Fiscal federalism as a cure to integration failures has been accompanied by a number of theories in economic, legal and political science. incomplete contracts create incentive structures for politically motivated actors to act “according to circumstances and interest”, defecting from the “common good” of a given community as a whole.
The “murkiness and contestability of sovereignty” within incomplete federal contracts hold incentives within the games played between higher and lower levels of government to shift the burden to other levels of government. This may put the community itself to test. History provides ample instances to illustrate how crises triggered by sub-national units’ unsound economic and fiscal policies resulted in centrally defined resolutions to return to macro-economic stability.
Pertinent questions concerning fiscal federalism concern the proper role of the central government, issues of macro-economic stabilization, problems of moral hazard and intergovernmental solidarity. One of the main problems therefore is how to deal with the following trade-off: central provision of public goods may produce inefficiencies because it fails to recognize and respect locally different preferences and conditions, whereas local provision of public goods may produce inefficiencies due to the failure of internalizing inter-jurisdictional externalities.