17 bases with which to finance public services.<sup>32</sup> Even if the vertical imbalance between different levels of government is resolved by adjusting revenue assignments (as suggested in Section 3.3) to the point at which for the subnational units with the richest tax bases, there was no longer any imbalance, any decentralization of taxing powers inevitably worsens the horizontal imbalance between units at the same level. Those who have more to tax are obviously made much better off by tax decentralization than those less favored. Consequently, in countries in which interjurisdictional disparities are of policy concern more decentralized taxes often require increased balancing transfers to poorer regions unless regional inequality is to be exacerbated.<sup>33</sup> This issue has, for example, been a major policy focus in China in recent years (Bahl and Martinez-Vazquez 2006b).

One may rightly be concerned with the prospect that tax decentralization will likely give more to those who already have most. Large cities, for example, are more likely to benefit than poor rural localities because they have both a larger tax base and a better chance of developing the administrative capacity to collect their own taxes. Rich coastal provinces will gain more than poor interior regions. The correct response, however, is not to deny those who are able to do so the chance – indeed, the responsibility – to help themselves more by taxing more but rather to design the intergovernmental transfer system properly to ensure that poorer regions and localities, while being encouraged to do as much for themselves as they can, do not fall behind too far. In other words, those concerned with equalization should focus more on getting the transfer system “right” from this perspective rather than, in effect, ensuring that the subnational tax system is “wrong” by denying those subnational governments that can and should tax themselves more the ability and responsibility to do so.

# **4.3. The Revenue Issue**

It was noted in passing above that one reason many countries have been reluctant to concede more taxing power to subnational governments is that central governments are understandably concerned with their own revenue positions. As Bahl and Bird (2008) note, however, it is also possible that fiscal decentralization, if successfully implemented, may increase rather than reduce total revenue mobilization. Central governments in developing countries usually rely on a combination of income and consumption taxes. In most such countries, however, these taxes properly have a high entry threshold.<sup>34</sup> For this and other reasons, in many countries small firms, most individuals, and many owners of immovable property are largely left out of the tax base. Even if this is done not by design

> 32 For a more detailed discussion of both horizontal and vertical imbalance, as well as estimates of both for developed federal countries, see Bird and Tarasov (2004).

> 33.Note, however, that at root the ‘need’ for transfers is determined by the political aims and institutions of each country and not by any abstract ‘optimality’ calculus. As May (1969) argues, the "taste" for regional equalization may and does vary greatly from country to country.  Among developed federal countries, for example, compare the explicit interregional redistributive grants of Canada and even more so Germany and Australia with the much less equalizing systems of Switzerland and the United States (Bird 1986).

> 34 Keen and Mintz (2004) suggest that the VAT threshold is too low in most developing countries.  On the other hand, because excluding businesses from VAT means that they are unable to obtain credit for tax imposed on their inputs, those concerned with the development of micro and small enterprises may tend to favor lowering tax thresholds rather than raising them (World Bank 2007).