Fiscal federalism is a subject of much recent interest, reflecting primarily developments of great economic significance in Europe. While economic transformation in Eastern Europe has focused attention on issues concerning fiscal decentralization within a nation state, economic integration in Western Europe has raised issues related to fiscal centralization across nation states. The Maastricht Treaty envisages fixed exchange rates within the European Union. This denies member nations access to independent monetary and exchange rate policies, thus emphasizing the role of fiscal policy as the remaining area of national autonomy in macroeconomic policy formulation. However, even fiscal policy is constrained by the convergence criteria of the Treaty, which were established to limit fiscal deficits and public debt, and so buttress sound monetary policies.
The fiscal federalism literature addresses mainly issues of fiscal decentralization. It answers the following questions: which expenditure responsibilities should be assigned to subnational governments from above? What taxation powers should be devolved? How should gaps between local spending and local taxes be closed? The analytical context has tended to be a mature federation—for example Australia, Canada, or the United States—although the analysis applies equally in many of the countries of Eastern Europe. But the institutional setting in Western Europe differs markedly from that of traditional federations; rather than asking ‘Why and what to decentralize?, ’ Western Europeans ask ‘Why and what to centralize?. ’
In response to the latter question, the European Union has adopted a ‘subsidiarity principle, ’ according to which public functions should always be exercised at the lowest possible level unless they are positively proven to be performed more effectively by a higher tier of government. This reverses the