Secession Risk and Fiscal Federalism

Why is fiscal federalism so often dysfunctional from an economic point of view? Particularly in the developing world, fiscally decentralized systems often lack hard budget constraints and an open, common market. This article argues that preventing secession can require fiscally deleterious institutions. Beyond the well-known device of "fiscal appeasement," central governments facing potential secessionist challenges try to hamstring regional tax collection and permit regional protectionism against goods and labor. While ethnic diversity has helped to preserve relatively robust forms of fiscal federalism in Canada and Switzerland, it has had the contrary effect in developing countries. Even among Western democracies, those governments unwilling to countenance secession are less likely to respond to secessionist challenges by decentralizing taxation powers. The political logic of decentralization may stymie efforts to reform decentralized institutions along the lines recommended by economists and the multilateral lending institutions.