The Political Economy Of Fiscal Federalism: Lessons For Nigeria

The debate over Value Added Tax (VAT) derivation in Nigeria highlights the perennial tensions inherent in federal systems: balancing economic efficiency with equity, and regional autonomy with national cohesion. While Nigeria’s socio-political realities are unique, lessons from countries like Germany, Canada, the United States, and India illuminate the complexities of fiscal federalism. These examples reveal a recurring truth: federalism is not about rigid principles or ideological purity. Rather, it is a pragmatic system of precarious balancing, anchored in elite bargains and political settlements that prioritise national stability over economic rationality.
In Germany, fiscal federalism is driven by the principle of solidarity, even in the face of significant regional disparities. The fiscal equalisation system ensures that wealthier states contribute to a common pool that supports less prosperous regions. While this mechanism is often contentious, particularly among donor states like Bavaria, it reflects a national commitment to cohesion. Without such redistribution, the economic divide between Germany’s affluent west and its historically disadvantaged east could destabilise the federation. The German experience demonstrates that equity and cooperation are essential ingredients of a resilient federal system, even if they come at the cost of economic efficiency.
Canada offers another instructive case. Its equalisation programme addresses disparities in provincial fiscal capacity by redistributing federal revenues to less wealthy provinces. Resource-rich provinces like Alberta often criticise the system, viewing it as punitive and a disincentive for innovation. Yet, the program has helped sustain national unity, particularly in regions like Quebec, where fiscal grievances could exacerbate separatist sentiments. By embedding redistribution in a cooperative framework, Canada demonstrates the importance of fostering a shared sense of purpose in a diverse federation.
The United States, despite its emphasis on competitive federalism, also exemplifies the importance of redistribution. While there is no formal equalisation programme, the federal government indirectly balances disparities through tax-and-transfer mechanisms and federal spending on programs like Medicaid and infrastructure. This implicit equalisation allows economically weaker states to maintain a baseline of public services, even as wealthier states lead in innovation and development. However, the lack of formalised redistribution also highlights the risks of uneven outcomes, as seen in stark disparities in education and healthcare across states.
India’s fiscal federalism operates through a blend of tax devolution and grants, mediated by its Finance Commission. The Goods and Services Tax (GST) further illustrates the country’s commitment to cooperative federalism, as states and the central government collaborate to harmonise tax policies. Redistribution ensures that less developed states like Bihar and Odisha can provide basic services, even as wealthier states like Maharashtra and Tamil Nadu maintain a competitive edge. Despite persistent tensions, India’s model underscores the necessity of balancing regional autonomy with national solidarity in a heterogeneous society.
For Nigeria, these examples are instructive. The VAT derivation debate reflects a clash between the competitive aspirations of wealthier southern states and the cooperative needs of poorer northern states. Southern states, particularly Lagos and Rivers, argue for greater retention of VAT revenues, framing it as a matter of fairness and efficiency. They contend that the current system rewards inefficiency and stifles innovation, as states dependent on federal allocations have little incentive to diversify their economies.
Conversely, northern states emphasize the redistributive principles of federalism, viewing central allocation as essential for national unity. Given Nigeria’s stark regional inequalities, they argue that devolution of VAT revenues would deepen existing disparities and exacerbate socio-political tensions. This divide mirrors the challenges faced by other federations, where wealthier regions often resist redistribution while less developed areas depend on it.
Nigeria’s path forward lies in recognizing that fiscal federalism is not just an economic arrangement but a political one. Redistribution, though often contentious, is a mechanism for sustaining the federation. The precarious balancing act seen in Germany, Canada, and India underscores that national cohesion requires sacrifices from all sides. Wealthier states must acknowledge their responsibility to support less developed regions, while poorer states must work toward self-reliance to reduce long-term dependency.
However, the lessons from these federations also point to the need for a political settlement—a negotiated framework that addresses the unique dynamics of Nigeria’s federation. An elite bargain must underpin any reform, with stakeholders agreeing on a system that balances resource control with redistribution. Such a settlement should recognise that excessive centralisation breeds inefficiency and stifles local innovation, while unchecked devolution risks fracturing the state. A hybrid approach, where states retain a portion of VAT revenues while contributing to a redistributive pool, could strike the necessary balance.
Ultimately, Nigeria must move beyond the rhetoric of “true federalism” to embrace a model that reflects its socio-political realities. No federation is perfect, and fiscal federalism is always a work in progress. The experiences of other nations show that pragmatism, not ideology, is the key to sustaining unity in diversity. Nigeria’s VAT debate is not just about taxation; it is a test of the country’s capacity to craft a federalism that addresses its unique challenges while fostering a shared sense of destiny.