A vertical fiscal imbalance occurs when the revenues of different levels of government do not match their expenditure responsibilities. This will necessitate transfer payments from the overendowed party to the underendowed party (vertical fiscal equalization).
A horizontal fiscal imbalance occurs when different regions of a country have different abilities to provide services due to different abilities to raise funds. This can occur if regions are able to raise more funds through their tax bases than other regions and/or the cost of provision of services is higher in some regions than in others.
This is usually rectified by weighting transfer payments toward the needier regions (horizontal fiscal equalization).
The discussion of horizontal fiscal imbalance and equalisation was of particular importance in the drafting of the new Iraqi constitution. It was a sticking point for the drafting process--with the oil rich regions seeking to minimise the reallocation of revenue while other regions sought to maximise equalisation payments.