Fiscal decentralization represents devolution of spending responsibilities from higher level to lower level of government accompanied by transfer of fiscal resources and administrative authority. The rising demand for decentralization in developing countries in recent years is a consequence of broader process of liberalization, deregulation, and urge for democratization with a need to bring the government closer to people for articulation of their needs and preferences. There is an increasing demand from regional and local leaders for more autonomy and taxation powers to support their expenditures.
The literature on fiscal federalism identifies the basic principles governing the intergovernmental fiscal system based on expenditure assignments on the basis of economic efficiency, fiscal equity, political accountability, and administrative effectiveness; tax assignments; intergovernmental transfers and borrowings by the sub-national and local governments. The intergovernmental transfers are necessitated to correct vertical and horizontal imbalances created because of mismatch between tax bases and expenditure assignments. These transfers can take different forms including sharing revenues and tax bases and establishing conditional or unconditional grants that throw the challenge of designing an appropriate system acceptable to all stakeholders in a federation.