Countries throughout the world are increasingly recognizing the benefits of fiscal decentralization. If done properly, decentralization allows people to have a greater influence on government decisions that affect their lives (see, for example, Bird and Vaillancourt 1998 for developing countries; Bird, Ebel, and Wallich 1995 on countries in transition from socialism; Litvack, Ahmad, and Bird 1998 for a review of World Bank experience with decentralization in a variety of countries). Even if decentralization is primarily adopted for such political reasons as assuaging separatist tendencies in certain regions, it may also improve the welfare of the population.

This chapter examines general principles of federalism, how expenditure responsibilities should be allocated across levels of government; how taxes should be assigned to various levels of government; and how transfers, if necessary (and they almost always are), can be designed. 1 Before doing this, however, distinguishing among the different varieties of decentralization is important to ensure that the concept is well understood. There are three commonly used meanings of decentralization as follows: