Transition to Market and Normative Framework of Fiscal Federalism

The mainstream literature on normative framework on fiscal federalism has been largely developed keeping in view the advanced market economies. It is necessary to modify these before they are applied to developing transitional economies to take account of the characteristics of these economies, legacies of past policies, and the nature of their institutions. The paper analyses the effect of lack of development of market institutions and legacies of planning on fiscal decentralisation and intergovernmental fiscal relationships. It attempts to identify the important features of these economies that make the modifications in the normative propositions necessary. These include, impact of planning in distorting the budgetary systems, overhang of public enterprises and its inhibiting influence on the development of the market, controls over prices and output and the distortions and invisible regional transfers they create, physical barriers to mobility and trade across different regions, need to replace public enterprise profits with taxes and variety of instruments used to establish regional equity under planning and the problems that they can create in a market economy. The paper argues that normative principles of fiscal federalism and intergovernmental transfers will have to be modified to take account of these special features before they are applied in designing and implementing these policies in developing and transitional economies. ∗ Director, National Institute of Public Finance and Policy, New Delhi. Email: [email protected]. Paper presented at the Conference on Fiscal Federalism, University of Torino, August 27-28, 2004. The author is grateful for the comments given by the participants at the above conference. In particular, the comments by Ehtisham Ahmad, Georgio Brosio, and Albert Breton were extremely helpful in revising the paper. Thanks are also due to Amaresh Bagchi for detailed comments on the paper. The usual