Dialling Incentives into HFE to Facilitate Reform (and Political Risk) in a Federation

Horizontal Fiscal Equalisation (HFE) is inevitable in any federation. What is not necessarily inevitable is that it should be a disincentive to accountability, impair transparency or lead to the adoption of State policies which are not in the national interest. The problem is however, that highlighting the possible disincentive effects of HFE are not easily demonstrated. This is because the debate around HFE is typically made complex because it is mixed with the broader debate about how a federation should be funded in general. In this paper a simple visual framework is developed to bring transparency to the issues involved in funding subnational governments in the presence of Vertical Fiscal Gap (VFG) and Horizontal Fiscal Gap (HFG). If we begin by assuming tax assignment and expenditure responsibilities are predetermined, then the funding of subnational governments through grants can be viewed as involving 3-stages, each involving different issues. The Stage 1 grant would be focussed on ensuring that in aggregate, across subnational governments, VFG is zero and this could be achieved with an equal-per-capita grant. The Stage 2 grant would address evidence of HFG through the application of HFE principles. The Stage 3 grant would be designed to achieve federally determined national objectives through supplementary grants which are quarantined from the Stage 2 grant distribution process. Using a visual framework to outline each grant’s role in funding subnational governments, it is possible to simply highlight that the focus on HFE in Stage 2 grants should be firstly on the measure on which to base equalisation and secondly, on the degree of redistribution through grants, to apply using that measure. The paper will show visually how Australia, Germany and Canada have designed their 3-Stage grants including the measure used and the degree of redistribution underpinning their response to HFE in Stage 2 grants. Use of this framework should facilitate a more transparent dialling in of incentives into Stage 2 grant design and with this a better understanding of how subnational governments are funded in practice and approaches which could improve accountability and incentives across a federation.