Federalism and Multilevel Governance

Federalism is a system of government organization in which power is divided between a central government and regional units (states, provinces, Länder), with each level possessing its own constitutionally enshrined powers. Federalism and the broader concept of multilevel governance have deep economic implications and are an important topic in political economy.

Types of Territorial Organization

States differ in their degree of decentralization:

Unitary state — power is concentrated at the center; local authorities are subdivisions of the central government, whose powers can be changed by ordinary law. Examples: France, Japan, most post-Soviet states.
Federation — powers are divided between the center and the subjects of the federation; this division is constitutionally protected and cannot be altered unilaterally. Examples: USA, Germany, Australia, Canada, Russia, India, Brazil.
Confederation — a union of sovereign states that delegate part of their powers to joint bodies but retain the right to secede. Historical examples: Swiss Confederation until 1848, German Confederation from 1815–1866. The European Union combines elements of a federation and a confederation.
Devolution — the transfer of powers from the center to regions within a unitary state. Example: devolution in the United Kingdom (creation of the Scottish, Welsh, and Northern Ireland Parliaments) or regionalization in Spain and Italy.

Economic Arguments for Decentralization

Oates’ Theorem. In a classical study, Wallace Oates showed: if citizens’ preferences differ between regions, decentralized provision of public goods increases welfare. A centralized solution, uniform for all, does not account for local preferences.

“Voting with your feet” (Tiebout). Charles Tiebout proposed a model in which citizens “vote with their feet” by choosing a jurisdiction with their preferred mix of taxes and services. Competition between jurisdictions creates pressure for efficiency. Poorly governed regions lose population and tax base.

Laboratories of democracy. Regions can experiment with policy. Successful experiments spread, unsuccessful ones are rejected. Federalism is a mechanism of institutional learning.

Checks and balances. Federalism limits central power by creating additional veto points. This protects against tyranny and a “predatory” state.

Economic Arguments Against Decentralization

Economies of scale. Many public goods (defense, macroeconomic stabilization, large infrastructure) are more efficiently provided at the national level.

Externalities. The policy of one region can have consequences for others. Pollution crosses borders; the “race to the bottom” — lowering taxes and regulation to attract business — can undermine public goods.

Inequality between regions. Decentralization can intensify territorial inequality. Rich regions provide better services; poor ones worse. Federal transfers mitigate but do not eliminate inequality.

Weakness of local governance. Local elites may be more corrupt and less accountable than the central authorities. “Capture” of local power by oligarchs is a real problem in developing countries.

Fiscal Federalism

Fiscal federalism is the branch of economics that studies the allocation of taxing and spending powers between tiers of government:

Principle of subsidiarity: powers should be exercised at the lowest level capable of performing them effectively. This principle is enshrined in EU treaties.
Tax allocation. Mobile tax bases (capital, high-income individuals) are better taxed at the central level; immobile (real estate) — at the local. Otherwise, tax competition undermines collection.
Vertical imbalance. Frequently, spending powers are more decentralized than taxing powers. Regions depend on transfers from the center, which creates problems of accountability and “soft budget constraints.”
Horizontal transfers. Equalizing transfers from rich to poor regions ensure a minimum level of services everywhere, but may weaken development incentives.

Political Economy of Federalism

Federalism is not only a matter of efficiency, but also of politics:

Managing diversity. Federalism is often used to manage ethnic, linguistic, and religious diversity. Granting autonomy to regions with a distinct identity can prevent secession (Belgium, Switzerland, Canada). However, federalism can also strengthen regional identities, providing a basis for separatism (Catalonia, Quebec, Scotland).
Who gets what? The division of powers is the result of political struggle. The center seeks to retain control; regions to expand autonomy. Resource-rich regions want to keep more revenue; poor ones want to receive transfers.
Stability of federations. Federations may collapse (USSR, Yugoslavia, Czechoslovakia) or consolidate (EU). Factors of stability: balanced federal structure, mechanisms for conflict resolution, interregional mobility, shared identity.

Multilevel Governance in the EU

The European Union is a unique example of multilevel governance:

Supranational level. EU institutions (Commission, Parliament, Court) have powers delegated by member states. EU law has direct effect and supremacy over national law in the EU’s fields of competence.
National level. Member states retain sovereignty in most areas and remain key actors.
Subnational level. Regions are increasingly involved in EU governance. The Committee of the Regions, regional representations in Brussels, and structural funds create a “Europe of the regions.”

The EU demonstrates both the possibilities and challenges of multilevel governance: coordination between levels is difficult; democratic accountability is blurred; but the system makes it possible to manage diversity and achieve integration.