Competitive Federalism: Promoting Freedom and Prosperity

The Federalism Project
Issues Paper No. 3

"... one of the great advantages of interstate federation [is] that it would do away with the impediments as to the movement of men, goods, capital between the states and that it would render possible the creation of common rules of law, a uniform monetary system, and common control of communications. ... But ... the establishment of economic union will set definite limitations to the realization of widely cherished ambitions ..."

F.A. Hayek, "The Economic Conditions of Interstate Federalism",
New Commonwealth Quarterly, vol. V:2 (September) 1939, pages 131-49.

"Human institutions are imperfect, government is imperfect, and the market is imperfect, because humans are imperfect ... government works best if we have a mix of different levels instead of a single centralized government."

G. Tullock, The New Federalist
(Vancouver: Fraser Institute, 1994), page 18.

INTRODUCTION

THE WORLDWIDE TREND TO CENTRALISATION IN GOVERNMENT IS MEETING WITH RESISTANCE

Among the world's most affluent countries of considerable size and among the government systems which have best guaranteed individual human rights over an extended period, a surprisingly large number are federations.  In the United States, Germany, Switzerland and Australia, among others, the central government is bound by the constitution to share the powers and tasks of governance with State (and sometimes local) jurisdictions. ⁽¹⁾  This division of jurisdictional powers is often the very reason why federations have a good long-term record of protecting civil rights and shielding the forces of spontaneous economic growth from the impediments which are created by centralised interventionism and rent-seeking.  We shall make the case that the positive association between federalism on the one hand and civil liberties and prosperity on the other is no coincidence.

In many nations which are not organised on the federal principle, local and regional government authority and regional or cultural solidarity have nevertheless been asserted in recent years.  Central government powers have been widely challenged in all sorts of regimes:  for example, certain regions of the United Kingdom and France have made periodic demands for a greater devolution of powers and finances from the centre (Boogman and van der Plaat, 1980);  Spain's metamorphosis into a genuine democracy was accompanied by the granting of greater autonomy to the regions;  Brazil's recent attempts at constitutional reform and control of government corruption hinged on devolving powers and finances to the federal States of Brazil;  and Italy is going through a renewal of its corrupted, centralised political and industrial system, which is driven by a renewed assertion of regional loyalties.  The amazing economic ascendancy of the Peoples' Republic of China cannot be understood without reference to the growing independence of local and provincial powers from the centre at Beijing and to the rivalry of different regional jurisdictions for new businesses.  The Soviet Union has disintegrated into different states, which are now experimenting with a wide variety of policies to overcome the costly legacy of centralised socialism, and many regions within Russia are seeking more local autonomy.  A number of previously centralised regimes in eastern Europe have sought "divorces" of regions, because the people wanted to be independent of central control (the "velvet divorce" of the Czech and the Slovak Republics;  the violent break-up of the former Yugoslavia).

The apparent exception to this general trend is the closer union of western Europe, especially under the Maastricht Treaty.  Many politicians in Brussels and the national capitals of western Europe see gains in their power if Europe centralises.  But there are strong countervailing forces against these attempts throughout Europe.  Nonetheless, it is possible that the traditional nation-states will be eroded from the top (in Brussels) and the bottom (in regional and local governments).

In short, the centralised nation-state, which was invented in the eighteenth century and became the general model of governance in the twentieth century, is now under historic challenge.  In the light of the above-mentioned developments it can be seen neither as necessarily the best system of governance, nor as necessarily a permanent way of organising collective action.

One major reason why regional loyalties have begun to assert themselves, and why the centralised nation-state may have passed through its zenith, is the change in transport and communications technology.  This revolution is now empowering individuals and smaller units, giving them access to channels of communication, markets and sources of knowledge which were previously only within the reach of big, centralised units, such as the mega-corporation and the nation-state (Naisbitt, 1994).  The new technology of decentralised computer networks and e-mail bulletin boards makes it easy for smaller units to evade the control of the nation-state.  Thus, national monetary policies are no longer effective, because national monetary restriction simply leads to international capital inflows which undermine the restriction.  When money travels around the world electronically, the notion of stimulating demand by piling up a bigger national money supply is about as ridiculous as trying to pile a hill of water on top of a pond.  National welfare policies that over-tax the rich and make transfers to the poor are failing everywhere, because the rich can now move to jurisdictions with less discriminatory tax regimes.  The same holds true of regulatory regimes:  heavy regulation tends to undermine the capacity of skilled people, capital and firms to earn a decent rate of return, by imposing high compliance costs on them;  consequently, interventionist regimes are being deserted by these wealth-creating resources.  Governments that offer a poor infrastructure and poorly-enforced laws increasingly find, too, that they are being deserted by tax-paying capital and firms.  In short, the power of the nation-state to do many of the things that it has traditionally done is now being undermined by globalisation (Kasper, 1990;  1994a;  McKenzie and Lee, 1991;  Drucker, 1993).

The relative power of centralised rule is waning, and citizens in regions are discovering that they may get a better supply of collective goods, which is financed by more just taxation, if they seek the devolution of many of the central powers.  They also discover that they have a relatively bigger say in governance if matters are decided at a lower level, than if they are faced by just one huge and distant central government.

AUSTRALIA'S PROGRESSIVE CENTRALISATION

Since the federation of the Australian colonies there has been a fairly steady trend towards centralisation in many functions of government.  This trend derived from the growing reliance on centralised taxation, coupled with the remittance of Federally-collected tax funds to the States.  It was part and parcel of the century of socialisation (c.1880-1980), which was characterised by the belief that big and powerful government could solve the problems which individuals could not.  Centralisation was facilitated by the inward-looking policies of the Federation from 1900-1980, because the competitive discipline of world markets, which would have induced more diverse administrative responses in various parts of Australia, was kept at bay (Kelly, 1992).  Centralisation was driven by ambitious Commonwealth politicians and bureaucrats, and occasionally speeded on by the High Court.  The history of Australian federalism for most of this century, of course, only reflected the general, worldwide tendency towards bigger, more centralised organisations, which has been put into reverse only since the global communications revolution started in the 1980s.

The historic centralisation tendency in Australia has been frequently inspired by egalitarian aspirations.  A powerful central government was seen as the guarantor of a fairly equal provision of public services, irrespective of whether the citizens wanted these services (or were paying the taxes to fund them).  Regional income redistribution along principles of regional income equality was indeed seen as a key function of government.  Similar egalitarian tendencies were also at work in the parallel process of wage formation.  Frequently, Australians were paid the same nominal wage for comparable work, irrespective of how far they were located from markets.  This led to a great and costly concentration of population and industrial activity in the port cities, and has created the very regional problems which the centralised fiscal system was meant to rectify.

The centralisation trend has to be seen as an integral part of the "Australian Settlement", under which a pervasive, paternalistic government protected and provided.  But the "Settlement" has proven not to be tenable (Kelly, 1992), because -- like more dictatorial forms of socialism in eastern Europe -- it eroded the spontaneous forces for long-term economic growth.  Reliance on a central fiscal authority to equalise and provide, as well as to dictate solutions to State and Local governments, will have to go in the wake of the demise of the "Australian Settlement".  The federal distribution of powers has one great advantage in the era of globalisation:  administrations can acquire the habit of competing with one another -- the best training programme for competing subsequently on the global scene (Kasper, 1993b).

OVERVIEW

Before we can discuss the consequences of centralisation in Australia and the possible consequences of decentralisation -- should we follow the new worldwide trend -- it seems necessary to discuss:

1. the economic rationale for government, which springs from the need to reduce the costs and risks of transacting business, and from scale economies;  and
2. the concept of competition in space, and resulting transport costs, as well as the mechanisms whereby different regions normally develop, and whereby "problem regions" are created.

These arguments, which seem essential to understanding the distribution of powers between different levels of government (central, state, local), will be put forward in Part I.

In Part II, we will discuss the "Competitive Federalist Principle", namely, that a distribution of powers of governance serves to protect the citizen from the opportunism and arbitrariness of the rulers, and how it tends to favour competitiveness and hence economic prosperity better than centralised government tends to do.

PART 1:  BASIC THEORETICAL CONSIDERATIONS

(A) THE RATIONALE FOR GOVERNMENT

It is no coincidence that long-lived democracies have flourished under federalism and that other countries are aspiring to a more decentralised organisation of governance -- namely, the devolving of some functions of governance to sovereign regional jurisdictions under the umbrella of a central government which holds ultimate sovereignty.  This has to do with both the benefits of government and the risk that government agents may employ their power opportunistically against the sustained freedom, equality and prosperity of the citizens.  To explain this, we have to comprehend:

1. that government is a setter of rules which reduce the costs and risks of individual interaction in markets and organisations;  and
2. that temptations are ever-present for government office-holders to use the powers entrusted to them in their own self-interest and to the detriment of efficiency and the freedom of the citizen;  this is known in the literature as the "agent-principal problem", which led some political philosophers to describe government as a clumsy, potentially dangerous giant, "Leviathan".

Transaction costs and institutional rules

It is well known -- though ignored by much of standard economic theory -- that people who interact in the market place incur "transaction costs".  Buying and selling in markets, and the division of labour, are essential to high living standards.  Indeed, growing living standards depend on an increasing division of labour and growing reliance on well-functioning, cheap-to-use markets.  The costs of market activities are:

• First, information costs incurred by people who want to buy and sell.  They have to find out who sells what, where, in what qualities, at what prices and conditions.  Frequently, expensive research and development is needed before a product is even available for sale.  Gathering information can be costly and risky.  The worth of information cannot even be known before we have incurred the cost and effort to acquire it.  Information search therefore creates a sunk cost, often in vain.  We may invest a lot of effort searching for information only to decide that, after all, the envisaged market transaction is not worthwhile.  Any device that reduces the costs and risks searching for information will therefore be welcome and will lead to the better exploitation of knowledge.  Governments can do much to provide, validate and circulate useful information, for example, about weights and measures, standards of behaviour, transparent laws and market information.
• Second, considerable costs are incurred in negotiating and settling a contract.  In our modem economy, goods and services may be very complex, and detailed aspects of a deal may have to be negotiated and certified.  Many contractual arrangements are open-ended, such as contracts for employment or the delivery of electricity, and many involve credit and mutual trust over long periods of time.  This requires often costly contracting and "legal buttressing" of deals made in the market.  Contracts also have to be fulfilled, and the fulfilment monitored.  This involves often considerable contracting, distribution and transport costs.  Laws and other institutions which facilitate contracting therefore have important benefits to wealth creation.  Government can do much to reduce these costs and risks by providing clear, transparent laws.
• If contract partners fail to comply because they behave opportunistically or are simply negligent, contracts have to be enforced.  This requires all sorts of arbitration, judicial activities and policing.  In addition, the agents who arbitrate, settle legal cases or police the contracts, have themselves to be monitored to ensure that they, the agents, do not behave in opportunistic ways and that they stick to the rules.  Anyone doing business in underdeveloped countries will be aware that, frequently, it is not the lack of rules, but the lack of credible enforcement that hinders wealth creation.  Government can greatly reduce the enforcement costs by maintaining a timely and impartial judicial system.

Transaction costs have been estimated to account for no less than 45 per cent of producing and selling the American national product (North, 1992, page 6).  Looking at the composition of what goes into Australia's national product, I estimate that the transaction costs (including distribution and organisation costs) in Australia as of the early 1990s are at least as high (Chart 1).  As specialisation is increasing and we are producing more -- and increasingly complex -- products, more and more costly transactions are needed.  This is behind the rapid growth of much of the service sector (trade, finance, business advice and other business services, and most of what governments do), which occurs despite the fact that new computing and communications technology is reducing the cost of each single transaction.  This cost reduction has indeed induced people to make many more transactions and subcontract more inputs through the market than was customary a generation ago.  As a result, the service sector, which is to a large degree a "transactions sector", has been the major driving force of economic and employment growth.

A society can economise on many transaction costs by ensuring that all members of society obey reasonably stable rules which constrain individual behaviour and give a certain structure to human interaction and co-operation.  Economists call these rules "institutions". ⁽²⁾  The formal and informal rules of a society are essential in controlling the level of transaction costs.  They determine the efficiency and rates of return for using a society's productive assets, such as labour, capital, knowledge and natural resources.  The institutions of a society therefore constitute a "soft infrastructure" which is much more important to economic performance and growth than the "hard infrastructure" of roads, ports and telecommunications networks.  And, different from the hard infrastructures that depreciate with use, the soft infrastructures improve as people use them more and for longer periods of time, because the rules become better-known and hence more reliable.  The old adage that "old laws are good laws" is based on this insight and mitigates the constant rule-changing activism that we are witnessing in Australia.

The institutions that matter most are informal rules which have evolved gradually in the light of accumulated experience.  People chanced upon a certain arrangement and found that it was conducive to long-term efficiency.  So they adopted it as a rule or imitated it.  Thus, Neolithic people probably discovered that the respect for private property and land ownership by other members of their society induced the proprietors to use their property and land more productively, and that living standards were promoted by this respect for private property;  as compared with a situation when possession of an asset had to be defended all the time against the attack by others.  And the merchants of Renaissance Europe discovered that "civic virtues", like reliability, honesty and punctuality, which constrained the opportunism of individual merchants, were immensely productive, because they reduced the risks and costs of transacting business and made entirely new types of trade feasible.  Indeed, a society's shared system of ethics and good manners is a code of rules that constrain individual opportunism -- lying, cheating, shirking, negligence, indiscipline and so on.  A shared ethical system makes life more predictable, and hence the interaction between people more efficient.  The contemporary experience of societies where little of that ethical-cultural infrastructure exists, or where the informal institutions of society have been destroyed -- for example, in parts of Africa or in present-day Russian society -- demonstrates how important these informal rules are to individual freedom, equity and prosperity.

Economising on transaction costs is, of course, extremely useful to overall economic performance and international competitiveness.  But it must also be recognised that one man's transaction costs are another man's livelihood.  Societies with bad institutions and high transaction costs tend to have high levels of those activities which create handsome incomes for those who administer transactions:  the lawyers, the bureaucrats, the toll collectors, the lobbyists, the consultants etcetera.  This is why there are concentrated interest groups that have a high stake in poor institutions (Olson, 1965) and why more economically rational institutional frameworks are prevented from arising.  Indeed, most of human history has been a period of stagnation because those who live by causing transaction costs got away with it (North, 1992;  Jones, 1987).

The state as a rule-setter

Voluntary compliance with informal rules does not always work.  In particular, in large mass societies, and with the frequent interaction of total strangers in markets, certain rules have to be spelled out formally and enforced.  Sometimes, people appoint third parties to interpret and enforce the rules;  for example, when they voluntarily submit to a respected authority for arbitration or to associations that set and police professional standards.  It is, however, frequently in the long-term interest of all members of society to support a ruler who sets and enforces a set of rules.  Law givers, from Hammurabi in ancient Babylon down to modem times, have been recognised for the important contribution they made to individual welfare and prosperity.  As good laws serve to lower transaction costs and raise productivity in an ordered society, people are able and willing to pay the rulers taxes for providing that service (Eggertson, 1992, pages 59-82).

The ruler of course could not serve the, often costly, rule-setting function without collecting taxes from the citizens.  The cultivation of the law -- and law-enforcement by courts and the police -- can be costly;  the collection and administration of taxes costs additional resources.  In Australia, the Tax Office alone is employing 17,000 people.  Nevertheless, the existence of transaction costs and the human tendency towards opportunistic behaviour, if not constrained by occasionally enforced rules, make it mutually beneficial to develop a government and to fund it.

Rules impose one cost on individuals not yet mentioned:  compliance costs.  Individuals, to operate within the rules, have to incur costs;  for example, they have to run accounts so that they can be assessed for taxation, they have to report certain activities to government, or they have to seek licences to conduct certain types of business.  International comparisons show that compliance costs vary greatly from country to country.  Good rules are designed to make it easy and cheap for citizens to comply.  Countries with bad rules place great burdens on complying citizens:  the rules may not be clearly knowable (lack of transparency), their interpretation varies arbitrarily, and the rules are designed for administrative convenience, rather than the convenience of the citizen.  Australian governments often impose very high compliance costs, for example, in personal and corporate taxation where the taxpayer has to incur a multiple of the comparable costs borne by British taxpayers (Pope, 1992).  Sometimes compliance costs are hard to identify.  The Commonwealth industrial relations legislation of 1993 again makes it potentially very costly for firms to fire employees.  This is why industrial businesses now often require a division to set aside about $30,000 in capital for each new permanent job as a provision to safeguard against firing costs.  All such compliance costs have to be taken into account when evaluating the value of new government rules.

In this vision of the state as setter of rules for economic interaction, the final test of whether government has a task or not is this:  if legislation, regulation or another administrative activity lowers the transaction costs to individuals and enterprises by more than it costs to administer the law, regulation or other administrative activity, then it should be undertaken.  If that justification cannot be found, then government has no role.  This vision would limit government activities to legislation and regulations that prevent damage to the rights of others and make smooth co-operation possible, as well as policing the institutional rules and defending the system from outside interference.

This vision of government is greatly at variance from the prevailing popular philosophies of what government should do.  These would suggest that government has to go far beyond creating a framework of order for otherwise free individual pursuits, by providing individuals with income (irrespective of effort or luck) and producing many of the goods and services which individuals want.  These latter functions, of course, bloat the government and create positions and influence for many of the agents of government.

The closest Australians have come to spelling out the vision of the state as a rule-setter was in the Fightback! programme, which the Liberal and National Parties published in 1991, but have since jettisoned.  Having first analysed the causes of national decline and discussed the perceived values of individual Australians, they advocated "economic growth based on individual private enterprise [as] the best way to generate a dynamic economy, to maximise freedom and to enable society to care properly for those in real need" (Liberal and National Parties, 1991, page 25).  From this they proceeded to develop a framework for certainty, on which individuals could rely in pursuing their aspirations.  They explicitly presented institution-setting as a "new role for government. ... The role of government must be to provide a framework of policy and law. ... Government should set the framework for action but not determine the content of action, which should, so far as possible, be left to individuals.  The failure of government to provide such a satisfactory framework has been a central cause of Australia's recent decline" (idem, page 26).  This new role for government was tied to the explicit recognition that such a style of governance -- ensuring a predictable and orderly environment -- would make Australia internationally attractive to mobile people, capital and technology, because this style of policy would offer "equal opportunity for all, not privilege for the influential few" (idem, page 29).

Whilst the concept of confining the state to serving mainly as the back-up and guarantor of supportive institutions did not get much of a run in Australia, this was the decisive factor underpinning West Germany's "miraculous" post-war recovery and in turning many of the East-Asian economies into highly attractive, highly competitive, prospering and equitable societies (Kasper and Streit, 1993;  Kasper, 1994a).

Quis custodiet ipsos custodes?  Rent-seeking by government agents

The institutional-economics theory of the state -- as sketched above -- unfortunately does not end there.  The general human tendency to behave opportunistically, if not constrained by institutions, also prevails among rulers and their agents.  They are tempted not to act in the common, long-term interest by implementing the rule of law before which everyone is equal.  This problem is amply documented in the economics literature where it is known as the "agent-principal problem" (for example, Eggertson, 1990, chapter 5).  As soon as we do not act on our own in our own self-interest, but employ an agent to do something for us, that problem arises.

It is widely recognised in corporate governance:  how to ensure that the company directors (the agents) work ceaselessly in the genuine interest of the shareholders (the principals).  There are many mechanisms in business that help to constrain the problem -- not least, well-functioning capital markets -- but these mechanisms are lacking in the public sector, where politicians and bureaucrats frequently refuse even to recognise that they are no more than the agents of the citizens who are the ultimate principals.

The agent-principal problem comes up in many guises.  Rulers may distort the rules, for example, by transferring property from the many poor to the few rich, and then accept bribes from the favoured rich.  Agents of governments – bureaucrats -- may cease to implement the will of the rulers and instead maximise their own gain, for example by high on-the-job consumption or by granting monopolies to one group in exchange for personal favours.  Bureaucrats may be negligent, undisciplined or plain lazy in their work, or they may implement internal administrative rules that enhance their on-the-job comfort to the detriment of the common wealth.  Judges may be corrupt, and enforcement agents, such as the police or prison officials, may be self-seeking.

For these reasons, externally-imposed formal rules (legislation, regulation) may often serve to undermine or destroy the internal institutions of society (custom, ethics, the law).  In any event, the formal institutions of government can work only if they are supported by the people, and if 99 per cent of the constraints consist of spontaneously-obeyed internal rules.  The saying that "excessive legislation destroys the law" has its origin here (Hayek, 1979).

The upshot of all this is that good government is an enormous, indeed an essential, benefit to human welfare, but that the temptation for opportunistic government is ever-present.  Government is indeed Leviathan, a giant that can help us or can crush us (Buchanan, 1975).  The critical and never-ending task with which any society has to struggle, therefore, is to create devices that constrain the politicians and the bureaucrats so that they act in the interest of the citizen, the real principal in the game of governance.

Controlling Leviathan

In the course of history, different devices have been invented to limit the agent-principal problem and rent-seeking in government, but none has been fail-safe:

• Confucius and other moral educators in both East and West advocated the ethical education of the rulers and the bureaucracy, ensuring that opportunism is constrained by rigidly-inculcated self-discipline and adherence to ethical standards and good manners.
• Societies in the Classical and European tradition have placed great trust in constitutions, that is, hard-to-change core rules which determine how subordinate rules are made and by what fundamental arrangements they are administered.  Constitutions often stress inalienable human rights.  This approach has also been advocated in recent times by the European "ordo" liberals and the American "constitutional economists", who advocate binding constraints on the free political will of parliaments (Kasper and Streit, 1993;  Buchanan, 1988).
• In many Western societies and elsewhere, democracy -- that is, the requirement for holders of collective power to compete periodically for the vote -- has been implemented as a device to control the arbitrary use of power by the agents of government.  Democracy may, of course, not be the only way to ensure the citizen's interest in civil and economic liberties and basic order, as the colonial, undemocratic regime in Hong Kong has demonstrated.  Nor is it sufficient to protect people from opportunistic rule, but it often serves to constrain agents from abusing their power in gross ways.
• Freedom of information and a free press tend to serve as powerful, supportive antidotes against the abuse of government powers, in particular when coupled with the periodic dependence of the agents on the democratic vote.
• Openness is probably the single most powerful supplement to limit the "principal-agent problem" in government.  Economic historians have shown that the emergence of transaction cost-saving institutions and of civil liberties in the face of arbitrary government in Europe has had a lot to do with the fact that the small countries of Europe were open.  People with innovative ideas -- like Christopher Columbus or the Huguenots -- who were not given local government support or who encountered opportunistic exploitative rent-seeking by the rulers, simply moved to a better kingdom in the neighbourhood.  Jurisdictions which provided good (that is, transaction-costs-and-risk-reducing) institutions therefore attracted mobile capital, entrepreneurs and other growth-enhancing resources and began to prosper (Jones, 1987).  This created economic successes, which were imitated.  Good government spread.  A similar process of competing jurisdictions was set in train over the past generation in East Asia, when the previously all-embracing, closed Chinese empire, from which there had been no escape and which therefore could engage in costly despotism, splintered at the edges.  People could move to Hong Kong, Taiwan or Southeast Asian countries or further afield if they encountered opportunistic and hostile agents of government.  This forced all governments to compete with each other in the game of attracting mobile resources by enhancing their institutions (Kasper, 1994a).  Even the power monopolies of the Chinese and the Vietnamese communist parties have had to yield significantly in recent years to the forces of contemporary international competition.  Openness has therefore proved a most powerful antidote to a style of government that fails to reduce transaction costs and risks and that tolerates self-seeking government agents (Kasper, 1990;  1993a;  Giersch, 1993).

Competing jurisdictions at home and internationally

The principle of openness -- which forces governments to compete with other governments in helping to reduce transaction costs and providing efficient, citizen-friendly administrative services in return for the taxes paid -- is a most powerful complement to the other devices that have been invented to maintain government of the people, by the people and for the people (and not the rulers!) over the long term.  As mentioned in the Introduction, the epochal changes of the transport and communications revolution have now made it much easier for owners of skills, capital or firms to vote with their feet.  Many patterns of behaviour and constructs of analysis that were developed in the fading era of the fairly closed nation-state now prove untenable.  In the era of globalisation now beginning, there is little political primacy over economic life, because more and more people simply evade political pressures by moving their assets internationally (Kasper, 1990;  McKenzie and Lee, 1992;  Drucker, 1993;  Sinn, 1993;  Naisbitt, 1994).  In this new era of globalisation, in which individuals and enterprises are empowered vis-à-vis self-seeking authorities, government has to switch to a new role:  being a support organisation for mobile resources, setting a transparent, non-discriminatory framework in which people can interact with confidence, efficiently and with growing productivity.  Countries that are practising this style of governance, such as many East-Asian countries, are attracting mobile resources and prospering.  Countries where the culture of the nation-state and self-seeking rule by political and bureaucratic agents is more deeply entrenched, are losing resources and will stagnate.  Divergent economic growth will soon force them to join in the international competition of jurisdictions (Giersch, 1993, pages 149-158).

The salubrious principle of openness and competition of jurisdictions is at work also within those countries where government power is not centralised.  Indeed, competing jurisdictions within federal systems are often able to discover and test those administrative devices that favour international competitiveness by first learning to compete internally (Bish, 1987;  Ostrom 1991;  Kasper, 1993b,c).  This is one of the great strengths of federations:  power is distributed and frequently held in check by intra-national rivalry;  the "agent-principal problem" is effectively limited.  At a time when transaction costs are rising to make up nearly half the cost level and when government looms large in shaping these costs, federations are gaining a growing advantage.  In addition, of course, citizens can enjoy more freedom if they have the option of moving from one jurisdiction to another within their own country (Kasper, 1993b).  Therefore, popular aspirations for freedom and prosperity are now injecting new life into the federal idea, as already observed in the Introduction.

The agents of governments (and other rent-seekers, for example, union officials) do not of course like being exposed to competition -- few people do.  To avoid exposure to the disciplines of competition, they try to create over-arching mechanisms that prevent the competition between jurisdictions.  This is often called "harmonisation" or "cooperation".  The gains in technical efficiency from avoiding competition (scale economies, fewer transaction costs) are stressed.  But in reality this often amounts to no more than a cartel of governments which want to evade the forces that compel them to behave in economically efficient ways.  Harmonisation and cartelisation protect the participants from having continually to strive for better ways of doing things.  This is why, in the long run, the removal of the uncomfortable discipline of inter-jurisdictional competition raises costs and leads to outcomes which are disadvantageous for the community at large.  The gain in comfort for those in control of rent-seeking institutions, such as bureaucratic agencies, unions and welfare lobbies, is far outweighed by the lesser long-term income growth for the community at large.

Seen in this light, the argument for harmonisation and centralisation is no different from the argument for industry cartels which the Trade Practices Act rightly bans.  Within countries with decentralised power distribution, the wish to avoid competition among jurisdictions leads to centralisation at the top.  In the international arena, we observe administrative co-operation between national governments and the delegation of powers to supra-national authorities -- sometimes to achieve genuine economies, but often to make life easier for government agents who would otherwise have to compete for mobile production factors.  The same motivation is at work when trade unions try to set up international deals that prevent workers in one region or country from competing with those of high-cost regions or countries.  This has, for example, been visible when Australian unions try to influence Asian workers to demand more "workers' rights", and when West German unions ensured that (much less well-equipped) East German workers got the same terms and conditions as in the West.  In both cases, the move is aimed at preventing the migration of capital, technology and firms to low-cost workers and at avoiding the consequent competitive pressure on high-cost workers.

In the face of competition in space, power centres that represent immobile production factors like labour and public administration will always try to create units which embrace all possibly competing locations.  In this way they avoid outsider competition and subservience to the same maxims of competition that apply to the mobile factors of production.

If one wanted to give an edge to competition within federal systems, one would allow for the secession of disgruntled States from the federation.  Such proposals have been made both overseas and in Australia (Radnitzky, 1990;  Sharman, 1993).  The possibility of secession would reinforce the evolutionary, competitive approach, and undermine centralist constructions as a means of finding administrative solutions to new problems.  The possibility of secession would also give States, which otherwise might be able to place utopian demands on the centre, the incentive to evaluate the pros and cons of being part of the federation in a more realistic manner.  The continual invitation for all members of the federation to evaluate the costs and benefits of co-operating probably leads to a continual wholesome discipline for all participants and prevents conflicts of a harsh kind (cf. the break-up of Yugoslavia).

One important argument for fostering competition among self-responsible State and Local governments within a country is -- as briefly mentioned -- that the domestic competition of governments is an appropriate training ground for politicians and administrators to behave in internationally competitive ways.  In the era of globalisation, federal regimes have the advantage that differing and competing administrative solutions can be tested within the country and that successes can be copied.  By contrast, centralised government regimes are in danger of committing centralised blunders.  The "gene pool" of administrative solutions is therefore so much richer in federal regimes, and, therefore, survival chances so much better than in central regimes.

The single greatest benefit of the decentralisation of government powers within a federal structure is that it controls the agents in the interest of individual pursuits.  Jurisdictional competition shifts the gameplan to constant evolutionary improvements and undercuts the centrally-designed schemes of social engineering that are known as "constructivism" (Hayek, 1979;  Radnitzky, 1990).  Centrally-imposed constructs of governance tend to be based on the view that individual pursuits and industry are sinful, potentially harmful activities that need be civilised and guided by the higher, more nobly motivated authority of government.  This viewpoint could be credibly argued in the 1920s or even 1950s.  But by now the experience in East and West, not least in the ex-communist countries, has shown that constructivism rarely works, because the centre simply does not know.  Societies tend to be more productive and creative if they rely on decentralised experimentation and discovery of useful knowhow, and trust in the competitive discipline to test what is really useful to the citizens.  Competitive federalism embodies this worldview and fosters an administrative culture which turns governments from antagonistic controllers into supporters of decentralised, individual initiatives.

Centralisation and ideology

How one thinks about centralisation versus federalism in governance probably depends in the ultimate analysis on one's basic conception of society.  In essence, there are two conflicting views:

• One basic social philosophy sees society in mechanistic terms, as a network of more or less firmly-defined, static relations, and as an objectively-determined system which can be influenced to attain pre-determined social goals, such as freedom, equity, economic welfare and social harmony.  This worldview leads to the advocacy of "constructivist interventionism" by a central authority that knows what is required and is in charge of attaining the social goals -- "constructivist" because society is shaped to fit a centrally conceived design, and "interventionism" because the centre influences outcomes by pervasive, collective action to obtain the chosen design.  This worldview sees society as a collective phenomenon in its own right, separate from the individual, and obeying its own rules which are not ultimately judged by the effect on the individual.
• The alternative social philosophy focuses first and foremost on the individual and on the changing, complex wants and resources of individuals.  People set their own goals and change them in a process of ceaseless interaction.  No one human mind can pretend to know all the relevant information (Hayek, 1988).  The framework of rules which order the interaction among people and constrain individual opportunism is judged as to the extent to which the rules allow the spontaneous realisation of prosperity and equity and the evolution of more efficient outcomes -- and that is efficiency as judged by individuals.  This individualistic, evolutionary view of society stresses that no central authority can have all the necessary knowledge to intervene or to construct designed states of the world.  Relevant knowledge is distributed throughout society and needs to be uncovered by spontaneous experimentation and imitation of the success stories in decentralised processes.  The individual has priority over society.

For most of the twentieth century, the constructivist worldview held sway.  Its most pronounced form was Marxism, as manifested in central planning and huge experiments in social engineering.  But constructivism also inspired most policy approaches in the West, not least because the agents of centralised collective action naturally favoured top-down, central intervention.  Moreover, the intellectuals, who see their role as inspiring the agents of government, had great enthusiasm for a worldview that accorded them decisive influence over the key decision-makers.

However, the evolutionary philosophy, which stresses individual discovery within an ordered framework, has gained growing support in recent decades because it is more attuned to the incredible complexity of modern society and its constant dynamic change.  Thus, new ecological approaches increasingly recognise the dynamic complexity of ecological systems, possibly because biologists have always thought in terms of open, evolutionary systems.  Evolutionary models are now spreading in the social sciences, where constructivist designs -- for example, Keynesian macroeconomic interventionism, industry policies to pick winners, or central planning -- are falling out of favour.  The evident failures of socialist central planning in attaining decent supplies even of basic consumer goods, health standards, old-age care or environmental conservation, are beginning to have a major impact.  In economics, this trend is reflected in the revival of Austrian economics, in the spread of evolutionary and institutional economics and the stress on spontaneous, bottom-up market interaction.  Of course, these fundamental changes are resisted by economists with a heavy intellectual investment in constructivist models and with memories of the "Economist King" who guides the hand of government.  Nevertheless, the philosophy is spreading that the key role of economic activity is not to economise on given resources to meet given, pre-determined objectives, but on "catallaxy", that is, the discovery of new wants, new resources and new knowledge by spontaneous interaction in competitive markets. ⁽³⁾

These basic and abstract concepts have deep implications for the extent to which one favours the centralisation of government or sees decentralised experimentation and competition of ideas as appropriate to solving the constantly changing and diffuse problems of governance and to restraining the individual, self-seeking aspirations of government agents.

At an even more fundamental level, one might put it in the terms of a recent book title:  Government:  Servant or Master? (Radnitzky and Bouillon, 1993).  One's attitudes to federal versus centralised government are probably shaped by whether one acknowledges the citizen as the ultimate reference point, whom government is to serve, or whether government is seen as an ultimate, separate reference point in its own right and with a mission to be the master of men.  Australian traditions are certainly strongly in line with a focus on the citizen and civil rights, but the practice often deviates from the tradition.

(B) COMPETITION IN SPACE:  WAGE RATES, TAXES, PRODUCTIVITY, JOBS AND GROWTH

This vast continent, where society was shaped by the "tyranny of distance", was fitted into a Federation on the assumption that the diversity of living conditions would be taken care of by diverse State governments, but that major differentials in living standards and provision of public goods would be evened out.  Over the near-century since Federation, Canberra politicians and judges have promoted centralisation of government, because they may have been leaning instinctively towards uniformity and centralisation as a means of counteracting the "tyranny of internal distances".  The need for a strong redistributive and interventionist centre may often have been accepted as an economic and political consequence of the very nature of Australia.  Many seem to believe that a central authority is unavoidable if Australians want to live in a fairly uniform, egalitarian Commonwealth.  Yet the costs of regional redistribution have been a drag on regional competition, and therefore on employment, economic growth and international competitiveness.

The notion that fairly equal living standards (per capita incomes) can be achieved in a wide, diverse space with uneven resources, population densities and development levels only through government redistribution (the tax-handout mechanism) is of course wrong.  Markets can work to ensure fairly even per capita incomes throughout a vast nation, without the heavy hand of a redistributive regional policy.  Moreover, it seems at least worth asking the question whether the objective of regional income equality is at all valid.  People may prefer a range of choices between rich and poor regions.  Not only are there compensating non-material factors (for example, possibly greater environmental amenity in poor areas), but rich individuals may want to live in poor regions and vice versa.

To unravel the question of centralised regional or inter-State redistribution policies and to provide a reference point for the analysis, we have to sketch a well-tested, but poorly known piece of economics -- how competition works in space.

A model of competition in space

If one wants to understand the costs of bridging vast distances and centralising governance, one has to begin from the basis of a theory that explains the effects of distance and regional diversity.  To do this, traditional mainstream economics is not of great help:  it assumes transport costs to be zero and often implies that all production and consumption occurs in the same spot!  We have to turn to "spatial economics", which has always been more of a German than an Anglo-Saxon economic speciality (Giersch, 1993, pages 119-136;  Kasper, 1993a).  This body of time-tested knowledge can be summarised as follows:

• Prices, product qualities and other conditions of contract are set in the big cities which are the nation's central market places.  Producers who are not located in the big centres have to absorb the costs of transport to, and communications with, the central market places (the "space-bridging costs"), if they want to compete successfully.  The further away from the centres producers are, the bigger the deduction for "space bridging" from the market price.  In other words:  the further away from the centre, the lower is the "producer revenue" per unit sold (or the "producer price" -- Chart 2).  If producers on the periphery are willing to accept this, they can of course flourish and sell in the central markets.
• Lower transport costs -- for example, thanks to better roads and rail -- reduce the "space-bridging cost" to those who operate towards the periphery.  Changing communications costs also affect this pattern, as is clearly visible in the current communications revolution.  They open up numerous new market opportunities for producers on the periphery.  In Chart 2, a reduction in transport and communication costs would be reflected in a less steep angle of decline in the "producer price".
• Producers of course respond to these locational forces:  expensive-to-transport products and services (perishables like fresh milk or strawberries, hard-to-transport services like haircuts) are being located near the concentration of demand in the central cities.  Cheap-to-transport cost products (wheat, timber) tend to come from the periphery.
• The prices to the producers, wherever they are located, are distributed between the various production factors that contribute to generating the product.  However, owners of production factors that are highly mobile in space -- such as capital, knowhow and enterprise -- who are located at the periphery, will not accept rates of return on their assets which are markedly below what they can earn if located in the city.  If the owners of mobile factors were made to absorb the transport costs, they would soon move closer to the centre (law of one price).  This means that those who are in control of the immobile production factors -- land, State and Local Government administrations, and (for most practical purposes and certainly now on the international scale) labour -- have to absorb the "space-bridging cost" (Chart 2).  As a result, we tend to get a "pyramid" of land prices, local wages and Local and State Government revenues that have their peaks in the central cities, and their highest Australian peaks probably in Sydney.  As we move away, land prices decline and so should wages and tax rates, if we want a fairly even distribution of economic activity in space and want to avoid excessive urban concentration.  If the prices of immobile production factors are allowed to reflect the distance to the centres, economic activity spreads in space.  Capital and entrepreneurship come to where the land and the labour are and even remote Local Governments can earn tax revenue for providing their services.
• The fact that land, labour and administrations have to absorb the full "space-bridging costs" and have lower revenues per unit of output does not necessarily mean of course that they earn lower incomes per capita.  Individual land owners simply will use more land to earn their income, making use of cheap land.  Production will consequently concentrate on outputs that use much land.  And labour in peripheral areas will get a small share of the revenue from one unit sold but will concentrate in activities with large throughput and possibly high labour productivity.  The spatial facts of life, as described here, simply say that certain products will not be produced near the periphery and others not in the city;  wage rates will differ.
• If such spatial price differentials are prevented by political or union action, then we tend to get artificial (and ultimately costly) agglomerations of capital and enterprises near the city centres and despoiled, economically-ailing regions on the periphery.  Labour then has to migrate to the central places where the jobs are, and peripheral land lies idle.

A few troublesome facts of Australian economic life (which many citizens have come to accept as unavoidable) point to strong and historically-persistent violations of the spatial price mechanism in this country:

• It has long been "Sydney or the bush".  We have highly concentrated megalopolises and vast empty spaces.  Regional centres, except along the Queensland coast, are ailing (Taskforce on Regional Development, 1993;  Bureau of Industry Economics, 1994).  The costs of conurbation to Australians (and their international competitiveness) are high, whilst, in reality, this country should enjoy stronger advantages from bountiful, cheap land.
• The State capitals other than Sydney, Greater Brisbane, Melbourne and possibly Perth, find it hard to thrive and keep up with the growth centres.  Peripheral states like Tasmania and South Australia keep losing citizens whereas the costs of living in Sydney and increasingly in Australia's second megapolis, Gold Coast-Brisbane-Sunshine Coast, are going up.  Yet people have to make the costly move from low-cost to high-cost locations because "that is where the jobs are" -- mechanisms have been put in place that hinder the movement of jobs to where the people are.
• Governments in the ailing regions find it hard to collect sufficient revenue to maintain competitive infrastructures and cultivate a local revenue base.  The central government feels therefore compelled to tax and subsidise the centres, in order to even out troublesome spatial differentials.  This imposes deadweight costs, yet appears to have failed to remedy Australia's fundamental spatial problem.

To understand how the untrammelled spatial price mechanism works to spread economic activity throughout space, we will first have to discuss how regional decline tends to be reversed by market forces and, second, what causes problem regions, that is, areas that slip ever more deeply into economic decline, losing people and government services.

Spatial market forces at work

Let us assume that a region suffers some decline because its dominant industry produces output which is suddenly less in demand.  A case in point would be a region dependent on textile production, like northern Tasmania or northern Victoria.  If market forces were left to act without artificial rigidities, land prices and the prices of locally-established capital, such as factory halls, would decline.  It is also likely that local wages would decline, reflecting fewer employment opportunities.  These, no doubt painful, price declines would, however, attract new enterprises which would discover new uses for the factory halls and would want to work with cheaper labour.  The attraction of such a region in decline to footloose enterprises could be greatly enhanced if Local government lowered its tax rates or offered particularly business-friendly infrastructures, services and institutional arrangements (deregulation;  enterprise zones).  If no central bail-out is on offer in the guise of regional policy or vertical fiscal transfers from the Commonwealth, such pro-active responses of Local governments are of course more likely.  The response time to a regional decline may of course be considerable.  If the overall economy expands and the centres are overheated, the lag will be relatively shorter.  And advances in transport and telecommunication are now making it easier for firms to move plants to areas that offer lower wages, land prices and taxes.  With them, the regional decline turns around.  The new, mobile industries may even turn problem regions into new growth areas.

A mirror picture occurs in areas with overheated local economies:  the costs of local land, labour and tax rates tend to rise fast and drive away those enterprises that can supply the local market from a distance.  Land-, labour-, and tax-intensive activities move out if their products are transportable.  Thus, we see the movement of storage, warehouses and many repair services to the periphery.  Many services are nowadays no longer produced at the centre;  accounting services, word processing and other routine operations that can now communicate with headquarters by wire take advantage of lower local costs in non-central places. ⁽⁴⁾  Workers in more peripheral locations are prepared to work for a lower nominal wage because their housing and other living costs tend to be lower than if they have to live in the big city and have to commute to the city centre.  Regional differentials in nominal wages are rarely translated into equally big differentials in real incomes.

What creates problem regions?

In many respects, Australia's regional economic mechanism is not allowed to work as just described.  Australia's regional problems often resemble those persistent problems in Italy's mezzogiorno.  Over a hundred years ago, the south of Italy (mezzogiorno) which was remote from the big markets of Milan and elsewhere in Europe, and which suffered from poor infrastructures and poor social capital formation (education, health, cultural institutions), was united with the more productive, better-located north.  Trade unions in the south agitated for uniform wages, especially from the 1920s onwards, and the tax system imposed the same rates on businesses throughout Italy.  Consequently, businesses and capitalists moved north, and many workers had to follow.  They were often reluctant migrants and had to accept great costs to their families' welfare.  Subsequently, successive Italian governments have paid out massive subsidies to the south.  They have failed to reverse the troublesome trend.  They now put strains on the cohesion of Italy and will probably lead to a federal structure of government.

Contrast this experience with the United States or Switzerland where remote areas have, time and again, been able to rectify regional problems by demanding lower local wages and imposing lower local taxes and regulatory burdens.  States and cantons in these federal systems were able to do much independently to address their local economic problems.  Combined with low land prices, this has exerted a powerful pull to get industry to the workers.  In the United States, this is how the West was initially won and how the underdeveloped South attracted the textile industry.  Similar mechanisms served to spread the post-war "economic miracle" in West Germany to the originally agricultural South, and converted Bavaria and Baden-Wurttemberg into dynamic growth regions.

In Australia's case, people (particularly those in unions or on awards) are often paid the same wage wherever they live.  Local and State governments are often not very influential in making ailing regions attractive, because they have little scope to vary tax rates, most taxation being centralised.  It is not hard to see that suppressed regional differentials in wages and taxes, and the suppression of autonomous regional development policies, explain many of Australia's troublesome regional problems.  Wage rates have long been fixed centrally by economically-irrational, quasi-legal processes.  Factory workers or university professors get the same rate of pay, irrespective of whether they work in central Sydney or in Townsville or Launceston.  The policy of equal pay has, of course, been defended on grounds of "social justice".  But what is the justice in foisting equal rates on someone in Sydney who has high housing, commuting and other living costs, and depriving people in rural areas of job opportunities?  The real reason for equal nominal wages is of course that uniformly-fixed nominal prices always appeal to central planners -- whether they sit in Moscow or Melbourne.  Excessive harmonisation has prevented emerging regional problems from being spontaneously rectified.

We can draw the conclusion that Australia's uniform wages and limited scope for differences in taxes and administrative standards have been important factors in creating ailing regions and States.  Artificial rigidities have forced innumerable families to move to big cities where they now have to bear high transport and housing costs.  The economically-rational market alternative is for capital and firms to come to where the people are throughout the nation.  This would also seem socially much more just.

When the excessive centralisation and "harmonisation" of government policies are at work and when markets are made to fail, regional policies are designed to rectify the consequences (Taskforce on Regional Development, 1993;  see also, however, Industry Commission, 1993).  The visible hand of central government then offers to rectify the outcomes, because the hamstrung "invisible hand" is accused of having failed.  Yet the promise of administrative solutions frequently serves only to perpetuate artificially-induced market failures.  It induces regional and State government officials to postpone tackling the true causes of problem regions.

Seen in this light, the egalitarian redistribution mechanism of Australian Federal-State-Local finances not only remedies the consequences of man-made rigidities.  It also contributes to their perpetuation.

PART 2:  THE COMPETITIVE FEDERALIST PRINCIPLE

The rationale for federalism revisited:  Subsidiarity

Human action is not always motivated by the individual pursuit of narrow self-interest and greed.  People often co-operate with others.  This provides security and comfort, and co-operation is frequently more efficient in realising individual aspirations than competition.  This is the reason why all societies live by a mix of competitive and co-operative modes of behaviour, and why all societies have implemented institutions to restrain the opportunistic, self-seeking instincts of individuals (Eggertson, 1990;  Hayek, 1979).

In complex modern societies, everyone is a member of hierarchies of different overlapping co-operative communities.  Everyone faces institutional constraints that derive from these various communities.  We may, for example, be at the same time members of families, networks of friends, clubs, churches, local council areas, Parents & Citizens Associations, States, the Australian nation, other nations, international professional associations, etc.  Each grouping in such a pluralist society places certain demands on us, and imposes certain rules that limit our freedom to act as we please.  The smaller the group, the greater, of course, is the relative influence that the individual has over what rules are being imposed and how they are implemented.  And if we belong to many different, overlapping communities, we are likely to enjoy greater individual freedom.  If individuals belong only to one community that governs all their actions almost exclusively, many aspects of their lives will be controlled by one central force (such as a totalitarian state or a strict religious order).  The freedom to pursue individual aspirations will then, in all likelihood, be severely constrained.  From this it follows that a pluralism of communities to which we belong tends to enhance our liberty and our scope to pursue our own happiness (Tullock, 1994).  This of course applies also to the pluralism of overlapping jurisdictions -- Local, regional, State, Federal.  The various jurisdictions for collective action can then be tailor-made to suit best the various purposes of collective action and thus best serve the citizen.

Different individual aspirations are furthered to differing extents by the size of the jurisdiction and tightness of its institutional control.  The local P&C Association is based on a shared purpose of promoting local education.  It does this best by being close to the action and to the information that is specific to the place.  It therefore is best confined to the one school.  Local government can handle many aspects of collective action, because it is close to the interests of local residents, because it is easier for citizens to give feedback on local collective actions, and because people who dislike their Local government can move relatively easily to a neighbouring council area that suits them better.  This gives the citizen a high degree of sovereignty and creates openness, which imposes a discipline on councils, thus controlling the agent-principal problem in Local government, as long as the council's finances depend on the number of people contributing taxes.  (This is the principle of "fiscal equivalence" discussed below.)  In this context, we should of course think not only in terms of a two-tiered system, but apply the principle to a multi-level system of jurisdictions (Local, regional, State, Federal).

Another frequent outcome of centralisation that creates a monopoly government agency is that the standard of performance required corresponds to the lowest common denominator.  A priori agreement can often be obtained in negotiations only if the poorest performer is accommodated, while the most highly motivated performers have little incentive to persevere with their standards.  After all, the group holds a monopoly.  So why make more than the minimum effort?  By contrast, competition between rival administrations is likely to generate a variety of standards, coupled with a variety of rewards.  Then, the citizens can decide what they prefer.  This mechanism was evident in the 1993 debate on the "National School Curriculum".  The next generation of young Australians was rescued from the low standards in mathematics that the central education bureaucracy advocated only by the independent initiative of New South Wales and other States that wanted the young to be better equipped to compete with young Singaporeans or Koreans than Canberra education officials thought necessary.  The general observation that competition raises standards all round as compared to centralised monopolies, applies to public administration, too.

All these considerations lead to the argument for the "principle of subsidiarity":  namely, that tasks of collective action should, in principle, be carried out at the lowest possible level of government administration.  The onus of proof for delegating rule-setting and other tasks of governance upwards should rest with those who advocate such delegation.  This principle underpins the oldest existing federation, the Swiss Federation of originally fiercely independent cantons, who were loath to delegate many tasks upwards until 1848, when a more formal, slightly more centralised constitution was implemented in response to the rise of big nation-states in Europe.  Powers should be delegated upwards, from Local council to State government, from State to national government, only after proper reasons have been submitted to and scrutinised by parliaments.  The reason for this is that, with each such move, the individual citizen loses influence, and governance becomes more anonymous.  Of course, not all rules and tasks of government can be dealt with effectively at Local or even State level.

Circumstances for centralisation

Circumstances and criteria that make it sensible to delegate rule-setting and other administrative functions upwards are:

1. Higher levels of government should set rules over areas where there is intensive interaction between members of the lower-level communities and where standardised rules greatly reduce transaction costs.  For example, it would create enormous transaction costs if each Local council imposed differing standards of measurement -- one using metric, another Imperial, yet another adhering to traditional Chinese weights and measures.  Neither does it make sense to have differing institutional rules governing areas of intensive mutual interaction such as transport and communication.  The rail-gauge story of Australia is well known and has often been used to advocate centralisation.  Likewise, identical road traffic rules save users high information and other transaction costs when they leave the local area that is familiar to them.  Another example of where a diversity of institutions would lead to high information and transaction costs would be the provision of different types of money by the different States of Australia.  Conversion costs and exchange-rate risks would outweigh the benefits of independent monetary policies by State governments and the competitive feedback on the conduct of State monetary policy.
2. Where the inhabitants of different local jurisdictions have a readily identifiable set of shared interests, and where scale economies exist, governance may be carried out without much loss (and indeed, with some gain) in administrative efficiency.  This is, for example, the case in defence and foreign affairs.
3. The case for delegating functions to the higher level of government is strengthened when some local communities or States would "free-ride", if other local communities or States provided the public good.  Hence, "pure public goods", such as defence, where -- in addition -- scale economies come into play, should be made the task of the higher level of government.
4. General framework rules that define the overall order for individual pursuits are another rule-setting activity that is best done at the higher level, whereas specific interventions affecting individual activity should be at the lowest possible level, so that affected individuals have a say and can better judge whether government agents really work in their interest.  This means, for example, that the basic codes of civil and commercial law should be set centrally, but specific market interventions left to the subsidiary levels of government.
5. The provision of material infrastructures should be done at the lower level, as long as the costs and benefits are incurred predominantly at the local level.  Only if there are strong external impacts on areas outside the Local government area should the task be delegated upwards.  A case in point would be the provision of an arterial road that is used intensively by the residents of neighbouring areas.  All the users should be made to contribute.
6. Where the conduct of a government activity bears risks of severe conflict between jurisdictions that would disrupt individual pursuits, higher-level consolidation also seems justified.  For example, when there is a danger of petty states engaging in war with each other, then there may be a case for forming a co-operative alliance or even placing that alliance under a common government authority.

On no account should mere administrative convenience be accepted as an argument for moving a task from the subsidiary to the higher central agency of government.  The argument that an administrative task can be done more conveniently at a higher level -- or by harmonisation amongst jurisdictions -- tends to be frequently offered.  But public opinion and elected politicians should unmask it for what it normally is:  the wish of administrators to monopolise or cartelise an area, and so to avoid the uncomfortable competitive controls on their behaviour.  The argument that technical efficiencies from centralisation can be reaped must always be weighed against the potential losses of long-term economic efficiency in administration if jurisdictional competition is suppressed.

Subsidiarity serves the citizen

The general rule in deciding these matters should be:  What does ultimately serve the citizens' interest best?  As a general principle, the task of governance should be done at the lowest possible level.  Only when welfare gains can be proven convincingly should higher levels of government be allowed to take over.  This loadstone of competitive federalism -- subsidiarity -- should best be made explicit in a constitution.  This rule might serve the pursuit of individual human freedoms better than an explicit enumeration of human rights.

The principle of subsidiarity will only work properly in fomenting the competition of jurisdictions if it is complemented by three other principles:

• the rule of origin (products legally produced in one jurisdiction are legal without further ado throughout the nation);
• exclusivity in the assignment of the tasks of governance (avoiding duplication by different levels of jurisdiction);  and
• fiscal equivalence (the tasks assigned to a government at a given level should be financed by taxes and fees imposed by that government at that level, which implies a strict limitation of vertical and horizontal transfers within the federal financial system).

The rule of origin

The "rule of origin" relates to free trade in goods and services.  It says that a product or service is automatically acceptable throughout the country if it is accepted on health, safety and other regulatory grounds in the State or local community where it has been produced.  In Australia, this rule is often violated.  States and Territories test and license a wide array of products that have already been approved elsewhere.  Apart from being a costly and unnecessary burden on innovators and customers, this procedure has created an unholy cartel of regulators.  Violations of the rule of origin lead to excessive regulation, because the regulators go unchecked by any competitive considerations which would otherwise control the compliance costs they impose on the public.  If the rule of origin were in force, there would be a powerful inducement to State and Local governments -- which want to attract industry so as to broaden their tax base -- to compete with each other in developing the set of regulations which serves the public best.  A competitive discipline would thus be imposed on the regulators because jurisdictions with excessive, non-transparent and ill-thought-out regulations would soon lose production, firms and jobs that migrate to a more congenial regulatory climate.

Experience in countries where the rule of origin prevails, shows that the most competitive States or localities are not necessarily those that offer the lowest health, safety or other standards.  Producers often appreciate being protected from their own opportunism and seek out those jurisdictions that design regulations which best promote their long-term success.  If products made in a State with poor safety standards are found frequently to hurt consumers, that State will soon lose its attractiveness to industry, which will seek product certification by a State with more appropriate and more credible standards.

When regulators have unchecked monopoly power over what products are licensed for sale within their jurisdiction (as is frequently the case in Australia), they are in no hurry to speed up the introduction of new products.  They can also adhere to extremes of administrative caution.  This is probably because of the lopsided incentive structure in public administration:  a regulator who has licensed just one product that causes harm is likely to face the penalty of losing the job, but he or she hardly ever gets rewarded for advancing general welfare by taking calculated risks when admitting innovative, useful products.  In public administration, the incentives are such that rewards and punishments in risk-evaluation are not commensurate with the task.  If, however, a competitive check in the form of the rule of origin is in place, then there is a more commensurate match of incentives to risk innovations.  In many instances, innovation has been slow in Australia because most licences are not administered with the gains to the community at large being taken into account -- but rather, only the possible personal risk to the regulator.

In the discussion about microeconomic reform, we now hear a lot about efforts to adopt more uniform nationwide standards and to negotiate more harmonisation of State and local regulations.  This is intended to achieve better technical efficiency and lower transaction costs, as well as for other valid reasons.  But experience shows that such administrative negotiations tend to go on forever.  A much faster, more business-friendly way is to remove the existing regulatory cost handicaps by adopting, without reservations, the rule of origin. ⁽⁵⁾  This would immediately induce State and local regulators to remove compliance costs worth many millions annually to business.  Europe moved, in principle, to the rule of origin with the adoption of the Single Market Act.  This experience has shown the great gains in competition, but has also illustrated how many entrenched pressure groups and local administrative interests are affected and are fighting back.

Much could, incidentally, also be gained if Australia applied the rule of origin more widely with regard to internationally-traded goods and services.  Instead of testing every new pharmaceutical locally, many of them (where Australian environmental conditions play no role) could be automatically admitted for sale throughout Australia once these pharmaceuticals have been accepted in any two other countries with respectable standards, such as the United States, the United Kingdom, Switzerland, Germany and Japan.

Exclusivity

A second supplement to subsidiarity, which is needed to make competitive federalism work, is that the various responsibilities for collective action are assigned exclusively, clearly and explicitly to one level of government.  Part V of the Australian Constitution spells out a very long list of Commonwealth tasks, implying that all other tasks are in the hands of subsidiary levels of government.  But Canberra has usurped tasks far beyond the original list, for example in industry regulation, health, education, welfare provision, environmental matters and Local government.  Consequently, there is now much messy overlap, contradiction and costly duplication between various levels of government.  This imposes unnecessary coordination and compliance costs.  It often greatly detracts directly from Australia's international competitiveness.  Many observers rightly decry the observed duplication of government functions.  They are, for example, pointing to massive, costly Commonwealth bureaucracies in health and education, despite the fact that virtually all health care and education are delivered by the States.  They point to burgeoning Commonwealth activities in economic services, although most infrastructural support services are still delivered by instrumentalities of the States.  The cause of so much costly duplication in Australia has been the expansion of the central government.  It has usurped supervisory functions, often without producing or delivering any services.  Commonwealth agencies often only monitor, plan and prescribe.  If proper State competition were permitted, this could often ensure better quality control of administrative standards than is now achieved by supervision from distant Canberra.

If one applies criteria of strict subsidiarity, one would assign to the Commonwealth the exclusive tasks of foreign affairs (narrowly defined), defence, monetary stability, regulating nation-wide transport and communications, laws and regulations which concern frequent civil and business interaction -- but not much else.  Huge Canberra bureaucracies in education, health, and the environment would be abolished.  The remaining Commonwealth functions could be financed from a low Commonwealth tax on personal and corporate incomes.  The States should then look after matters such as providing transport infrastructures, regulating general industrial conditions, and administering the "big picture" aspects of the environment.  This would leave local communities much freedom to shape the more detailed conditions of life and work, including accepted public obligations of public welfare provision and education.  These tasks would be financed from locally-raised taxes (see below).  Just imagine how much attention, care and commitment would be dedicated to the local poor, if local rates had to provide for them, and how much attention would be accorded to local politics, if local politicians were held largely responsible for job creation and job security!

Assigning exclusive tasks to the various levels of government is unlikely to create administrative monopolies or an increase in agent abuse of the principals' (the citizens') interests.  Thanks to subsidiarity, most tasks of governance would be carried out by competing jurisdictions.  Such competition would go a long way toward ensuring quality control in government administration, making the proliferating apparatus of Commonwealth or State supervision and intervention largely superfluous.  It is true that some Local councils or States might be run badly.  This might even force some residents or production plants to migrate, causing them real costs.  But competition is never cost-free.  Nevertheless, economic experience has shown time and again that -- even where short-run technical efficiencies may be had from centralisation or cartel formation -- the constant stimulus of competitive pressures nearly always produces superior long-run results in terms of productivity growth, job creation and freedom.  The fallacy of centralisation -- or partial centralisation by making higher levels of government co-responsible for a task -- is that it tends to remedy some immediate symptoms of administrative failure, but it overlooks the basic fact that centralisation erodes the underlying causes for good long-term performance.  This general argument against central control and monopoly is widely accepted for business, where competitive trade practices are enforced.  But it applies equally to government and administrative practices, where centralisation and harmonisation are normally accepted uncritically.

Fiscal equivalence

The third principle needed to ensure that competitive federalism works well is fiscal equivalence.  This means that governments must finance their assigned and chosen tasks with the funds that they raise themselves through taxes, fees and borrowings for which they are responsible.  The basic rationale for fiscal equivalence is that public expenditures are disciplined by the need to raise taxes and that those who are the beneficiaries of a public service should, as far as possible, be identical with those who are asked to fund the service.  Inefficient compromises, free-riding and much political conflict can then be avoided.  Greater self-responsibility and efficiency are achieved when vertical and horizontal inter-government transfers are largely eliminated.  Fiscal decentralisation combined with fiscal equivalence would generate incentives for State and Local governments to develop their own tax base and to cultivate it so that it grows.  They would then pursue good, far-sighted economic development policies and compete with neighbouring administrations for mobile resources.

In the setting discussed here, the need to nurture the tax base soon pervades the entire style of government and turns administrators from antagonists of industry to supporters of economic activities that pay tax.  The rules on which institutions evolve are then reshaped to promote a partnership between government and citizens, as the East Asian experience with attracting industry from the rich countries has shown (Kasper, 1994a).  Fiscal equivalence would of course also force governments at all levels to live with the long-term consequences of poor tax and development policies, imposing in itself a desirable discipline.

The Australian Constitution did not recognise the notion of fiscal equivalence.  In the course of this century -- typically in wars and national crises -- further taxing powers were shifted to the Commonwealth.  Probably from the beginning, a fairly central tax collection has been the foundation for the general trend to centralisation.  As a result, there is now great vertical imbalance in Federal-State finances, as well as in the share of taxes and rates which is raised directly by local authorities.  A large share of State and local tasks is financed with grants from higher up, that is, without any direct critical check by local taxpayers and local legislatures.  States and Local governments have become dependent on the "financial welfare" drip.  This may suit many State and Local politicians and bureaucrats who wish to shirk the responsibility, in the eyes of the voters, for raising taxes and who may at times welcome the excuse for not doing something by laying the blame on the higher level of government.  The lack of fiscal equivalence, of course, erodes the responsibility of State and Local governments for their own affairs and the efforts by these governments to contribute to overall competitiveness.  During the 1980s, for example, many State-owned enterprises (such as rail, ports or insurance companies) were corporatised and realised considerable productivity gains.  These gains were often not passed on to the users of the services of government-owned enterprises, because the central government squeezed the States by retaining a higher share of overall public revenues, and the States felt forced to use monopoly profits from State-owned enterprises to make up the shortfall.  More generally, the lack of fiscal equivalence has forced States into some unusual pricing policies by State-owned enterprises.  These then often undermined the international competitiveness of exporting firms, and are diminishing economic growth and job creation.

In Australia, subsidiary administrations do not have to compete all that much by nurturing their own tax base;  rather, they are able to agitate for greater remittances through the political game.  This set-up has politicised fiscal affairs, while greatly weakening important competitive stimuli on administrators to foment economic development within their jurisdictions.  Fiscal equivalence seems needed to reduce moral hazard on the part of administrators and politicians at State and local levels.

In practice, fiscal equivalence would mean, for example, that the citizens of South Australia and the Northern Territory, if they really think they can benefit from it, should pay for an Adelaide-to-Darwin rail line.  And that the citizens of Queensland should not be asked to contribute fiscal transfers to mitigate the consequences of anti-development policies adopted by Tasmania, or the consequences of -- shall we say, rather unconventional! -- financial experiments by the Victorian and South Australian governments during the 1980s.  Fiscal equivalence would certainly mean that the competent development policies of Queensland will reap long-term tax benefits for Queenslanders, whereas nowadays the tax growth resulting from such efforts by the State government is largely siphoned off to Canberra.  The development incentive is consequently weakened and the evaluation of costs and benefits of State and local projects is lopsided.  Nevertheless, we are now witnessing some effects of a "fiscal equivalence mechanism" at work when industrially-rigid and fiscally-derelict States in the south are losing citizens and jobs and well-run States like Queensland and Western Australia are gaining.  The relative shrinkage and growth of the State tax base has a powerful corrective influence on those who still believe that they wield political primacy over individual aspirations, as the changes in Victoria demonstrate.

The principle of fiscal equivalence should be applied also to Local governments.  They, too, should finance their own expenditures by local taxes and fees.  It is frequently asserted that Australian Local governments are controlled by short-sighted local interest groups and are often not very efficient.  What does one expect when these authorities are subjected to hand-out dependency and are given little unconstrained long-term responsibility for their own affairs?  However, general assertions of poor Local government do not hold water in the light of the evidence.  Competent Local councils can and do make a great deal of difference, and often conduct their business effectively and efficiently despite the disincentives that are built into their unwritten fiscal constitution (see Insert "How Can a Local Government Compete?").  The "hand-out mentality" syndrome would soon vanish altogether if councils were financially fully responsible and could go broke -- in which case they would either be taken over by more competent teams or be put under stricter State rules that forced them to finance deficits and debts by increasing local rates.  Local residents who knew that they had to underwrite the full tax consequences of poor local administration or of costly policy experiments by their councils would soon exercise their voters' rights more resolutely and wisely than is now the case.

HOW CAN A LOCAL GOVERNMENT COMPETE? The author led a team which conducted a case study of the attractiveness of the economically-successful Gladstone-Fitzroy region in central Queensland on behalf of Queensland Treasury. (6)  Some of the reasons why this resource-rich area around a splendid harbour is highly attractive were obvious.  But why did all sorts of businesses that do not depend greatly on energy or a port also gravitate towards the Gladstone region?  And why did several firms in industries which rely on energy and port facilities stipulate that, if they were to set up shop in Australia, they would do so only in the Gladstone region and nowhere else in Australia? The answer to these questions emerged in one industry case-study after another:  the Queensland State government is more world-market oriented than other State governments and has done more to lower the costs of doing business in the State than others, and -- above all -- the Local government of Gladstone acts as a partner to business, rather than an antagonistic controller.  They see industry as an opportunity to create a wealthy, secure community in an attractive, clean environment, not as a polluter and enemy of other civic aspirations.  In short, they have created a favourable institutional framework for industry and job-creation -- and, by the way, also for growing revenue. The reasons why the Gladstone City Council and related local organisations have adopted this frame of mind -- which is reminiscent of the approach to governance in the successful East Asian economies -- are, it seems, that regional industry sells so much directly in highly competitive world markets and that the region owes little to governments in Brisbane, let alone Canberra.  When the local meatworks closed, the local community stared stark economic failure in the face.  It was then that they laid the basis for a big new industrial city and began to act accordingly.  And when there was a major industrial confrontation in the local aluminium industry in the highly-charged national atmosphere of the mid-1970s, both labour and industry learnt very quickly that they needed sensible cooperation for both to prosper together.  Workers and administrators realised that they were in fairly direct competition with workers and administrators in Taiwan, Canada and Singapore.  Being many miles from ACTU headquarters and remote from the antagonistic industrial atmosphere which had grown in artificially-protected industries further south, no doubt facilitated that learning process. The wish for more secure jobs and revenue from a prospering industry base inspired the 'Gladstone Taskforce', a grouping of people from labour, local business, residents and local administrators.  They look quickly at proposals for new industries and then make credible commitments, helping new industries to come in.  In one case, the Local government heard that ICI was prevented by environmental agitation from establishing a new chemical plant elsewhere.  Gladstone took the initiative to invite ICI to consider Gladstone as an alternative location for that plant.  This project was quickly scrutinised by the 'Taskforce';  and the community at large was invited to have a say.  The 'Taskforce' satisfied itself that the benefits in terms of jobs and revenue far outweighed the risks and drawbacks, indeed that the high local standards of environmental amenity, health and safety could be guaranteed.  They then proceeded to help the new plant to go ahead and fit in with the local community and economy. Gladstone has not cut corners on attainment of legitimate regulatory goals.  But the rules are clear, transparent and reliably enforced.  An exceptionally clean heavy-industry city is visible testimony to that goal-oriented, but business-friendly regulatory style.  In turn, the high standards protecting the civic and natural environment, which have imposed costs on local industry, have made it easy for producers to attract and retain skilled staff.  The Gladstone community seems consequently at ease with industry whether in its working clothes or at leisure. Had the Local government had greater autonomy in providing for necessary local infrastructures and in financing its budgets from local taxes and borrowing, rather than remittances from higher up, it is likely that Gladstone's industrial-infrastructural development would have run more smoothly.  As things stand, many of the benefits of a soundly-growing economy, which Local government has done so much to cultivate, are siphoned off to distant capital cities.  A system of competitive federalism, as proposed here, would have greatly enhanced the local rewards for the co-operative spirit of labour, industry and Local government.  The incentives for a development-friendly Local government, with which it is good to do business, would have been even stronger.  It is likely that such a system of competitive federalism would have generated more Gladstones around Australia -- and with that a more self-responsible and prospering nation. Despite existing constitutional and administrative disincentives, Gladstone has achieved something that seems to elude most other communities in Australia:  the use of good natural resources for much value-adding before exporting these resources to dynamic Asia-Pacific markets.  The local culture of management, industrial relations and administration, which owes nothing to the traditional Australian industry model and so much to the disciplines of global competition, has made all the difference.

The principle of fiscal equivalence also means that all levels of government have the right to be creative in designing and developing their own revenue systems.  Reserving one type of tax or another for one specific type of government is at variance with full fiscal self-responsibility.  Nevertheless, even if specific types of taxation were not reserved to specific levels of government, governments would choose taxes appropriate to their level of operation:  Local governments are likely to levy revenue on land, residence and economic activity in their area, and probably would avoid corporate income taxes because corporate incomes accrue in distant headquarters, rather than the local plant.  The States would experiment with different mixes of direct and indirect taxes, and fees for service.  They would be keen to develop resources because future spending depends on development.  They would soon find out what yields appropriate revenue and what reduces the State's attractiveness to mobile residents and firms.  Jurisdictions will avoid those types of taxation which the taxpayer finds easy to avoid by shifting the taxable circumstance to tax havens.

Fiscal equivalence does not mean that we need a multiplicity of tax offices and endless duplication of paperwork by the taxpayer.  It is possible for one integrated tax office to levy and administer all taxes -- Federal, State, Local -- according to the area in which one lives, works or operates a plant.  Electronic data-processing nowadays makes it possible and cheap to tailor-make integrated tax bills according to differing Federal, State and Local tax scales, and to divide the revenue collected among the various jurisdictions.

Competitive federalism is an interdependent system

The principle of subsidiarity will work effectively to control Leviathan only if supplemented by the three other principles we have discussed -- the rule of origin, exclusivity and fiscal equivalence.  These four rules together constitute competitive federalism.  They are mutually reinforcing.  If one principle is violated, then the competition amongst jurisdictions suffers.  If, for example, all tax rates were set centrally, then the autonomy and self-responsibility of State and Local governments would be seriously prejudiced.  Likewise, exclusivity in assigning tasks -- and this defined for broad, clear categories -- is needed to ensure that subsidiarity works properly -- and is comprehended as working properly in the eyes of citizens and their elected parliamentarians.  As soon as there is overlap of administrative responsibility or the dividing lines become fuzzy, it is impossible for the citizen to know who is responsible and thus to make the right decisions when voting or moving between jurisdictions.  Lack of exclusivity prevents governments from getting the proper competitive feedback from citizens.

The point has to be made forcefully that competitive federalism, as defined here by subsidiarity and the other three principles, is a cohesive whole.  To pick and choose is not possible without undermining the competitive impact on government.

Competitive federalism in Australia

The trend in Australia for most of this century has been for a growth of Commonwealth responsibilities, often duplicating traditional State activities and also trespassing into Local government tasks.  Both the external affairs power and the condition-laden remittances of funds from Canberra to lower levels of government have been used to promote the trend to centralisation, often with the tacit compliance of Local and State politicians and bureaucrats who were loath to compete.  Parliamentarians, who should monitor whether the interests of the average citizen are safeguarded and furthered by their governments, have frequently failed to prevent the formation of administrative cartels and monopolies, often, no doubt, because their ideology prevented them from favouring competition, and often because they were captured by the very administrative interest groups that they were meant to monitor and control on behalf of the electorate.

Competitive federalism can relaunch microeconomic reform

A fiscal regime of competitive federalism as outlined above would be greatly at variance with what has gradually evolved in Australia.  Our system often suits the agents of government, rather than the principals, that is us, the sovereign citizens.  It is therefore useful to describe how such a competitive system of government would work.

A regime of competing jurisdictions would be designed to cope with human imperfections, as recognised by Gordon Tullock in one of the epigraphs to this paper, whilst trying to retain the great advantages of federal co-operation, which Hayek had in mind when he wrote on federalism, in the other epigraph.

A constitution of competitive federalism would allow administrators and elected politicians to engage in a great variety of experiments.  But experimentation would be tempered by the discipline of fiscal equivalence (the risk of going broke) and the discipline of competition with other competing jurisdictions.  It would not be the fools' paradise of experimentation by monopolists or actors whom someone else automatically bails out.  At a time of rapid change in our international environment, when Australia is faced with the urgent need to come up with many new administrative solutions and is hampered by sticky traditions in attaining microeconomic reforms, each inducement to experimentation can help to free the process and generate the many creative ideas that we will need to prosper in the globalised world economy.

No one can know all the right responses to the breakdown of the "Australian settlement" and the manifold challenges of the global economy.  Centralist designs are bound to be found wanting.  Decentralised, competitive experimentation seems to be the best gameplan for identifying the right responses.  If we pretend to be able to cope by centralising, or by harmonising responses until the most hidebound partner consents, we are likely to lose the "competitiveness footrace".  But if we decentralise, some jurisdiction has a chance of finding some useful solutions, and other jurisdictions can emulate the successes.  The more we decentralise, the better the chances for re-launching Australia's half-finished microeconomic reform agenda.  Distributing more of the political and practical risks amongst different States and local communities offers more promise than engineering yet more centralised schemes.

The decentralised approach would, of course, offer foreign investors a much wider range of choices.  Just as a private department store that offers a great variety of models is more attractive than a Soviet state store, where only one model is on offer, an Australia where different States offer competing tax-service packages would be more attractive to international investment customers.  The one centrally-imposed stock answer in administration is rarely appropriate to investors who shop around.  Federations are normally in a better position to do well than Soviet state stores.

Competitive federalism at work

A greater amount of administrative experimentation, of course, offers no guarantee that we will discover the right solutions.  Some experiments will go wrong.  But because negative consequences for future revenue will be quickly envisaged, they are more likely to be abandoned quickly than under the present administrative regime, which often encourages good money to be thrown after bad lest political reputations be prejudiced.  Fiscal equivalence would serve as the equivalent of "red ink" in business.

The possible counter-argument against competitive federalism -- that there will be duplication in revenue-raising by many States, and in rule-setting and other administrative tasks -- is addressed by the principle of exclusivity and the rule of origin.

Another counter-argument to a competitive federal system is that, given Australia's history, the States tend to be more inward-looking and opportunistic than the Commonwealth government and that a disinterested Commonwealth government is needed to discipline the States.  This concern seems to be built on a misunderstanding of competitive federalism.  If a State attempted to pursue protectionist policies, it would violate the rule of origin.  And if it managed to pursue a very interventionist line without violating the rule of origin, the flow of people and jobs would soon send back signals that this would cut the tax base.  The principle of equivalence would ensure, to a much greater degree than is presently the case, that these signals are taken on board by those who design collective action.  Interventions may well be undertaken to favour certain citizens or producers, and attract these to the State or Local government area.  Experience will soon tell whether such favouritism comes at the expense of others, who would begin to migrate.  It may also be argued that States could borrow to "buy themselves new industries", granting tax concessions in the hope of obtaining a faster-growing tax base later.  Concessions may be a valid entrepreneurial punt by State and Local authorities.  If the bet comes off, the State will be the winner.  If it is mistaken, capital markets will soon reflect expert opinion and mark down the State's credit rating.  This is, as we have seen among Australian States in the past five years, a very visible and powerful market corrective.  Under a regime of competitive federalism, policies to "buy industries" would soon be cross-examined and penalised if misguided.

One way to become highly attractive to wealth- and job-creating capital, talent or firms, is to make the administrative rules and institutions simple and transparent.  Streamlining existing legislation and regulation is a competitive response that is likely to bring high rewards in terms of future tax-base growth.  Implementing a style of administration that saves those subject to administrative action as many compliance costs as possible is another way of attracting resources within Australia and internationally.  Administrations that act as if they were a law unto themselves tend to shape their business according to administrative considerations, that is, convenience to the regulator, rather than to the client, and effortless activity for the regulator.  A switch to competitive federalism would change this approach.  Citizens and industrial firms would be king.  They would be treated more with the courtesy and responsiveness with which the automobile associations or other businesses treat their customers, rather than the despondency, rudeness and indecision so often evident in "government shop fronts".

Judging by what evidence there is on international comparisons, Australia does not measure up all that well when it comes to the user-friendliness of government.  It is true that we have inherited a rather stable, lawful political framework.  But competing countries are catching up or overtaking us on that score.  Table 1 shows some criteria that matter to the international competitiveness of governments as of 1993.  The Table is based on international rankings of 37 countries both on relevant statistics and opinion surveys of internationally-experienced businessmen.  The first column shows an aggregate value, out of a theoretical maximum of 37, the second column shows the ranking of the selected countries out of a total of the 37 countries covered.  These comparisons are based on the 1993 World Competitiveness Report (for details see Kasper, 1994a).  The Table covers the three big industrial economies (US, Japan, Germany) that normally still set international benchmarks, as well as Switzerland, New Zealand and the new industrial countries in the Asia-Pacific with which we have increasingly to compete.  It can be seen that:

• our transport infrastructure is not highly rated (considering the necessities of this vast, thinly-populated continent) but that communications are reasonably well developed;
• we still have deficient policies for openness, while foreign investment policies are perceived as reasonably transparent and favourable;
• Australia still offers relatively low political risks (8th out of 37 countries);
• we rank surprisingly poorly on cultural openness;
• competition policies are fairly competitive by international standards;
• the "institutional infrastructure" for business (clear, stable, easy-to-understand rules) is acceptable by international standards and that the "climate for doing business" in Australia is moderately attractive, but a dozen other countries are still ahead of us;  and
• policy making is not considered stable and reliable.

This shows that the Australian system of government offers the world a mix of moderate strengths with administrative failures and costly competitive handicaps.  A less central-government-focused approach could help to remedy the weaknesses -- faster than any centrally-designed microeconomic reforms, should the leading political parties again marshal the will for new initiatives.

The details behind the competitive handicaps of Australian governments, which we do not have the space to report here, can often be explained by the long tradition of inward-looking policies (protectionism) and a rather self-centred administrative approach.  But, as of the 1990s, these handicaps begin to hurt our prospects.  For the first time this century, Australians are now living in an integrated economic area, the CER, ⁽⁷⁾ in which at least one government is not under central Australian control.  Table 1 indicates where the independent New Zealand government is beginning to offer healthy administrative competition.  This in itself adds an important new dimension.  At least one outsider to the often cosy cartel of Australian governments is now within the two-nation common market.  Our competitive weaknesses, of course, also matter because we are now in a dynamic region where often fairly dramatic microeconomic reforms and institutional innovations are carried out.  A decade ago, Australian institutions and political stability constituted a distinct competitive advantage.  Now that relative lead is being eroded.  In such a situation, it must be realised that centralisation and rigid adherence to past ways of doing things could cost us dearly.

Table 1:  Australia's Government:  International Quality Comparisons
R = ranking out of 37 old and new industrial countries (1 = most attractive)

Country	Transport infrastruct.	R	Communic. infrastruct.	R	Policies on openness	R	Foreign investment policies	R	Risk & security	R
Australia	13.8	23	23.1	14	15.4	26	12.4	11	29.1	8
New Zealand	30.2	3	29.6	4	26.3	9	9.6	26	27.7	9
Germany	28.8	7	26.4	8	21.7	15	10.6	21	22.9	12
Switzerland	30.2	4	30.4	2	7.3	35	8.9	29	32.6	1
Japan	23.8	15	22.6	15	10.2	30	9.0	28	29.9	6
USA	25.8	12	25.6	9	16.7	23	13.1	9	18.9	19
Singapore	36.0	1	30.1	3	27.0	7	14.1	7	30.1	5
Hong Kong	29.2	6	30.7	1	34.6	1	12.3	13	19.9	18
Taiwan	19.4	19	21.4	17	18.8	19	10.0	24	21.3	17
S. Korea	10.4	29	14.9	27	3.7	37	5.9	33	18.6	20
Malaysia	21.8	17	16.1	24	13.0	29	17.4	1	24.0	10
Thailand	8.6	33	8.6	33	6.4	36	10.9	20	15.4	24
Indonesia	8.4	34	6.4	36	7.9	34	9.3	27	14.0	24
Country	Cultural Openness	R	Competition policies	R	Institutional settings	R	Climate for doing business	R	Stability of policy	R
Australia	13.0	32	23.0	12	22.7	10	22.7	12	14.3	28
New Zealand	22.6	10	34.1	2	30.8	3	27.7	5	14.3	29
Germany	17.2	23	17.5	20	19.3	20	23.3	11	21.7	13
Switzerland	11.4	33	21.8	15	20.8	14	16.6	24	25.1	4
Japan	20.0	15	20.9	18	14.0	26	20.9	15	31.7	1
USA	14.6	30	21.6	16	16.1	25	24.3	10	18.9	20
Singapore	30.6	3	32.4	3	33.4	1	30.9	1	24.9	5
Hong Kong	27.0	6	35.9	1	29.4	6	30.3	2	23.7	8
Taiwan	27.6	5	29.6	5	20.1	15	27.3	6	15.3	26
S. Korea	17.4	22	14.9	26	10.9	33	14.0	30	19.9	19
Malaysia	25.4	7	25.6	7	31.1	2	28.4	4	23.4	9
Thailand	21.0	14	22.0	13	17.6	20	24.7	9	27.6	3
Indonesia	19.4	18	16.1	23	19.1	18	18.9	17	23.7	7

How are the States measuring up?

It is a sign of the new era of globalisation that, suddenly, jurisdictional competition, at least among the States and Territories, is being noticed and analysed:

• We now see regular data on employment or Gross State Product in the press.  These data show that Queensland's contribution to the national product has risen steeply since the late 1980s (from around 14 to some 15.5 per cent now);  that Western Australia's economic importance is rising steadily, and that Victoria and Tasmania are in relative decline, as has been South Australia since the mid-1980s.  New South Wales tends to contribute a fairly steady 35 per cent to GDP.
• There are frequent reports on State tax policies, which tend to show information such as that indicated in Table 2, and indebtedness which varies greatly between big-spending and fiscally-cautious States.
• Other institutions analyse the State budgets regularly for fiscal responsibility.  In 1993-94, Tasmania was awarded the "Most Responsible Budget Award", the Commonwealth the "Lemon Award for the Most Irresponsible Budget" (Wood, 1994).
• Economists and business groups are surveying the States as to their past and prospective economic performance (for example, The Australian, 29 April 1994, page 2).  The picture that emerges tends to rate the growth prospects of Queensland and Western Australia highly, and those of the ageing southern States poorly, with NSW rating average.  A recent ranking of the conduct of economic policy (idem) gave Queensland and Victoria the highest marks and South Australia and Western Australia the poorest ratings.

Table 2:  Some Data on How the States Measure Up

	NSW	Victoria	Queensland	Western Australia	South Australia	Tasmania
Approx. contribution to GDP (%)	35	27	16	10	7	2
State taxes:   Stamp duties on conveyancing of house     (% of median house value)   Financial institutions duty on $5,000 deposit   Payroll tax (50 workers, at AWE of Aug. 1993)   Petrol licensing fee (cents per litre)   Land tax (on value of $10 million)   Tax-free threshold   Gambling tax (on-course win/place)   State indebtedness (% of revenue, est. 1993-94)     including employee entitlements	2.70% 0.06% $64,421 7.04 $147,700 $160,000 14.25% 176%	3.30% 0.06% $59,520 8.43 $430,540 $20,000 14.25% 330%	2.50% 0 $39,068 0 $177,120 $160,000 15% 45%	2% 0.06% $45,668 5.67 $192,575 $10,000 14.25% 197%	2.90% 0.07% $52,589 9.11 $345,320 $80,000 14.25% 208%	2.50% 0.06% $88,607 6.15 $246,113 $1,000 14.25% 223%

Source:  ABS, NSW Treasury, 1994;  Wood, 1994

Such comparative evaluations serve the useful purpose of stimulating competition between the States and curbing self-centred, inward-looking behaviour.  If one could be confident that Commonwealth transfers did not reward poor performers and penalise the States which have kept debts and taxes low, one would have the beginnings of the spirit of a properly competitive federal system.

The message which emerges from comparisons among Australian States is that State governments make a difference.  Low tax rates tend to favour high growth.  Also, indications are that State regulatory requirements differ considerably.  If one can go by episodic impressions, Queensland tends to have more streamlined, transparent laws and an efficient administration, whereas some southern States have more intrusive, non-transparent and dirigiste institutions.  This contributes to their poorer growth records.  Accordingly, the inter- State migration pattern favours the States with low taxes, expeditious administration and resulting high growth.  Although economic factors cannot explain everything, it appears that the statist policies of Victoria in the 1980s (and the tax consequences), as well as greater fiscal and regulatory responsibility of both conservative and Labor governments in Queensland, have converted the Newell Highway into a one-way road!  If anyone needs proof of what the average Australian wants, he need go no further.  And what is good for citizens seems also to be good for small business, big industry, the heavy lift cranes in the ports, the logistics operations of many importers, international airlines, etc:  these resources are moving to where they best prosper.

Competition enhances institutional evolution and the administrative culture

A most important consequence of competitive federalism is that it changes the very quality of public administration.  Competition tends to lift the entire administrative culture and forces governments to concentrate on the main tasks.  A change to competitive federalism in Australia would be akin to the changes that we have been observing in industry since a bipartisan commitment made tariff reductions credible:  monopolistic, rent-seeking behaviour has been giving way to, often exhilarating innovation and a spirit of success.  It is time that this same "cultural revolution" spread to public administration.  The longer-term competitive success of Australian industry will depend on it.

After eight decades in which the underlying rules favoured monopoly administrative practices, we now need a climate that draws the administrative "holy cows" into the microeconomic reform process if we are to attain better international competitiveness.  Judging by many international precedents, many politicians and administrators would find the cold showers of competitive reform exhilarating, once they convinced themselves to begin.  Australia requires no less than a sea change in the climate and culture of governance so that it fits into a competitive world economy where no country can dictate terms, and where no one has the luxury of a monopoly.  Monopoly illusions that could proliferate in the past behind a tariff wall and the "tyranny of distance" are no longer tenable.  This has by now been realised in private industry.  It needs to be fully driven home in the public sector which has not yet gone through the required cultural revolution of acknowledging that it, too, competes with the public sectors of other countries -- and will be better for doing so pro-actively, willingly and knowingly.

CONCLUSION:  COMPETITION AMONG GOVERNMENTS
TAMES LEVIATHAN AND SECURES LIBERTY

The argument for competitive federalism has been conducted here primarily in economic term, because economic interests, globalisation and the need for completing the microeconomic reform agenda will -- in my opinion -- exert constant economic incentives for cancelling the still largely prevailing exemption from competition of politicians and administrators at all levels of government.  But the rewards for turning from monopoly and centralism to competitive federalism are not only material.  Ultimately, greater individual liberty from unnecessary strictures and collective controls is the most important reward of jurisdictional competition.  In the nineteenth century, Australia created a res publica with a strong commitment to free, sovereign citizens.  In the course of this century much of that primacy of the free citizen has been eroded and collectivist maxims have often been placed above individual liberty.  This may have freed us from full self-responsibility for our deeds, but it has turned a youthful, optimistic nation into a collection of welfare claimants and whingers.  The beginnings of microeconomic reform in the 1980s have triggered many constructive and optimistic responses -- as well as adjustment pains in those sectors and areas that now have to compete more.  These responses need to be spread.  Greater freedom will prove exhilarating to most people, if they rediscover the liberty of doing their own thing.

Civil and economic liberties are not appreciated in Australia as much as in countries where they are suppressed by totalitarian rulers.  But the gradual Australian slide into welfare collectivism and dependency on government guidance has eroded our traditional liberties in many walks of life.  If those who rule and administer us are compelled to do so in ways that make them compete with administrators and rulers in other jurisdictions, many of us will rediscover greater civil and economic liberties.  At least the enterprising young generation is likely to welcome an Australia where Leviathan is disciplined by competing in a framework of competitive federalism.

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REFERENCES AND FURTHER READING

Bish, R. (1987), "Federalism:  A Market Economic Perspective", Cato Journal, vol. 7 (Fall), pages 377-97.

Boogman, J.C. and G.N. van der Plaat (eds) (1980), Federalism -- History and Current Significance of a Form of Government (The Hague:  Martinus Nijhoff).

Buchanan, J.M. (1975), The Limits of Liberty:  Between Anarchy and Leviathan (Chicago:  Chicago University Press).

—— (1988) "Constitutional Imperatives for the 1990s:  A Legal Order for a Free and Productive Economy", in A. Anderson and D.L. Bark (eds), Thinking About America (Stanford:  Hoover Institution Press), pages 253-264.

Bureau of Industry Economics (1994), Regional Development:  Patterns and Policy Implications (Canberra:  AGPS).

Business Econometrics and Forecasting, University of New South Wales (1994), Survey of Australian States.

Daves, S.R. (1978), The Federal Principle (Los Angeles, Ca.:  University of California Press).

Drucker, P.F. (1993), Post-Capitalist Society (New York:  Harper Business).

Dye, T.R. (1990), American Federalism:  Competition Among Governments (Lexington:  Lexington Books).

Eisinger, P.K. (1988), The Rise of Entrepreneurial States (Batlow:  University of Wisconsin Press).

Eggertson, T. (1990), Economic Behaviour and Institutions (Cambridge, U.K.:  Cambridge University Press).

Giersch, H. (1993), Openness for Prosperity (Cambridge, Mass.:  M.I.T. Press).

Hayek, F.A. (1939), "The Economic Conditions of Interstate Federalism", New Commonwealth Quarterly, vol. V:2 (September), pages 131-49.

—— (1979), The Political Order of a Free People (London:  Routledge & Kegan Paul).

—— (1988), The Fatal Conceit (London:  Routledge & Kegan Paul).

Hirschman, A.O. (1970), Exit, Voice and Loyalty (Cambridge, Mass.:  Harvard University Press).

Industry Commission (1993), Impediments to Regional Industry Adjustment.  Issues Paper (Canberra:  Industry Commission).

Jones, E. (1987), The European Miracle, 2nd ed. (Cambridge, U.K.:  Cambridge University Press).

Kasper, W. (1990), "The Defeat of Political Power.  How International Factor Mobility is Ending the Primacy of Politics over Economic Life", Economic Witness, A.I.P.P., no. 48 (28 June).

—— (1992), "The Conditions of International Competitiveness -- A Queensland Case Study", in D.P. Doessel (ed.), Micro-Economic Reform for International Competitiveness (Brisbane:  Economic Society of Queensland), pages 315-26.

—— (1993a), "Spatial Economics", D. Henderson (ed.) Fortune Encyclopedia of Economics (New York:  Warner Books), pages 82-85.

—— (1993b), "Competitive Federalism:  May the Best State Win", in G. Walker, S. Ratnapala, W. Kasper, Restoring the True Republic (Sydney:  Centre for Independent Studies), pages 53-69, reprinted in Policy (Winter) 1994.

—— (1993c), "Making Federalism Flourish", in:  Samuel Griffith Society, Upholding the Australian Constitution (Melbourne:  Samuel Griffith Society), pages 167-182.

—— (1994a), Global Competition, Institutions and the East-Asian Ascendancy (San Francisco:  International Center for Economic Growth).

—— (1994b), "The Calculus of World Competitiveness and Institutional Innovation", Economic Analysis and Policy, vol. 24:l, forthcoming.

—— and M.E. Streit (1993), Lessons from the Freiburg School:  The Institutional Foundations of Freedom and Prosperity (Sydney:  Centre for Independent Studies).

Kelly, P. (1992), The End of Certainty (Sydney:  Allen & Unwin).

Kohr, L. (1957), The Breakdown of Nations (New York:  Dutton).

Liberal and National Parties (1991), Fightback! - It's Your Australia (Canberra:  Coalition Parties).

McKenzie, R.B. and D.R. Lee (1991), Quicksilver Capital -- How the Rapid Movement of Wealth has Changed the World (New York:  Free Press).

Migue, J.L. (1993), Federalism and Free Trade (London:  Institute of Economic Affairs).

Naisbitt, J. (1994), The Global Paradox -- The Bigger the World Economy, the More Powerful its Smallest Players (Sydney:  Allen & Unwin).

New South Wales Treasury (1994), Inter-State Comparisons of Taxes and Charges, 1993-94 (Sydney:  NSW Treasury), mimeo.

North, D.C. (1992), Transaction Costs, Institutions, and Economic Performance (San Francisco:  International Center for Economic Growth).

Ohmae, K. (1990), The Borderless World (New York:  Harper Collins).

Olson, M. (1965), The Logic of Collective Action (Cambridge, Mass.:  Harvard University Press).

Ostrom, V. (1987), The Political Theory of the Compound Republic:  Designing the American Experiment (Lincoln, Ne:  University of Nebraska Press).

—— (1991), The Meaning of American Federalism (San Francisco:  Institute of Contemporary Studies).

Radnitzky, G. (1990), "European Integration:  Evolutionary Competition against Constructivist Design", paper presented to the General Meeting 1990 of the Mont Pelerin Society, Munich.

—— and H. Bouillon (eds) (1993), Government:  Servant or Master? (Amsterdam-Atlanta:  Rodopi).

Sawer, G. (1969), Modern Federalism (London:  C.A. Watts).

Seldon, A. and F.G. Pennance (1965), Everyman's Dictionary of Economics (London:  Dent & Sons).

Sharman, C. (1993), "Secession and Federalism", in Samuel Griffith Society, Upholding the Australian Constitution, volume 3 (November), pages 97-114.

Siebert, H. and M.J. Koop (1993), Institutional Competition versus Centralisation:  Quo Vadis Europe? (Kiel:  Institute of World Economics) Working Paper no. 548, January.

Sinn, S. (1993), The Taming of Leviathan:  Competition among Governments (Kiel:  Institute of World Economics) Working Paper no. 433.

Task Force on Regional Development (1993), Developing Australia -- A Regional Perspective (Canberra:  mimeo).

Thomas, K. (1992), "Australia's New Constitution?" Australian Business Monthly (November), pages 66-72.

Tiebout, C .M. (1961), "An Economic Theory of Fiscal Decentralization" , in:  National Bureau of Economic Research, Public Finances:  Needs, Sources, Utilization (Princeton:  Princeton University Press).

Tullock, G. (1985), "A New Proposal for Decentralising Government Activity", in:  H. Milde and H.G. Monissen (eds), Rationale Wirtschaftspolitik in komplexen Gesellschaften (Stuttgart:  Kohlhammer), pages 139-148.

—— (1994), The New Federalist (Vancouver, Canada:  The Fraser Institute).

Wood, R.J. (1994), 1993-94 Budget Backgrounder (14 February;  Toowoomba).

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ENDNOTES

1.  This is not the place to review the bountiful literature on federalism.  Readers who want more background reading are referred to Daves, 1978;  and Boogman and van der Plaat, 1980;  as well as the Australian classic on the topic, Sawer, 1969.

2.  Institutions in this definition (rules that structure and constrain individual behaviour) must not be confused with organisations, such as banks or insane asylums, to which common English usage often refers as "institutions".  Organisations are structures of human and other resources which are created to attain a shared purpose (see North, 1992;  Kasper, 1994a, pages 12-19).

3.  Catallaxy is derived from the Greek word katallatein -- to interact with strangers in the market, to learn from them, to turn them into friends and to prosper with them (Seldon and Pennance, 1965, pages 49-50).

4.  Service provision by wire over long distances is rapidly expanding.  Many service industries consequently become footloose:  typists in Jamaica do the business correspondence for New York firms, Irish booking agents do the booking work for U.S. airlines when it is night time in America, and Gold Coast operators instantaneously settle the bets on Hong Kong race courses.  Do you know where the operators live when you ring the local airline for flight information?

5.  This is implicit in the Mutual Recognition process.

6.  The report, which is owned by Queensland Treasury, has not been published.  However, see Kasper, 1992, and 1994b.

7.  The Australia-New Zealand Closer Economic Relations area.