Fiscal Federalism in Theory and Practice

Abstract

A number of countries have pursued fiscal decentralization within a broad context of political and economic reforms to improve the performance of their public sector. Fiscal decentralization can potentially improve the allocation efficiency of the public sector and increase the capacity of a nation to address its pressing economic, social and political problems. The effectiveness and sustainability of such an approach, however, is conditioned by the existence of core democratic institutions and implementation capabilities.  When political imperatives dictate the adoption of fiscal decentralization, however, the process would confront problems of the commons, capacity constraints and externalities that would limit the potential efficiency gains from decentralization on the performance of the public sector. This paper develops a theoretical and practical argument on the economic rationale for and concerns of pursuing fiscal decentralization in a poor economy within a political environment of ethnic federalism. The paper discusses the current practice of fiscal decentralization in Ethiopia and outlines issue areas where fiscal policy could be used to address problem of chronic poverty, uneven regional development patterns, and improve the efficiency of public resource utilization