The ECB/EC/IMF did not touch in the Peculiar Case of Portuguese Fiscal Federalism.

(The 10 capital sins: #1)
Today we finally knew the “Memorandum of Understanding Of Specific Economic Policy Conditionality” produce by the troika (ECB/EC/IMF). It has some positive contributions, but as I expected it sidestepped some major “capital sins” of public finances. Let us start with Portuguese “federalism”: MAIN PROPOSALS from the troika: to reduce transfers to local and regional governments by at least 175M in 2012 and by 175M in 2012 and limit the reduction of the regional personal and corporation income tax rates to 20%, when compared with mainland tax rates. These measures do not address the structural problem of Portuguese strange “Federalism”.
When Wally Oates developed his seminal work - "Fiscal Federalism" - almost 30 years ago and gave birth to 1st generation theory of fiscal federalism, he was cautious saying that his approach was economic, although he acknowledge that political issues were relevant. Two decades after, a 2nd generation theory has given more importance to political issues.
Well, in the case of Portugal political issues are determinant in shaping and they are responsible for increased public expenditure. What economic theory still suggests is that countries with several tiers of government (federal or unitary states) should have the main taxes (mainly personal and corporate income taxes and VAT) shared by the upper two levels of government (federal/central and regional) or three (also including municipalities) and this should be supplemented by a set of intergovernmental grants designed in a way to somewhat partially equalize revenues (positively discriminating in favour of poor regions) and other to promote efficiency.
The Portuguese model is very peculiar, and almost nonexistent in Europe. One level of government (the Regions of Azores and Madeira) have all tax revenue generated in the territories. Citizens of these regions do not contribute one cent to the national functions of the state. Additionaly, there is a generous regional finance Act that transfers funds to the regions, and also a Local Finance Act which transfers funds to regional (and mainland) Municipalities. Finally, several regional expenditures are funded directly by the State Budget (e.g. Police, Universities, etc.). Obviously all these transfers and expenditures are funded by taxes generated in mainland Portugal. A particular weird situation exists today, since the current Local Finance Act (2007) gives the municipalities the possibility to have up to 5% of the personal income tax (IRS). The government of Portugal wants this revenue to come from the regional IRS, but the governments of the regions want it to come again from the State Budget.
It is clear that this peculiar model of "Portuguese Fiscal Federalism" has no economic rationality, but it has a political explanation. This article of the Constitution was introduced in 1976 after the revolution. At that time a minor threat of independence of the islands must have frightened the politicians in mainland Portugal and the norm was adopted. Over the last 30 years, there were several amendments of the Constitution, which did not change this norm. Also the laws regulating the relationships between the Republic and the Regions (Estatutos Politico Administrativos) have been revised and the tendency has been an ever increasing degree of autonomy. Again the explanation is political. Members of Parliament (MPs) elected from these regions have been pivotal to produce majorities in the national parliament, so that they usually have a big bargaining power.
These issues obviously were not considered by the troika. We just have some cuts in transfers. When the storm of the fiscal unbalance will be over, expenditure will grow again, since here no structural reform is suggested.
Proposal 1 : Preferably to change this norm in the Constitution and the regional finance act, in line with what are the best practices in developed countries (tax sharing arrangements) and the economic theory of fiscal federalism suggests. If this is considered not politically feasible decrease substantially (!) regional transfers. Deduct the value of expenditures that should continue to be financed through the budget (e.g. police), from the value of transfers.
Proposal 2 : Suggest to Eurostat that revenues and expenditures of the regions be classified in S1312 (where state accounts are considered en federal countries). If the regions in Portugal have more taxing powers and a greater share of revenues than states in federations why should they not be considered in S1312? This would increase transparency.