The long statehood history of Ethiopia is known for its decentralized governance system with many autonomous regions and principals ruled by hereditary regional chiefs under various titles, but accountable to King of Kings at the centre. The autonomous regions were not only paying annual tribute to the king of kings, but also had to cooperate with the centre. Powers of the regional chiefs started to diminish at the turn of the nineteen century and had been completely abolished in the early twentieth century. The century old exclusive, suppressive and highly centralized governance system came to end in and a multi-ethnic federal arrangement has been adopted.

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As a subfield of public economics, fiscal federalism is concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government". In other words, it is the study of how competencies expenditure side and fiscal instruments revenue side are allocated across different vertical layers of the administration.

It may be noted that the ideas of fiscal federalism are relevant for all kinds of government, unitary, federal and confederal. The concept of fiscal federalism is not to be associated with fiscal decentralization in officially declared federations only; it is applicable even to non-federal states having no formal federal constitutional arrangement in the sense that they encompass different levels of government which have de-facto decision making authority.

This however does not mean that all forms of governments are 'fiscally' federal; it only means that 'fiscal federalism' is a set of principles that can be applied to all countries attempting 'fiscal decentralization'. In fact, fiscal federalism is a general normative framework for assignment of functions to the different levels of government and appropriate fiscal instruments for carrying out these functions.

The questions arise: a How federal and non-federal countries are different with respect to 'fiscal federalism' or 'fiscal decentralization' and b : How fiscal federalism and fiscal decentralization are related similar or different? While fiscal federalism constitutes a set of guiding principles, a guiding concept that helps in designing financial relations between the national and sub-national levels of the government, fiscal decentralization on the other hand is a process of applying such principles.

Federal and non-federal countries differ in the manner in which such principles are applied. An original definition of fiscal federalism states that "fiscal federalism" concerns the division of public sector functions and finances among different tiers of government.

In undertaking this division, Economics emphasizes the need to focus on the necessity for improving the performance of the public sector and the provision of their services by ensuring a proper alignment of responsibilities and fiscal instruments. While economic analysis, as encapsulated in the theory of fiscal federalism, seeks to guide this division by focusing on efficiency and welfare maximization in determining optimal jurisdictional authority, it needs to be recognized that the construction of optimal jurisdictional authority in practice goes beyond purely economic considerations.

Political considerations, as well as historical events and exigencies, have in practice, played major roles in shaping the inter-governmental fiscal relations in most federations. Even in non-federal states, there has been a growing movement towards greater fiscal decentralization in recent years. Some analysts have attributed this to globalization and deepening democratization the world over on the one hand and increasing incomes on the other.

Other specific reasons for increasing demand for decentralization are:. Moreover, in recent years, decentralization has become a feature of reform agenda promoted and supported by the World Bank as stated in the World Bank Report of and other multilateral institutions. The rationale for this has been in part that decentralization promotes accountability.

It is not therefore surprising that by , 62 of 75 developing nations had embarked on one form of decentralization or another. Fiscal federalism in Ethiopia has been adopted within a unique political landscape of ethnic federalism. The TPLF-led government that replaced the Dergue has redrawn the political map of the country and adopted ethnic based federal structure of government.

This experiment has been formalized in the Constitution. However, the constitutional provisions operate with political centralism that has remained to be the distinguishing feature of the current political system. Fiscal federalism derives its nature and characteristics from constitutional provisions as well as the state of economic development, the pattern of income and resource distribution, and the institutional capacity of the system.

The constitutional provisions define the framework within which decision-making would be exercised and establishes the vertical and horizontal structures that find meaning within the prevailing socio-economic environment of the system.

The vertical structure defines the assignment of fiscal decision-making power between the federal and lower tiers of government. The horizontal structure outlines the nature of interaction across cross-sections of government levels. This aspect addresses how regional governments interact to each other especially when there are externalities and spillovers.

The main economic rationale behind fiscal decentralization is improving efficiency of public resource utilization, creating enabling environment for private sector development and the growth of the national economy.

The theory of fiscal federalism addresses three issues related to fiscal decision-making: assignment of responsibilities and functions between the federal government and the regional governments, the assignment of taxation power and the design of inter-governmental transfer subsidy of fiscal resources coupled with provisions about the borrowing windows to sub-national governments.

These factors give rise to a third issue of the relative size of the public sector in the national economy. It is therefore the dynamics of these processes and public policy choices that ultimately shapes the performance of the fiscal sector and its impact on the national economy. An important aspect of the exercise of fiscal federalism is the assignment of fiscal functions to the federal and the sub-national governments and the appropriate means of financing these responsibilities. The theory of fiscal federalism does not provide a clear-cut separation of fiscal responsibilities that would promote economic efficiency and resource distribution.

The broad thrust of normative theory is that expenditure responsibilities in areas of macroeconomic stabilization and redistribution functions should remain within the domain of the federal government whereas allocation functions should be assigned to lower levels of government. The argument is based on the reasoning that lower levels of government have limited capacity and policy instruments to provide stabilization and redistribution functions.

Due to the nature of the responsibilities, the federal government usually assumes macroeconomic stabilization and income redistribution functions and make sure that regional governments would not take measures that are not compatible with such functions.

Moreover, there are functions such as national defense and foreign affairs that have national public good character and hence usually assigned to the central government. Fiscal decentralization and the assignment of functions can generate economic efficiency of the public sector. If preferences are heterogeneous across jurisdictions, which is most likely the case, decentralized decision-making power as to the provision of local public goods and services improves efficiency by tailoring services to the preferences of the local population.

The main argument is that local governments are closer to the local population and can identify their choice and preferences better than the central government. Accordingly, when the decision to provide a bundle of public goods is made by local officials and these officials are directly accountable to the local voters, there is an incentive for the local public officials to provide services that reflect the preferences of the local population.

Moreover, as long as there is close relation between the benefits from public services and taxes on the local taxpayers, there is additional incentive to utilize resources efficiently and cost effectively. At least by implication, the theory recognizes the need for local authorities to exercise choice in the provision of public services that are of higher local demand instead of resorting to the unitary solution. The decentralization theorem suggests that, under such conditions, decentralization of fiscal decision-making can improve efficiency of the public sector and the welfare of the local population.

Once the allocation of expenditure responsibilities is conducted according to such broad principles, the fiscal system needs to address the issue of assigning taxing power that broadly identifies who should tax, where and what. The imposition of taxes, in the absence of lump-sum source of taxation, always involves a certain degree of economic inefficiency. In the context of fiscal federalism, the assignment process needs to identify the comparative efficiency and effectiveness of providing the fiscal instruments to the multi-tier decision-making centers so as to finance public functions and activities in the most efficient manner possible.

What kind of taxes should be assigned to the federal government and which should be assigned to the local governments? The theory and practice in the assignment of taxation power identifies the following main criteria in assignment process: taxes on mobile tax bases, redistributive taxes, taxes that could easily be exported to other jurisdictions, taxes on unevenly distributed tax bases, taxes that have large cyclical fluctuations, and taxes that involve considerable economies of scale in tax administration should be assigned to the national or federal government.

There are efficiency and equity considerations behind such principle of tax assignment. The assignment of taxing power between the federal and the regional governments and the provision for concurrent power to share establishes the basic link in which the behavior of one of the parties would influence the decision making power of the other and its effective tax base.

There is a possibility for vertical tax externality that might require additional policy instruments to correct their effect on other levels of government. When there are clear cases in which vertical tax externalities are prevalent, the tension between the federal and the state governments would arise.

This in turn would require mechanisms for the assignment of taxing power and revenue based on the nature and characteristics of the tax base. The assignment of taxing power is a thorny issue in fiscal policy and its application is influenced by a number of considerations.

First, despite the legislative assignment of taxes, the actual potency of the tax network depends on the nature and development of the national economy, the relative distribution of economic activities across jurisdictions, and the administrative efficiency of the taxation system. Second, the practice of fiscal federalism, especially when citizens across regions with diverse economic and demographic situations are treated unequally, gives rise to the violation of one of the core principles of horizontal fiscal equity.

Moreover, fiscal decentralization might also potentially breach the principle of vertical fiscal equity by not treating taxpayers with different capacity to pay differently. Third, despite the monopoly of taxing power resides at the disposal of the government, the reach of the taxation network depends on the economic circumstances of the potential taxpayers.

The fiscal system of Ethiopia has historically been characterized by high centralization and concentration of fiscal decision-making power at the center. Moreover, the structure of the fiscal system shares important features with other underdeveloped economies in terms of reliance on indirect taxes, dependency on international trade taxes, and persistent fiscal deficits.

The current fiscal system of Ethiopia features some departures from the previous systems and striking continuities in the structure and essential elements of fiscal performance of the economy. The main features of fiscal aggregates of Ethiopia suggest that either the government is not willing to fundamentally change its fiscal policy stance or the fiscal system is governed by the structural features of the economy that are not easily amenable to change in response to fiscal policy reforms.

A closer examination of the main features of the fiscal system suggests that both factors play a role in the process. The nature and structure of the economy, the resulting tax bases, the excessive dependence on international trade taxes and external grants, and persistent deficits all contribute to the prevailing features of the fiscal sector as do the fiscal policy stance of the government.

This behavior of excessive spending left an average fiscal gap of about 10 percent. Foreigners provided about 3 percent as charity and lent about 4 percent of GDP and the rest was financed mainly from domestic banking system. A fiscal system that resorts to borrowing to cover about 36 percent of its spending appetite would sooner or later confront the consequence of its behavior.

It is an important predictor of a looming crisis. This behavior of fiscal spending also affected the macroeconomic situation in which aggregate expenditure run in excess of domestic production. The country has become increasingly dependent on foreign aid and borrowing to finance its consumption and investment expenditure.

The fiscal system, nonetheless, witnessed important changes over time. Government revenue increased during the s and reached a peak of The fiscal regime was extremely coercive and led to distortions in resource allocation.

The prohibitively high marginal tax rate had driven most activities underground and tax evasion and corruption were on the rise. Such a system was indeed unsustainable and the change in the political regime precipitates a collapse in the fiscal system. The decline in revenue was particularly severe from business profit taxes, export taxes and revenue from government investment income.

The collection of government revenue collapsed from about a quarter of GDP to about The transitional government introduced a number of fiscal and monetary policy reforms that had mixed implications on the revenue collection.

The amendment in the tax codes, devaluation and gradual depreciation of the exchange rate, elimination of taxes on exports except coffee duties , and the privatization process have had important implications on the amount and structure of government revenue. The average tax revenue for the period was about One typical feature of the tax structure is its narrow base. There is an increasing dependency on foreign trade, especially import, taxes in recent years.

The devaluation of the currency and its subsequent depreciation over time somewhat expanded the domestic currency denominated tax base on imports. The tax revenue-to-GDP ratio for developing countries is about 18 percent and for African countries is about 20 percent.

The ratio of tax revenue in GDP for advanced countries is significantly higher than developing countries, at about 38 percent, reflecting the state of economic development, the tax base and the efficiency of tax administration. This pattern could broadly be attributable to the structure and performance of the economy, the administration of the taxation system, and the design of the taxation system.

A longer view of the fiscal resource allocation behavior of the government, despite marginal changes in some aspects of the fiscal components, suggests that there has not been enduring and significant shift in policy over the past two or so decades. The current government in power, except some marginal changes, shares important characteristics and behavior in fiscal policy with its predecessor.

Foreigners still provide about 3 percent as grants and lend about 3. The remainder of about 2. The relative performance of the current fiscal regime shows some improvement and yet it still covers about 23 percent of its spending by borrowing. The result of such features of government revenue and expenditure has been the emergence of persistent fiscal deficits and the accumulation of public debt.

Domestic government revenue apparently has been barely enough to cover recurrent government expenditure let alone to generate resources for financing capital expenditure. The level of deficit has increased so much so that in recent years it has been as much as the total tax revenue collection of the government. Such a stance of fiscal policy is unsustainable and the external grants, even if important to partially narrow the gap, would not and could not resolve the problem.

The government has increased its appetite for borrowing from foreign sources to bridge the gap and when external borrowing does not satisfy it resorts quite easily to borrow from the domestic banking sector. The fiscal performance of the country is reflections of a typical underdeveloped and agrarian based economy in which the majority of the population lives in chronic poverty and a government that devotes its effort to extraction of resources from the economy and failing to allocate these resources to priority areas and sectors of the economy.


An Economic Analysis of Fiscal Federalism in Ethiopia

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