An important function of federal constitutions is to establish how resources are allocated to the different levels of government. These resources include public service, money, taxing power, and natural resources. Since providing adequate financial resources is a necessary pre-condition for political and administrative decentralization, the rules that determine resource distribution play an important role in establishing the structure of a federal system. Resource should be allocated in proportion to the services and other tasks that each level of government is responsible for implementing. Equally, the responsibility for raising resources should be given to the level of government that needs to use them.

However, in some cases a government may be better at raising resources, but may not need the resources for itself. This issue arises most clearly in the area of taxation. The most productive type of taxes (corporate tax, customs duties) is most efficiently raised and collected by the national government, yet a part of that revenue may be best spent in the sub-national units. In other cases, a regional government may be capable of raising much more revenue than another. To resolve such issues, and to uphold the general principle of equalization of resources and development, a complex scheme of taxation and revenue distribution is often required.

Central governments are usually responsible for major taxing powers such as customs, excise and corporate income taxes. In case of India and Austria, personal income tax is also the responsibility of central government. Central and regional governments usually share sales and consumption taxes in most federations. In general, central governments usually have more power to collect revenue than regional governments.

The most important areas of financial co-operation in federal states are taxation and fiscal equalization. The right to tax (or at least to influence levels of taxation) gives regions control over their income. This is a crucial precondition for political autonomy. Regions which depend on federal generosity find it difficult to oppose policy initiatives which come from central government. Without their own resources, regions are forced to co-operate in almost every matter with the central government.

Taxation

We can distinguish two models of taxation policies in federal states. Once again, the degree of decentralization that exists in a federal system is likely to affect the distribution of tax powers between the two levels of government. Taxation in Decentralized Models Political power is more balanced in a system of separate (and sometimes dual) taxation, which we find in the United States and Canada, where the states or provinces have their own taxation powers and can add their regional taxes to the federal ones (especially sales taxes).

Taxation in Cooperative Models

In Germany the federal level has a near monopoly with regard to tax raising powers. Tax laws are only made at the federal level. The regional governments are involved in the process of federal taxes legislation through the Bundesrat (the upper house where regional governments are represented on the national level).

Tax receipts are distributed to the federal, regional and the local level on the basis of fixed formulas. The revenues created by (sales tax, personal income tax, and corporate income tax, (which make up more than 70 per cent of all tax income), are shared between the three levels of government.

Fiscal Equalization

Fiscal equalization is the transfer of financial resources to sub-national governments. Its main objective is to allow sub-national governments to provide their citizens with similar sets of public services at a similar level of taxation. Fiscal equalization supports fiscal decentralization by correcting potential imbalances that result from sub-central autonomy. Fiscal equalization arrangements are necessary in all federal states. They increase the sustainability of federal states by supporting poorer regions through re-distributing tax income.

The easiest solution for the problem of diversity in regional tax income is the redistribution of federal tax income to the sub-unit government. This is called vertical equalization and is used in in Austria, Australia and Spain.

A different kind of fiscal equalization is horizontal equalization. Horizontal equalization requires sub-unit governments to support each other. Richer regions help poorer regions to make sure that they can provide similar services at a similar tax rate. Horizontal taxation does not assume that this assistance will occur indefinitely. Rather transfers continue until poorer regions have developed the capacity to raise the necessary revenue by them.

In principle, all financial equalization policies are intended to provide temporary assistance until a sustainable revenue raising capacity of all regional governments can be established. Financial support by other regions or the federal level is supposed to help those regions that cannot help themselves so that the economic underdevelopment of a region should not be a permanent status.

Fiscal Equalization in South Africa South Africa has a Commission with the responsibility to make recommendations about allocation of revenue raised nationally to the provinces taking into account various criteria including: • The need to ensure that the provinces and municipalities are able to provide basic services and perform the functions allocated to them • The fiscal capacity and efficiency of the provinces and municipalities • Developmental and other needs of provinces, local government and municipalities • Economic disparities within and among the provinces • Obligations of the provinces and municipalities in terms of national legislation. Source: The Constitution of the Republic of South Africa (1996)

The Case Study: Natural Resource revenues in Pakistan Natural-resource revenues come principally from royalties, license fees, export taxes, and corporate taxes. They are by far the largest source of revenues in Nigeria, where the central government collects them, and then shares them with the states based on various principles, including equality of states, population, and derivation (more for the producing states). In Russia, both royalties and export taxes are important, and the central government now dominates their collection with some small advantage for producing regions. In Pakistan – where resources are distributed primarily based on population figures, the system lead to imbalances where the revenue raise in some provinces were disproportionately distributed to others. Specifically, the provinces of Baluchistan and Sindh produced much more of the natural resources revenue than they were allocated by the central government, while Punjab was allocated much more than it produced. For example, Sindh produces 71% of the total production of gas in Pakistan whereas the share of Balochistan, Punjab and KPK is 22%, 5% and 2% respectively. The share of Sindh, Balochistan, Punjab and KPK in the oil production is 56%, 25%, 1% and 18% respectively. Prior to the 18th Constitutional Amendment, the central government used to take away 88.5% of the royalty on natural resources. The provinces were left with only 11.5% of the revenue raised from natural resources in their region. This revenue was further reduced by corruption in the bureaucracy and government. The population of these provinces felt that they were being deprived of their ownership rights over their natural resources. However, the 18th Constitutional Amendment changed this situation. No longer 11.5%, but 50% of natural resource royalties are now shifted to the provincial level. This change has made a positive impact on development of the natural resource rich provinces Balochistan and Sindh. Source: Crisis of Federalism in Pakistan: Issues and Challenges