What is the best arrangement of fiscal powers and responsibilities between the different levels of government? This is a question at the center of policy debate in countries around the world (Bird, 1993). Fiscal decentralization is about the division of fiscal powers among levels of government, a subject that are always considered to be related with the issue of revenue sharing. In fact, it also involves the assignment of taxing powers and expenditure responsibility, the method of transfers between levels of government (both central-state and state-local), borrowing powers, local autonomy in taxing and budgeting decisions, and many civil service issues.
Economists invoke an efficiency criteria in arguing for smaller local government, i.e., in arguing for fiscal decentralization. If preferences for public services differ across subgroups of the population, and if externalities are not present, then national welfare is maximized if local communities vote their preferences and provide the level and mix of public services that they want. Non-economists might take the same view, but couch it in different terms: getting government closer to the people will lead to more participation in government, will likely provide an outcome that is closest to the preferences of the median voter, and will allow the political process to guarantee a more efficient operation of local government.
A second argument for fiscal decentralization is that it can enhance revenue mobilization. Some taxes are suited to local government in that their assessment and collection requires familiarity with the local economy and population, and because they are perceived as quasi-benefit charges that finance local services. The property tax and other land based taxes are usually thought of as local government taxes. It is also true that central government value-added and income taxes often do not reach smaller enterprises. Typically, small firms are legally exempt from income tax and VAT for administrative reasons. Workers outside the formal sector often escape taxation because the administrative apparatus cannot find them. Local governments, it could be argued, might be able to capture this untapped fiscal capacity because of their greater familiarity with the local tax base.
The fiscal decentralization mentioned above is usually considered as vertical, while the horizontal decentralization emphasizes more on resource and power allocation among local governments. In the process that local governments compete for investments and other resources, first, they have the incentive to provide more public infrastructure and services (mainly for attracting investments); second, they would tend to maximize output under the constraint of resources. As a matter of fact, horizontal fiscal decentralization, or local government competition, is considered one of the main reasons for economic growth after 1978 economic reform in China. However, on the other side, there are evidences showing that the over-competition between local governments has a negative effect on economy too. To be more specific, in the process of local government competition, the officials incline to spend more money on the projects that can easily manifest themselves as the officials’ achievements, such as infrastructure and direct investment, than human resource investment and R&D. Such myopic behavior will harm future growth.