raise what it spends and answer for it. Where money is collected at the centre and handed down, dependence and resentment follow. This essay follows his comparison of five federations, the United States, Switzerland, Germany, India and Canada, and draws out the lessons he offers newer federations such as Pakistan.

What is fiscal federalism?

Fiscal federalism is the division of taxing and spending powers between a national government and its states, provinces or cantons. For the author, it is the real test of a federation: a list of legislative subjects means little unless each tier also controls revenue of its own and is accountable for how it uses it.

He stresses that the lists printed in a constitution are not a reliable guide to how federal a country really is. Two federations can share almost the same division of subjects yet end up very differently, because what matters is who controls the purse. A level of government that funds its own budget can plan, experiment and compete. A level that waits for transfers can only lobby. The rest of his comparison shows how the five federations below arrived at their present balance, and why some kept their units strong while others drifted towards the centre.

How did the United States build its fiscal union?

The American union was built on money. The author points out that the first national government under the Articles of Confederation failed because it could not pay its way. The 1787 Constitution, and Alexander Hamilton's financial measures that followed, gave the union a sound fiscal base while leaving residual powers with the states.

In his account, the federalists read the new Constitution with one aim in mind: never to repeat the collapse of 1781. Hamilton's programme created a national bank and a mint, levied an excise on distilled spirits, kept tariffs low and had the federation take over the war debts of the states. Trade and industry flourished, revenue rose, and the close tie between the national government and the business community gave the union a firm footing.

Over the following two centuries, the federal government grew far beyond the founders' expectations. The author lists the reasons: the expansion from 13 to 50 states, broad Supreme Court readings of the power to tax and to make laws that are necessary and proper, the Northern victory in the Civil War, the technological leaps of the twentieth century, the Great Depression and the New Deal, two world wars and the rise of international organisations. Yet the original federal design acted as a brake. The national government grew, but not by swallowing the states. All tiers expanded; Washington simply expanded faster. The American story also began from the bottom up, with colonial assemblies that raised taxes with local consent, a history the author explores in Local Self-Government: Nordic, Indian and Pakistani Lessons.

Why does Switzerland give cantons real taxing power?

Switzerland was designed as a union of cantons that would give the centre only the powers it needed to survive. The author notes that its constitution lists no exclusive federal powers, grants no general spending power, and limits federal taxation in duration and extent, so cantons and municipalities still decide most public income and spending.

The Swiss framers of 1848 took a middle path between America's weak Articles of Confederation and its stronger 1787 Constitution. The federal administration is small, and the laws it passes are mostly carried out by the cantons. The author regards Switzerland as one of the most durable federations of the modern era, and he traces its success to cooperation. The constitution obliges the federation and the cantons to support each other, while defence, trade and the harmonising of law belong to the centre. The Swiss sum this up as one army, one market and one law.

Switzerland has not stood still. To narrow the gap between richer and poorer regions, the fiscal role of the federation has grown through many constitutional amendments since 1874, and the constitution has been totally revised twice. Even so, the author finds that the bottom-up structure survives: cantons kept their wide original autonomy and still share sovereignty with the federation. Referendums keep the system legitimate in a country of several cultures, because each community can see the state as its own.

How does Germany hold richer and poorer regions together?

Germany, in the author's reading, is a special case: a welfare federation built on shared powers rather than delegated authority. Much of what the Länder do is shared with other Länder or with the federal government, and that habit of cooperation let West Germany absorb the far poorer East after 1990.

The Basic Law began as a compromise between German delegates who wanted a more centralised state and the Western Allies, who preferred a looser one. At first the federation made most of the laws and the Länder ran most of the administration. Over the decades, the author argues, relations matured through coalition and consensus rather than command. He draws on the history of the Saar, which twice voted against separation from Germany, as evidence that cohesion grows from consent.

Reunification is his strongest example. West Germany carried the heavy cost of raising living standards in the East, and transfers continued long after. Most Germans in both parts of the country, he notes, still regard reunification as good for Germany, and even Bavarian separatism lost ground. His lesson is that national integration depends on investing in public welfare and giving every tier of government room to develop. A federal system that helps its units realise their productive potential is, in his words, a tested road to national unity.

Why does India's fiscal federalism lean towards the centre?

India inherited a unitary habit from the Government of India Act of 1935. The author argues that its constitution gives the Union a very long list of exclusive subjects, a dominant role in the concurrent field and all residuary powers, while its Finance Commission distributes revenue without vertical fiscal balance, leaving states little room to build capacity.

He shows how far the Union's reach extends. Parliament can take control of any industry it declares to be in the public interest, and that power was once used to regulate goods as minor as matches and zip fasteners. Central planning shaped state economies. All-India Services, managed from the centre, staff senior state posts. The Rajya Sabha cannot balance the weight of the populous states, and the constitution can be amended without the states' consent. Emergency provisions, including President's Rule and central control over state spending, have a strongly centralising effect, and governors have often behaved as agents of the Union.

On money, his verdict is that South Asian constitutions kept colonial financial procedures, leaving much of the budget beyond a legislative vote, and that revenue collection and distribution became even more centralised than under the 1935 Act. India's Finance Commission works under law made by Parliament, which is a real difference from Pakistan, as the essay on the NFC Award and how federations share revenue explains. Yet a commission that shares out central collections, without giving states taxes of their own, cannot by itself create a competitive federation.

What is vertical fiscal imbalance and why does it matter?

Vertical fiscal imbalance is the gap between what a lower tier of government must spend and what it can raise itself. The author treats it as the central weakness of centralised federations: when provinces depend on transfers, their own revenue capacity withers, accountability blurs and every round of revenue sharing becomes a quarrel.

Canada shows the opposite path. Its provinces were given direct taxes that grew with the economy, and fiscal self-reliance made Canada more decentralised over time. Australia, which began with strong states, became highly centralised once the Commonwealth controlled the main taxes and used grants as leverage. The author tells that contrast in detail in The Historical Role of Financial Governance in Federal Evolution.

Pakistan sits at the far end of the imbalance. The federation collects the major taxes, the provinces receive shares of a divisible pool, and local government has almost no revenue of its own. In the author's view, this design pre-empts healthy competition between provinces, shrinks their capacity to collect revenue and gives every underperforming government a ready excuse. The 2010 changes enlarged the provincial share of the pool but did not hand over taxing power, as discussed in The 18th Amendment in Pakistan: Devolution Compared.

What lessons apply to newer federations?

He draws four lessons. Give every tier taxes of its own. Keep exclusive federal powers to truly common fields such as defence, currency and external trade. Treat fields such as the environment and population planning as national concerns rather than provincial ones only. And treat the federal bargain as a contract between partners, not as a delegation from the centre.

He warns against copying early American federalism without its context. The United States strengthened its centre because its first national government had been too weak to survive. Post-colonial federations in South Asia face the reverse problem: governments modelled on imperial power structures that are already too strong. For them, the path forward lies in moving real fiscal power downwards, so that provinces and local governments can innovate, compete and be judged on results.

Finally, he ties fiscal federalism to democracy itself. Where taxes are raised close to the people who pay them and spent with the approval of their representatives, citizens identify with the state. Where money flows from a distant centre, they feel governed rather than represented. That idea runs through his wider argument in Why Constitutions Fail, and What Makes Them Flourish and across all of Mian Ashiq Hussain's essays.

Frequently asked questions

What is an example of fiscal federalism?

Switzerland is the author's clearest example. Its cantons and municipalities control most public income and spending, the federation's power to tax is limited in time and scope, and federal laws are largely administered by the cantons, which keeps a bottom-up union intact.

What is vertical fiscal imbalance?

It is the mismatch between the spending duties of states or provinces and the revenue they can raise themselves. The author argues that where this gap is filled by central transfers rather than by tax powers, lower tiers become dependent and lose both capacity and accountability.

Is India fiscally federal?

In the author's view, only partly. India's constitution is federal in form, but the long Union List, residuary powers, central services, emergency provisions and centralised revenue distribution give it strong unitary features inherited from the Government of India Act of 1935.

Why has the Swiss federation lasted so long?

The author credits cooperation between the federation and the cantons, wide cantonal autonomy, a small federal administration, a flexible constitution revised twice in full, and direct democracy through referendums, which lets each cultural community see the state as its own.

Read the full argument

This essay compares five federations. The book goes further, tracing how fiscal design shaped the fate of states from the American colonies to the break-up of Pakistan in 1971, and setting out the author's agenda for reform. Read it in How Constitutions Flourish or Fail.