As a subfield of public economics, fiscal federalism is concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government". In other words, it is the study of how competencies (expenditure side) and fiscal instruments (revenue side) are allocated across different (vertical) layers of the administration.

It may be noted that the ideas of fiscal federalism are relevant for all kinds of government, unitary, federal and confederal. The concept of fiscal federalism is not to be associated with fiscal decentralization in officially declared federations only; it is applicable even to non-federal states (having no formal federal constitutional arrangement) in the sense that they encompass different levels of government which have de-facto decision making authority. This however does not mean that all forms of governments are 'fiscally' federal; it only means that 'fiscal federalism' is a set of principles that can be applied to all countries attempting 'fiscal decentralization'. In fact, fiscal federalism is a general normative framework for assignment of functions to the different levels of government and appropriate fiscal instruments for carrying out these functions. The questions arise: (a) How federal and non-federal countries are different with respect to 'fiscal federalism' or 'fiscal decentralization' and (b): How fiscal federalism and fiscal decentralization are related (similar or different)? While fiscal federalism constitutes a set of guiding principles, a guiding concept that helps in designing financial relations between the national and sub-national levels of the government, fiscal decentralization on the other hand is a process of applying such principles. Federal and non-federal countries differ in the manner in which such principles are applied. Application differs because unitary and federal governments differ in their political & legislative context and thus provide different opportunities for fiscal decentralization.

An original definition of fiscal federalism states that "fiscal federalism" concerns the division of public sector functions and finances among different tiers of government. In undertaking this division, Economics emphasizes the need to focus on the necessity for improving the performance of the public sector and the provision of their services by ensuring a proper alignment of responsibilities and fiscal instruments. While economic analysis, as encapsulated in the theory of fiscal federalism, seeks to guide this division by focusing on efficiency and welfare maximization in determining optimal jurisdictional authority, it needs to be recognized that the construction of optimal jurisdictional authority in practice goes beyond purely economic considerations. Political considerations, as well as historical events and exigencies, have in practice, played major roles in shaping the inter-governmental fiscal relations in most federations. 

Even in non-federal states, there has been a growing movement towards greater fiscal decentralization in recent years. Some analysts have attributed this to globalization and deepening democratization the world over on the one hand and increasing incomes on the other. Other specific reasons for increasing demand for decentralization are:

• Central governments increasingly are finding that it is impossible for them to meet all of the competing needs of their various constituencies, and are attempting to build local capacity by delegating responsibilities downward to their regional governments.

• Central governments are looking to local and regional governments to assist them on national economic development strategies.

• Regional and local political leaders are demanding more autonomy and want the taxation powers that go along with their expenditure responsibility.

Moreover, in recent years, decentralization has become a feature of reform agenda promoted and supported by the World Bank (as stated in the World Bank Report of 1997) and other multilateral institutions. The rationale for this has been in part that decentralization promotes accountability. It is not therefore surprising that by 1997, 62 of 75 developing nations had embarked on one form of decentralization or another.

Fiscal federalism in Ethiopia has been adopted within a unique political landscape of ethnic federalism. The TPLF-led government that replaced the Dergue has redrawn the political map of the country and adopted ethnic based federal structure of government. This experiment has been formalized in the 1994 Constitution. However, the constitutional provisions operate with political centralism that has remained to be the distinguishing feature of the current political system.

Fiscal federalism 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 would be exercised and establishes the vertical and horizontal structures that find meaning within the prevailing socio-economic environment of the system. The vertical structure defines the assignment of fiscal decision-making power between the federal and lower tiers of government. The horizontal structure outlines the nature of interaction across cross-sections of government levels. This aspect addresses how regional governments interact to each other especially when there are externalities and spillovers. The main economic rationale behind fiscal decentralization is improving efficiency of public resource utilization, creating enabling environment for private sector development and the growth of the national economy. The theory of fiscal federalism addresses three issues related to fiscal decision-making: assignment of responsibilities and functions between the federal government and the regional governments, the assignment of taxation power and the design of inter-governmental transfer (subsidy) of fiscal resources coupled with provisions about the borrowing windows to sub-national governments. These factors give rise to a third issue of the relative size of the public sector in the national economy. It is therefore the dynamics of these processes and public policy choices that ultimately shapes the performance of the fiscal sector and its impact on the national economy.

An important aspect of the exercise of fiscal federalism is the assignment of fiscal functions to the federal and the sub-national governments and the appropriate means of financing these responsibilities. The theory of fiscal federalism does not provide a clear-cut separation of fiscal responsibilities that would promote economic efficiency and resource distribution. The broad thrust of normative theory is that expenditure responsibilities in areas of macroeconomic stabilization and redistribution functions should remain within the domain of the federal government whereas allocation functions should be assigned to lower levels of government. The argument is based on the reasoning that lower levels of government have limited capacity and policy instruments to provide stabilization and redistribution functions. Due to the nature of the responsibilities, the federal government usually assumes macroeconomic stabilization and income redistribution functions and make sure that regional governments would not take measures that are not compatible with such functions. Moreover, there are functions such as national defense and foreign affairs that have national public good character and hence usually assigned to the central government.

Fiscal decentralization and the assignment of functions can generate economic efficiency of the public sector. If preferences are heterogeneous across jurisdictions, which is most likely the case, decentralized decision-making power as to the provision of local public goods and services improves efficiency by tailoring services to the preferences of the local population. The main argument is that local governments are closer to the local population and can identify their choice and preferences better than the central government. Accordingly, when the decision to provide a bundle of public goods is made by local officials and these officials are directly accountable to the local voters, there is an incentive for the local public officials to provide services that reflect the preferences of the local population. Moreover, as long as there is close relation between the benefits from public services and taxes on the local taxpayers, there is additional incentive to utilize resources efficiently and cost effectively. At least by implication, the theory recognizes the need for local authorities to exercise choice in the provision of public services that are of higher local demand instead of resorting to the unitary solution. The decentralization theorem suggests that, under such conditions, decentralization of fiscal decision-making can improve efficiency of the public sector and the welfare of the local population.

Once the allocation of expenditure responsibilities is conducted according to such broad principles, the fiscal system needs to address the issue of assigning taxing power that broadly identifies who should tax, where and what. The imposition of taxes, in the absence of lump-sum source of taxation, always involves a certain degree of economic inefficiency. In the context of fiscal federalism, the assignment process needs to identify the comparative efficiency and effectiveness of providing the fiscal instruments to the multi-tier decision-making centers so as to finance public functions and activities in the most efficient manner possible.

What kind of taxes should be assigned to the federal government and which should be assigned to the local governments? The theory and practice in the assignment of taxation power identifies the following main criteria in assignment process: taxes on mobile tax bases, redistributive taxes, taxes that could easily be exported to other jurisdictions, taxes on unevenly distributed tax bases, taxes that have large cyclical fluctuations, and taxes that involve considerable economies of scale in tax administration should be assigned to the national or federal government. There are efficiency and equity considerations behind such principle of tax assignment.

The assignment of taxing power between the federal and the regional governments and the provision for concurrent power to share establishes the basic link in which the behavior of one of the parties would influence the decision making power of the other and its effective tax base. There is a possibility for vertical tax externality that might require additional policy instruments to correct their effect on other levels of government. When there are clear cases in which vertical tax externalities are prevalent, the tension between the federal and the state governments would arise. This in turn would require mechanisms for the assignment of taxing power and revenue based on the nature and characteristics of the tax base.

The assignment of taxing power is a thorny issue in fiscal policy and its application is influenced by a number of considerations. First, despite the legislative assignment of taxes, the actual potency of the tax network depends on the nature and development of the national economy, the relative distribution of economic activities across jurisdictions, and the administrative efficiency of the taxation system. Second, the practice of fiscal federalism, especially when citizens across regions with diverse economic and demographic situations are treated unequally, gives rise to the violation of one of the core principles of horizontal fiscal equity. Moreover, fiscal decentralization might also potentially breach the principle of vertical fiscal equity by not treating taxpayers with different capacity to pay differently. Third, despite the monopoly of taxing power resides at the disposal of the government, the reach of the taxation network depends on the economic circumstances of the potential taxpayers.

The fiscal system of Ethiopia has historically been characterized by high centralization and concentration of fiscal decision-making power at the center. Moreover, the structure of the fiscal system shares important features with other underdeveloped economies in terms of reliance on indirect taxes, dependency on international trade taxes, and persistent fiscal deficits. The current fiscal system of Ethiopia features some departures from the previous systems and striking continuities in the structure and essential elements of fiscal performance of the economy. The main features of fiscal aggregates of Ethiopia suggest that either the government is not willing to fundamentally change its fiscal policy stance or the fiscal system is governed by the structural features of the economy that are not easily amenable to change in response to fiscal policy reforms. A closer examination of the main features of the fiscal system suggests that both factors play a role in the process. The nature and structure of the economy, the resulting tax bases, the excessive dependence on international trade taxes and external grants, and persistent deficits all contribute to the prevailing features of the fiscal sector as do the fiscal policy stance of the government.

For the period 1980/81-2001/02, the government on average extracted about 18 percent of GDP from the public and spent about 28 percent of GDP, of which recurrent spending took more than 19 percent and only 9 percent left for capital spending. This behavior of excessive spending left an average fiscal gap of about 10 percent. Foreigners provided about 3 percent as charity and lent about 4 percent of GDP and the rest was financed mainly from domestic banking system. A fiscal system that resorts to borrowing to cover about 36 percent of its spending appetite would sooner or later confront the consequence of its behavior. It is an important predictor of a looming crisis. This behavior of fiscal spending also affected the macroeconomic situation in which aggregate expenditure run in excess of domestic production. The country has become increasingly dependent on foreign aid and borrowing to finance its consumption and investment expenditure.

The fiscal system, nonetheless, witnessed important changes over time. Government revenue increased during the 1980s and reached a peak of 24.8 percent of GDP in 1988/89 before it declined drastically during the subsequent two years of political turmoil in the country. The fiscal regime was extremely coercive and led to distortions in resource allocation. The prohibitively high marginal tax rate had driven most activities underground and tax evasion and corruption were on the rise. Such a system was indeed unsustainable and the change in the political regime precipitates a collapse in the fiscal system. The decline in revenue was particularly severe from business profit taxes, export taxes and revenue from government investment income. The collection of government revenue collapsed from about a quarter of GDP to about 10.6 percent by 1991/92.

The transitional government introduced a number of fiscal and monetary policy reforms that had mixed implications on the revenue collection. The amendment in the tax codes, devaluation and gradual depreciation of the exchange rate, elimination of taxes on exports (except coffee duties), and the privatization process have had important implications on the amount and structure of government revenue. The average domestic revenue to GDP ratio has recovered gradually and for the period 1991/92 to 2001/02 the average reached about 17.2 percent with a gradual and yet increasing trend. The average tax revenue for the period was about 11.7 percent of GDP.

One typical feature of the tax structure is its narrow base. There is an increasing dependency on foreign trade, especially import, taxes in recent years. The devaluation of the currency and its subsequent depreciation over time somewhat expanded the domestic currency denominated tax base on imports. The tax revenue-to-GDP ratio for developing countries is about 18 percent and for African countries is about 20 percent. The ratio of tax revenue in GDP for advanced countries is significantly higher than developing countries, at about 38 percent, reflecting the state of economic development, the tax base and the efficiency of tax administration. This pattern could broadly be attributable to the structure and performance of the economy, the administration of the taxation system, and the design of the taxation system.

A longer view of the fiscal resource allocation behavior of the government, despite marginal changes in some aspects of the fiscal components, suggests that there has not been enduring and significant shift in policy over the past two or so decades. The current government in power, except some marginal changes, shares important characteristics and behavior in fiscal policy with its predecessor. The current regime spends about 26 percent of GDP and extracts from the public about 17 percent of GDP.

Foreigners still provide about 3 percent as grants and lend about 3.7 percent of GDP. The remainder of about 2.4 percent of GDP has been financed from domestic borrowing. The relative performance of the current fiscal regime shows some improvement and yet it still covers about 23 percent of its spending by borrowing. The result of such features of government revenue and expenditure has been the emergence of persistent fiscal deficits and the accumulation of public debt. Domestic government revenue apparently has been barely enough to cover recurrent government expenditure let alone to generate resources for financing capital expenditure. The level of deficit has increased so much so that in recent years it has been as much as the total tax revenue collection of the government. Such a stance of fiscal policy is unsustainable and the external grants, even if important to partially narrow the gap, would not and could not resolve the problem. The government has increased its appetite for borrowing from foreign sources to bridge the gap and when external borrowing does not satisfy it resorts quite easily to borrow from the domestic banking sector.

The fiscal performance of the country is reflections of a typical underdeveloped and agrarian based economy in which the majority of the population lives in chronic poverty and a government that devotes its effort to extraction of resources from the economy and failing to allocate these resources to priority areas and sectors of the economy. When this is coupled with a de facto fiscal centralization and stance of inefficient public resource allocation, it fails to address the priorities of the majority of the population and hence becomes increasingly unsustainable. However, both political imperatives and changes in the overall economic policy of the country opened the door for fiscal policy innovation.

As far as the current system of fiscal federalisms and division of revenues in Ethiopia goes, the FDRE Constitution provides that the Federal Government and the States all collect taxes and shall share revenue, taking the federal arrangement into account. By taking into consideration principles such as ownership of revenue, regional character of revenues sources, convenience for administration, population, and wealth distribution, sharing of revenue between the Federal Government and the State Governments serves the following purposes: enhancing the efficiency of the central and the regional governments so as to enable them to carry out their respective duties and responsibilities; helping the regional governments to develop their regions on their own initiatives; narrowing the existing gap in development and economic growth between the regions of the country; and encouraging common interest activities of the regions.

In sharing of revenues, taxes are grouped into three: central (that of the Federal Government), regional and joint. As far as collection of the revenues goes, the regional governments collect their own revenues whereas the Federal Government collects not only its own revenues but also the joint revenues, of course with a possibility of delegation whenever deemed necessary.

According to Article 96 of the FDRE Constitution the revenues of the Federal Government include customs duties, taxes and other charges levied on the importation and exportation of goods; income tax collected from employees of the Federal Government and international organizations; income, profit, sales and excise taxes collected from Federal Government owned enterprises; taxes collected from national lotteries and other games of chance; taxes collected from income generated through air, rail, and sea transport services; taxes collected from rent of houses and Federal Government owned properties; charges and fees on licenses issued and services rendered by the Federal Government; taxes on monopolies; and Federal stamp duties.

In a similar manner, Article 97 enumerates the revenue sources of the regional governments of the country as comprising of income taxes collected from employees of the States and of private enterprises; fees collected from land usufructuary rights; taxes collected from the income of private farmers and farmers incorporated in cooperative associations; profit and sales taxes collected from individual traders operating within state territories; taxes on income from water transportation within state territories; taxes collected from rent of houses and State Government owned properties; profit, sales, excise and income taxes collected from State owned enterprises; taxes on income, royalties, and land rentals from mining operations; charges and fees on licenses issued and services rendered by the State Governments; and royalties for use of forest resources.

Apart from these, there are certain revenue sources which are shared by the Federal and State governments. The joint revenues are listed in Article 98 of the FDRE Constitution as constituting profit, sales, excise and income taxes on enterprises jointly established by the Federal and State governments; profits of companies and dividends of shareholders; and income and royalties derived from large-scale mining operations and all petroleum and gas operations. For those powers of taxation which have not been explicitly stated in the provisions of the FDRE Constitution, such as value added tax, Article 99 clearly stipulates that the exercise of such powers is to be determined by a two-third majority vote in a joint session conducted by the House of Federation and the House of People’s Representatives, thus subjecting the exercise of this so-called “undesignated power” to strict requirements.

The exercise of the taxing powers of both the Federal and Regional governments has to take certain considerations into account. For one, both governments are required to ensure that any tax is related to the source of the revenue taxed and that it was determined per the proper procedures. Secondly, both governments are required to ensure that the relationship amongst themselves is not adversely affected by the tax and that the rate and amount of taxes are commensurate with the services that the taxes help deliver. Finally, both governments are prohibited from levying and collecting taxes on each other’s properties unless it is a profit-making enterprise.

The FDRE Constitution gives much power to the regional states. Collectively, the regional states are granted the status of a nation. They are given self-determination up to secession. Self-determination is broadly understood to mean as the use and development of one's language, culture, history and administrative structure. Beyond the "unrestricted right to administer itself", self-determination also includes proportional representation at federal organs. In order to resolve conflicting claims over representation, territory and resource, the constitution has created the House of Federation whose members are elected by State Councils. The ethnic groups are represented at this institute. This House is composed of "representatives of nations, nationalities and people" at least one for each of them, plus an additional member for nation or nationality for each one million of its population". Ethnical conflicts and boarder disputes are referred to the House of Federation. This body has the role of supreme interpretation of the constitution and resolving key question of the nationalities/ethnic groups.

The regional states have their respective autonomous governments set up. Accordingly, each regional government includes a State Council (the highest organ of state authority) and a State Administration (highest organ of executive power). The State Council is the highest political authority: it defines the region's policy and has all legislative, executive and judiciary powers regarding the region, except for those under the responsibility of the central government, such as defense, foreign affairs, economic policy etc. The State Council plans, approves, heads and controls economic and social development programs. It drafts, approves and manages the regional budget. The State Administration is the highest executive authority of regional government. It is elected by the State Council and includes 15 Executive Committee members. The State Administration enforces, as appropriate, the policies, proclamations, regulations, plans, guidelines and decisions of the central government and of the State Council. It manages, coordinates and supervises the activities of regional offices, zone administration offices and Weredas (district) offices. It drafts and submits economic and social projects to the State Council for approval, and manages the projects once they have been approved. It drafts the region's budget, submits it for approval to the State Council and manages the budget once approved.

At the broadest level, the general principle underlying the allocation of authority and legislative responsibility in federal systems has been that matters of common interest and concern to the country as a whole should be assigned to the federal government, and matters of a decidedly regional or local character should be assigned to the regional governments. In actual fact, however, there is a weak federal executive power whose relationship with the regional governments is not yet clearly coordinated. Constitutionally, the federal government is not effectively centralized through presidentialism. The president has a symbolic role. The federal executive power is vested in the Prime Minister and in the Council of Ministers which are politically accountable to the House of Peoples' Representatives in all the decisions it adopts. As enshrined in Article 77 of the Constitution, the Council of Ministers among others, ensures implementation of laws, and decisions adopted by the Federal Parliament, decided organizational structure of Ministries and other Federal Parliament, decided on organizational structures of Ministries and other organs of government responsible to it, coordinates the activities of organs of government, discusses and refers draft proclamations to the Lower House, and decides on the general socio-economic and political strategies the country should pursue.

State Councils of the regions are also responsible for appointment of the highest executives in charge of the various organs of State. The respective constitution of the various regional states stipulates that the State Councils are entrusted with the power of forming the Executive Committee, which is the highest state-level executive organ. State executive bodies are responsible for the execution of laws, policies and strategies falling within their jurisdiction. These include administering land and other natural resources in keeping with Federal laws, formulating and execution economic, social and development policies, strategies and plans of the state in question.

Consequently, health, security, and agricultural development and similar other matters seriously demand that the pertinent Federal and State executive organs work in close collaboration. There could be contexts where the common decisions of the two become vital to ensure maximum benefits in a particular area. But there is a weak exchange of information between the two levels. Under such circumstances, it is possible that the regional states can only issue and enforce their own laws not that of the federal government.

The most important factor which underlines the further autonomy of the regional states is the assigning of residual power. The Federal Constitution as stipulated in Article 52(1) states that "All powers not given expressly to the Federal Government alone, or concurrently to the Federal Government and States are reserved to the States". Accordingly, any residual power unspecified in the constitution is left for the States. It thus allocates residual authority to the constituent units. The significance of the residual power is that the regional states can exercise legislative power over matters not specified in the constitution.

The above three points suggest that the relationship between the federal government and the regional states is asymmetrical, even though they are in principle considered to be equal. Nonetheless, the financial and manpower resources of the regions are very limited. The revenue base of the regions is not that productive and expansive. Currently, they are dependent on federal fund, particularly for capital budget. They are not yet economically strong to claim that their laws supersede that of the federal law. According to the constitution, they are given all the power to develop their region.

As can be inferred from Sub-Article 7 of Article 62 of the FDRE Constitution, which enumerates the powers and functions of the House of Federation, there is a possibility by which the Federal Government may transfer revenue to the regional governments. Such a system of transfer payments or grants, by which a central government shares its revenues with lower levels of government, is an important aspect of the subject matter of ‘fiscal federalism’. The underlying rationale behind transfer of revenue is the existence of a fiscal gap at the sub-national level emanating from lack of locally generated own revenue to finance own expenditure; differences in the regions’ level of economic development and endowment with natural resources lead to the formation of a fiscal gap.

Federal governments use this power to enforce national rules and standards. Such transfers of revenues usually fall under three categories: conditional, unconditional and equalization grants. A conditional transfer from a federal body to a state, or other territory, involves a certain set of conditions. If the lower level of government is to receive this type of transfer, it must agree to the spending instructions of the federal government. The second type of grant, unconditional, is usually a cash or tax point transfer, with no spending instructions. Unconditional grants are usually general purpose grants aimed at addressing vertical imbalances. The third type of grant, equalization grant, is used to address horizontal imbalances between regional governments through the channeling of resources from the relatively wealthier regions to poorer ones; thereby equalizing the capacity of regional governments to provide a national standard level of goods and services.