Multi-levelled government systems vary widely in how they allocate responsibilities and sources of revenue between central and non-central governments. While the optimal degree will vary from country to country, there are theoretical reasons for allowing sub-national governments to assume a significant role in stewarding their economies.

Proponents of what is called “first generation” fiscal federalism (FGFF) argue that responsibilities for service provision are best allocated according to where their benefits will be felt. Thus, services that deliver localized benefits are better provided by sub-national governments, as their closeness to end-users entails greater information regarding local needs and the best combination of taxes and services (Oates 1999).

In addition, sub-national governments are subject to market mechanisms to a greater extent than their national equivalents. Tiebout argues that, assuming perfect flows of information, firms and citizens will weigh a given state or province's tax burden and public services with its neighbours. Should a given territory's taxes or services be judged sub-optimal, firms and citizens will then “vote with their feet” for the jurisdiction that offers the best combination of both. This competitive pressure will improve efficiency, as states or provinces strive to retain investment and taxpayers (Tiebout 1956).

While theoretically sound, this work has been complemented by “second generation” fiscal federalists (SGFF). They first contend that it is relatively rare that countries satisfy most or all of the underlying assumptions needed for sub-national governments to effectively compete with one another. The necessary conditions for this so-called “market-preserving” federalism are: a clearly specified hierarchy and scope of authority for each level of government; a sufficient level of policy authority and autonomy for sub-national governments; a domestic market with freely mobile labour and capital; a hard budget constraint on sub-national governments; and the institutionalized allocation of political authority (Weingast 2009, p. 281).

For example, constitutionally specified revenue transfers or central government bailouts of state or provincial debt can undercut the potential of inter-provincial competition. And, clearly specified responsibilities for each level of government and sufficient policy autonomy for sub-national governments can be problematic in authoritarian political systems. This is because central governments in unitary and even most federal systems have the legal authority to intervene in states or provinces under “extraordinary circumstances”.