As authority over public expenditures has shifted from central toprovincial and local governments in countries around the world overthe last two decades, prevailing approaches to the study ofdecentralization in welfare economics and public choice from the1970s and 1980s have given way to new political economy approaches.The first generation of theories envisioned central and lower-levelgovernments as distinct sovereigns within their own spheres ofactivity. Recognizing a more complex reality, the political economyliterature is rethinking the notion of sovereignty in multi-tieredsystems. Motivated by recent difficulties with fiscaldecentralization and fiscal discipline, this essay rethinks thenotion of fiscal sovereignty, viewing it as an evolving set ofbeliefs in the context of a dynamic game of incomplete informationplayed between central and subnational governments.Provincial or local governments, along with their creditors andvoters, attempt to assess the credibility of the centralgovernment's commitment to abide by pre-specified intergovernmentalfiscal arrangements. When higher-level governments dominate thefield of taxation and take on heavy co-financing obligations—ascentral governments do in virtually all newly decentralizingcountries—the central government's commitment not to bail outsubnational governments in the event of debt-servicing crises is notcredible. In other words, subnational governments withoutsignificant tax autonomy will not be viewed as sovereign borrowers,and this has important implications for their fiscal behavior.