Even when local governments or other local bodies are assigned meaningful legal functional responsibilities, are given extensive political space and have strong local administrative control over their functions, it is possible for central authorities to retain control local affairs by limited the financial resources and the degree of fiscal autonomy available to local bodies. In contrast, in an effective local governance system, local governments are assigned the appropriate level and mix of own source revenues and intergovernmental fiscal transfers; have adequate autonomy over their own source revenue instruments; and are able to effectively administer their local finances.

Intergovernmental or subnational financial arrangements are traditionally grouped into four aspects or “pillars” of subnational finance. The first pillar of intergovernmental finance or fiscal decentralization is the assignment of expenditure responsibilities and the management of local expenditures. The next three pillars of intergovernmental finance deal with the ways in which local government expenditures are funded, namely, the assignment of revenue sources; the provision of intergovernmental fiscal transfers; and the institutional framework surrounding subnational borrowing and debt.

The different aspects of fiscal decentralization (or “fiscal federalism”) and local government finance have been studied extensively by the public finance (economics) literature. Whereas the first generation theory focuses largely on designing optimal fiscal decentralization policies and interventions, the “second generation fiscal federalism” literature explicitly acknowledges the role of institutional decision-making and political economy forces in multi-level governance systems. As such, the second-generation literature recognizes that central and local political decision-makers are not necessarily benevolent rulers that maximize the social welfare of their constituents, but rather, that the assignment of functions and responsibilities—as well as the design and functioning of the entire intergovernmental fiscal system—is shaped to a large extent by the personal and institutional motivations of political and institutional decision-makers at all levels.

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