Federalism, Fiscal Authority, and Centralization in Latin America

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This book explores the politics of fiscal authority, focusing on the centralization of taxation in Latin America during the twentieth century. The book studies this issue in great detail for the case of Mexico. The political (and fiscal) fragmentation associated with civil war at the beginning of the century was eventually transformed into a highly centralized regime. The analysis shows that fiscal centralization can best be studied as the consequence of a bargain struck between self-interested regional and national politicians. Fiscal centralization was more extreme in Mexico than in most other places in the world, but the challenges and problems tackled by Mexican politicians were not unique. The book thus analyzes fiscal centralization and the origins of intergovernmental financial transfers in the other Latin American federal regimes, Argentina, Brazil, and Venezuela. The analysis sheds light on the factors that explain the consolidation of tax authority in developing countries.

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Editorial Reviews

From the Publisher
' … a major contribution to our understanding of how federalism has developed in the largest Latin American countries over the past century.' Journal of Latin American Studies

'… will undoubtedly form part of the burgeoning canon on fiscal federalism from a political economy perspective.' Political Studies Review

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Meet the Author

Alberto Diaz-Cayeros is an assistant professor of political science at Stanford University. He previously taught at the University of California, Los Angeles. He received his M.A. and Ph.D. in political science from Duke University. His dissertation won the award for best dissertation granted by the political economy section of the American Political Science Association. Diaz-Cayeros has published articles in the Journal of Theoretical Politics, Comparative Political Studies, Politica y Gobierno and several edited volumes.

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Cambridge University Press
0521861632 - Federalism, fiscal authority, and centralization in Latin America - by Alberto Diaz-Cayeros


Federalism, Party Hegemony, and the Centralization of Fiscal Authority

1.1. The Fundamental Dilemma of Fiscal Centralization

The centralization of authority is essential to national politics. Acephalous societies are characterized by violence, warlords, and the constant threat to property and life. Some degree of central control over a territory is essential for the formation of a state. Although the threat of force can create a territorial unit, its consolidation only occurs when political authority becomes expressed in the capacity to tax. This book explores the politics of fiscal authority, focusing on the centralization of taxation in Latin America during the 20th century. The first half of the book explores this issue in great detail for the case of Mexico. The political (and fiscal) fragmentation associated with civil war at the beginning of the century was eventually transformed into the highly centralized regime we associate with Mexico today. Fiscal centralization was more extreme in Mexico than in most other places in the world, but the challenges and problems tackled by Mexican politicians were not unique. The second half of the book thus analyzes the other Latin American federal regimes – Argentina, Brazil, and Venezuela. My hope is that this book will shed light on the factors thatexplain the consolidation of tax authority in developing countries not only in Latin America but elsewhere. The basic premise of the theoretical framework of this book is that fiscal centralization can be best studied as the consequence of a bargain struck between self-interested regional and national politicians.

   The book argues that fiscal centralization occurs when national politicians use the power of the central government to protect regional politicians from challengers and electoral threats in exchange for financial resources. In turn, regional politicians are willing to forgo fiscal authority. This exchange cannot easily be made: Local politicians are initially unwilling to give up their capacity to tax absent guarantees by the national elites that a strong central government will not later exploit their financial dependence. This is the fundamental dilemma of fiscal centralization.

1.2. Fiscal Centralization around the World

Fiscal centralization is ubiquitous in the contemporary world. According to the International Monetary Fund (IMF) Government Finance Statistics (GFS), revenue centralization, measured as the share of tax and nontax revenue collected by the national level of government, averaged 81 percent at the close of the 20th century. Expenditures were less centralized, with national governments’ share of total expenditures by all governments averaging 74 percent.1 Although there are wide differences among countries in the level of centralization they exhibit, and both types of centralization (revenue and expenditure) usually go hand in hand, in all countries – regardless of their level of development and political organization – there is far less centralization in expenditures than in revenues. The gap between these two indicators is usually filled by various forms of financial transfers.

   Why is tax collection so centralized? Even as expenditures have been decentralized the world over since the 1980s, why do countries seldom devolve revenue authority to subnational spheres of government? How did tax authority become centralized initially? In order to address these issues, this book explores the political process of tax authority concentration in the Latin American federations. An in-depth study of the Mexican case is contrasted and compared with the evolution of other Latin American federations. I show that in Mexico, as in Argentina and Venezuela, tax centralization was accompanied by the creation of overarching revenue-sharing and other expenditure transfer systems. State and provincial politicians in those three federations agreed to give up their power to tax in exchange for financial transfers and secure political careers protected by the power of the federal government. Brazilian states, in contrast, did not abdicate their tax authority. This allowed Brazil to remain a highly decentralized federation. The circumstances under which the Latin American federations solved the dilemma of fiscal centralization or remained revenue-decentralized differed greatly. In all cases, political representation conditioned the construction of regional coalitions that determined the specific way in which fiscal bargains unfolded. Altogether, the experience of the four countries sheds light on the process of consolidation of central political and fiscal authority in federal developing countries.

Figure 1.1.  Revenue centralization and level of development (based on data from World Bank, 1999).

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   Figure 1.1 shows the range of variation in revenue authority centralization prevailing around the world. The figure shows the amount of revenue from tax and nontax sources that was controlled by national governments as a percentage of total revenue collection (national plus local and intermediate governments).2 Countries are ranked on the horizontal axis according to their level of development measured by their purchasing power parity per capita gross domestic product (GDP, logged) from the Penn World Tables. Latin American federations are placed on the graph at similar values in terms of their development, but they vary widely in their degree of revenue centralization. Mexico and Venezuela show levels of centralization found in many unitary states, whereas Brazil and Argentina show low levels of centralization more in line with those found in other federal regimes.

   These statistics consider revenue-sharing systems, which are one specific form of intergovernmental transfers, as revenue collected by the recipient government. This means that the graph exaggerates the level of revenue decentralization in Latin America, where revenue-sharing arrangements are an important source of subnational revenue. Taxes subject to revenue-sharing are collected and controlled by the central level of government, not the recipient units. The nature of fiscal authority and the scope for redistribution are radically transformed when revenue-sharing arrangements exist.

   When fiscal bargains are struck between local and national politicians for the creation of revenue-sharing systems, the locus of authority over taxation is shifted away from state governments. In Argentina, Mexico, and Venezuela, local elites were willing to make such bargains and create encompassing revenue-sharing systems, abdicating their authority to collect taxes. In Brazil, revenue-sharing was created by the military governments. From the outset, that transfer system played a more limited role in Brazil than in the other Latin American federations because the most important revenue source for the rich states in Brazil was the value-added-tax, which states controlled. If revenue-sharing systems are accounted as transfers rather than subnational revenue, decentralization in Argentina, Mexico, and Venezuela is lower than 10 percent. Tax authority in those three federations then looks more similar to the patterns of relatively centralized countries such as Indonesia or Thailand, which are not federal. Of the Latin American federations, only in Brazil has tax authority remained decentralized in the sense that revenue decentralization is large, even subtracting revenue-sharing.

Figure 1.2.  Revenue centralization in the 20th century. Note: 1990s data for Eastern Europe and former Soviet Union countries.

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   The Latin American federations were far less centralized at the beginning of the 20th century than they are today. State governments had substantial fiscal authority at the time. Figure 1.2 compares the level of tax centralization around the world observed in 1935 with the average centralization observed during the 1990s.3 In this graph, revenue-sharing in the four Latin American federations is accounted as belonging to the government collecting the taxes, not the recipient government. In most countries, tax collection became more centralized at the end of the century than it was at the beginning. However, some countries resisted this trend toward centralization more vigorously than others. Specifically, of the Latin American federations, Brazil retained a high level of decentralization, Mexico and Argentina became highly centralized, and Venezuela retained the high level of centralization it has had since the end of the 19th century.

   At the beginning of the 20th century, state (provincial) and local governments around the world maintained a large degree of fiscal authority. The authority to levy excise, sales (turnover), income, or inheritance taxes did not belong exclusively to national governments. But over the course of the century, most national governments centralized and obtained exclusive authority over these taxes while local and state governments instead got transfers from the central level. The fundamental problem of such fiscal centralization is that the credible construction of intergovernmental transfer systems, where state and local tax authority is substituted by financial transfers from the central (federal) government, is never easy to achieve. The Latin American federations illustrate that this is not a linear process of centralization. Tax centralization hinged on the ability of regional and national politicians to face critical challenges and find specific solutions for them.

Figure 1.3.  Fiscal centralization in the Latin American federations (own calculations from country-specific sources).

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   Figure 1.3 shows the evolution of the share of taxes collected by the central governments in the Latin American federations as a percentage of total revenue coming from all levels of government (central, state/provincial, and municipal).4 The statistics for subnational revenue collection in Brazil and Mexico are rather complete. In Argentina and Venezuela, in contrast, there are long periods of time for which there is no reliable information on which to construct a good indicator of the share of subnational tax collection, because of the paucity of state- and provincial-level revenue-collection data. The gaps in the graph are periods during which it was not possible to reconstruct the fiscal shares, although a detailed reading of country sources suggests that those shares probably remained more or less constant during the years without information.5 It should be pointed out from the outset, particularly for the case of Argentina, that the relative shares of revenue collection do not mean that the fiscal relations between the federal governments and the provinces remained fixed: In fact, much of the story that this book tells is about the role of federal transfers to provinces (for which we have far more information), which witnessed radical transformations throughout those years. Hence, while fiscal authority became centralized, the amount of resources at the disposal of subnational governments varied widely through time.6

   The federal government share provides, despite its deficiencies in Argentina and Venezuela, an indicator of the degree of centralization in fiscal authority. During the course of the 20th century, taxation became centralized in the hands of national governments in virtually all the countries, but the evolution and final levels of centralization varied widely. This book provides an explanation for the variation in the paths toward centralization followed by the Latin American federations. Venezuela was always a highly centralized country. Argentina, in contrast, remained a rather decentralized country, notwithstanding frequent changes in the financial relationship between the provinces and the federal government. Brazil has been highly decentralized, although the years of military rule saw an increase in fiscal centralization. Mexico has gone through waves of centralization: one that started in the 19th century, another one after the 1930s, and a third one after the 1970s.

   There are common international shocks that explain the tendency of all countries to centralize revenue collection after 1929. However, the graph makes it patently clear that much of the variation depends on the individual domestic processes that each country underwent. The relative importance of the federal government in revenue collection in Mexico hovered at around 65 percent until the 1940s and then increased after 1947. Centralization was reduced during the 1960s, only to increase steadily since the early 1980s. The federal government in Mexico today concentrates around 90 percent of fiscal authority.

   The Brazilian path was quite different from the one exhibited by Mexico. In 1886, the central government in the Brazilian empire collected 76.8 percent of the national revenue (Murilo de Carvalho, 1993: 39–41). This was reduced to 65.8 percent in 1907, when the data in the graph for Brazil begins, after federalism was introduced. Brazilian states retained high levels of fiscal authority throughout the 20th century, as shown in the graph, notwithstanding the growth in the overall size of the federal government. Even when the military governments in the 1964–1988 period sought to centralize fiscal authority, Brazil remained far more decentralized than Mexico.

   Venezuela did not experience any significant decentralization in revenue throughout the century. Once tax authority had become concentrated in the federal government in the 19th century, states could not wrest control of taxes away from the central jurisdiction. Argentina has often been regarded as a country experiencing ebbs and flows in fiscal centralization (Eaton, 2001). The evidence suggests, however, that once the centralization of tax authority was achieved in Argentina in the 1930s, the federal share of revenue collection never fell below 70 percent.7

   Why were states and provinces willing to give up their relative weight in the federal pact, as reflected in their fiscal authority? This centralization of fiscal authority is puzzling on several grounds. In contrast to unitary regimes, in federations, state (or provincial) governments have the constitutional authority to collect taxes. The argument of this book is that from the point of view of the constituent members, there are gains to be reaped from a centralized system of revenue collection. However, federal governments face a commitment problem in order to credibly promise to substitute decentralized systems of tax collection with transfer arrangements. The credibility of transfer systems has been taken for granted in most research on federalism. I argue that credibility in transfers emerges from a political bargain articulated through both political institutions and the party system.

   In Mexico, a hegemonic party provided an institutional solution to the dilemma of commitment encountered by regional politicians in the process of state-building. This institutional solution tempered the centrifugal forces unleashed by the Mexican Revolution and set the stage for a period of moderate growth with political stability. The hegemonic party structured a highly disciplined system of progressive ambition. Local politicians were willing to empower the federal government to pursue a centralized national “developmentalist” strategy.8 The PRI system protected local politicians from electoral challenges and ensured them attractive political careers. Local politicians surrendered their fiscal authority because they were protected from competition in local electoral and economic markets.

   An institutional solution to the federal commitment problem was attempted in Argentina through the delegation of enforcement of the fiscal bargain to a third party, namely the central bank. This solution turned out not to be self-enforcing given the shifts between democracy and authoritarianism that the country witnessed throughout the 20th century. The distrust between the provinces and the federal government was further enhanced whenever partisanship differed between levels of government. By the 1980s, the system of revenue-sharing collapsed altogether. In Venezuela, authoritarian federal governments during the first half of the century were able to impose a virtually unitary system of government, blurring federalism and often cheating states from their constitutionally mandated transfers. The fiscal arrangement only became binding when a stable two-party system and a transition to democracy were achieved after 1958. In Brazil, state governments instead kept fiscal authority, so the system remained highly decentralized. A credible threat by the most powerful states to challenge the federal government always remained in place. Not even the military rulers successfully centralized the system to the extent that they envisaged. Instead, in order to stay in office, they had to construct a ruling coalition through a crafty combination of respecting the fiscal authority and political autonomy of the powerful states while constructing a redistributive revenue-sharing transfer system.

1.3. Federalism, Political Parties, and Fiscal Authority

A federal system can be defined by two (necessary and sufficient) conditions. First, state (or provincial) executives must emerge from elections held within a state (provincial) jurisdiction independently from the national one. Second, states (provinces) must possess inherent fiscal authority.9 Such an ideal-typical definition of federalism is not incompatible with other characterizations found in the literature. This definition highlights, however, the conditions of representation and taxation in federal systems.10 To the extent that state executives are the product of state elections and, once in office, possess an independent tax base, one can say they reside in a federal regime.

   According to the previous definition, so long as a candidate for office must face election at the state level independently from the national candidates (regardless of the level of threat imposed by the challengers), and if once in office can exercise tax authority and decide the allocation of financial resources, we should regard the institutional arrangement as federal.11 This does not mean that the orientation of a politician is more likely to be national in unitary systems and local in federal systems. As much of this book will argue, such an orientation depends on the equilibrium reached in the complex interaction among .scal authority, political ambition, and party systems.12

© Cambridge University Press
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Table of Contents

1. Federalism, party hegemony and the centralization of fiscal authority; Part I. Fiscal Centralization in Mexico: 2. Regional fragmentation and failed commitment; 3. The official party as a regional compromise; 4. Nominations, veto players and gubernatorial stability; 5. Transfers and redistribution in the Mexican States; Part II. Centralization and Revenue-sharing in the Latin American Federations: 6. Venezuela: unitarianism in disguise; 7. Argentina: regime change and fragile credibility; 8. Brazil: the retention of fiscal authority; 9. State building, political institutions, and fiscal authority.

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