An Economic Analysis of Fiscal Federalism in Ethiopia

Introduction

A growing number of countries have adopted fiscal federalism in an effort to improve the performance of their public sector. The underlying theme of the reforms is restructuring the public sector and improving its efficiency. In the context of fiscal policy, the reforms entail decisions in identifying the optimal distribution of functions and powers between the federal and subnational governments and providing fiscal decision-making power to subnational governments. This process introduces specialization of functions and changes the very relationship between the government and the citizen-voters in important ways.

Fiscal federalism is essentially the choice and distribution of fiscal decision-making power across multilevel governments. The adoption of fiscal decentralization in most countries has meant a clear departure from their practice of operating a centralized fiscal system within a unitary political regime. The failure of the centralized system of economic and political administration is one of the forces behind the temptation of a number of countries to experiment with some forms of decentralization of both political and fiscal power. Some countries implemented fiscal decentralization whereas others opted for de-concentration of centralized decision making without actual fiscal decentralization.¹ In some cases, fiscal decentralization followed the political imperative of establishing a federal political structure.

Fiscal decentralization has economic effects and particularly affects the utilization and allocation of public resources. Whereas decentralized fiscal decision making generates efficiency gains, the significance of such gains needs to be measured relative to what the process entails in terms of distribution and macroeconomic stability objectives. Moreover, undertaking fiscal decentralization before local institutional capacity is developed might involve significant economic cost and inefficiency in resource utilization.² After all, partial decentralization may not necessarily bring to the people at the grass-roots level improved governance and accountability that responds to local priorities and preferences.

Fiscal federalism in Ethiopia, the subject of this article, has been adopted within a unique political landscape of ethnic federalism. The Tigray People's Liberation Front (TPLF)–led government that replaced the Derg has redrawn the political map of the country and adopted an ethnic-based federal government structure. This experiment has been formalized in the 1994 Constitution. However, the constitutional provisions operate with a political centralism that has remained the distinguishing feature of the current political system.

The theme of this article is that fiscal federalism in the context of ethnic politics and de facto political centralization hampers the realization of the economic potential of the country and hence constrains efforts to address core economic problems. I address the economic prudence of pursuing fiscal decentralization in a poor country and the ways in which such a policy affects fiscal discipline, resource allocation, and efficiency of resource utilization as well as the growth performance of sectors in the economy. The rest of the article is organized as follows. The next section reviews the main strands of the theory of fiscal federalism and develops an economic argument on issues of fiscal federalism; the following sections review the fiscal system of Ethiopia and address the issues involved in the practice of fiscal federalism in Ethiopia and their implications for fiscal performance. The final section makes concluding remarks and highlights areas for policy action.

The Theory of Fiscal Federalism

Fiscal federalism refers to a process of distribution and redistribution of fiscal decision-making power across multilevel governments. It derives its nature and characteristics from constitutional provisions as well as the state of economic development, the pattern of income and resource distribution, and the institutional capacity of the system. The constitutional provisions define the framework within which decision making will be exercised and establish the vertical and horizontal structures that find meaning within the socioeconomic environment prevailing in the system. The vertical structure defines the assignment of fiscal decision-making power between the federal and the lower tiers of government. The horizontal structure outlines the nature of interaction across cross-sections of government levels.

The main economic objectives of fiscal decentralization are improving the efficiency of the public sector, creating an enabling environment for private sector development, and promoting economic growth. However, fiscal decentralization also affects other...