Lessons from International Practices of Intergovernmental Fiscal Transfers

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Lessons from International Practices of
Intergovernmental Fiscal Transfers

• Anwar Shah, World Bank
• XVI Regional Seminar on Fiscal Policy
• CEPAL/ECLAC, Santiago de Chile
• January 26-29, 2004

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Instruments of intergovernmental finance

• Unconditional vs conditional transfers
• Unconditional preserving local autonomy and
  enhancing inter-jurisdictional equity
• Conditional providing incentives to undertake
  specific activities
• Conditional Transfers
• matching vs non-matching
• open-ended vs. closed-ended matching
• Input based conditionality vs output based
  conditionality
• Input based conditionality often intrusive and
  unproductive. Output based conditionality can
  advance grantors objectives while preserving
  local autonomy

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Perceptions on intergovernmental finance are
generally negative

• Federal/Central Giving money and power to
  sub-national governments is like giving whiskey
  and car keys to teenagers
• Provincial and Local We need more grant monies
  to demonstrate that money does not buy
  anything.
• Citizens The magical art of passing currency
  from one government to another and seeing it
  vanish in thin air.

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Ironically these perceptions are well grounded in
reality in LDCs

• Primary focus on dividing the spoils
• Passing the buck transfers revenue sharing with
  multiple factors (Brazil, Argentina, India, RSA,
  Philippines and more)
• Asking for more trouble grants deficit grants
  (Hungary, India, and more)
• Pork barrel transfers or political bribes
  (Brazil, India, Pakistan, USA)
• Command and control transfers (most countries)
• Overall Intergovernmental finance is the
  dominant source of revenue but creates perverse
  incentives for fiscal management and
  accountability

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No need to despair .

• As properly designed fiscal transfers can be part
  of the solution rather than part of the problem.

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Governance Structure 20th Versus 21st Century

• Unitary
• Centralized
• Center manages
• Bureaucratic
• Focused on inputs
• Command and control
• Internally dependent
• Closed and slow
• Intolerance of risk

• Federal / confederal
• Globalized localized
• Center leads
• Participatory
• Results matter
• Responsive and Accountable
• Competitive
• Open and quick
• Freedom to fail/ succeed

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From Dividing the Spoils to Creating An Enabling
Environment for Responsive and Accountable Local
Governance

• Tax Decentralization
• Output based fiscal transfers
• operating
• capital
• Fiscal equalization transfers
• Responsible borrowing

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Considerations in the Design of Fiscal Transfers

• Consistency of design with a single objective
• Simple and transparent allocation criteria
• Create incentives for competitive service
  delivery and support citizen-centered governance
• Provide incentives for fiscal prudence
• Ensure flexibility in use but accountability for
  results
• Stable and predictable
• Equitable ( entitlements vary inversely with
  fiscal capacity and directly with fiscal needs)
• One size does not fit all urban vs. rural,
  large vs. small
• Sunset clauses to ensure periodic review and
  assessment

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Objective Grant Design Better Practices Practices to Avoid
Fiscal Gap Reassign, tax base sharing Canada Deficit grants, tax by tax sharing
Regional fiscal disparities Fiscal capacity equalization Australia, Canada, Germany, Denmark, ECA General revenue sharing with multiple factors
Setting national minimum standard Block transfers, conditions on service standards Ex-Indonesian roads and education, Chile Conditions on spending
Benefit spillovers Matching grant S. Africa teaching hospitals
Influencing local priorities Open-ended matching Canada social assistance Ad hoc grants
Stabilization Capital grant with upkeep requirements Political and policy risk guarantee Stabilization without upkeep
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Transfers to deal with fiscal gap

• Fiscal Gap Structural imbalance as a result of
  a mismatch between revenue means and expenditure
  needs.
• Reasons
• Inappropriate assign Reassign
• Limited tax bases Allow joint occupancy or tax
  decentralization.
• Tax competition Federal collection and general
  (not on a tax-by-tax basis) revenue sharing.
• Tax room lacking Tax abatement and tax base
  sharing (Canada ).
• Practices to avoid deficit grants tax by tax
  sharing.

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Transfers to set national minimum standards

• Rationale
• National economic union or internal common market
• Redistributive role of the public sector and the
  national government
• Design conditional non-matching block transfers
  with conditions on standards of service and
  access.
• Better practices Indonesia roads and primary
  education grants Colombia and Chile education
  transfers Canada health and post-secondary
  education transfers.
• Practices to avoid Conditional transfers with
  conditions on spending ad hoc grants.

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An Example Education grant to encourage
competition and innovation

• Allocation basis to state/local governments
  Population aged 5-17
• Distribution basis to providers Equal per pupil
  to both public and private schools
• Conditions Universal access to primary and
  secondary education. Private school access to
  poor on merit. Improvements in achievement scores
  and graduation rates. No conditions on the use of
  funds
• Penalties Public censure, reduction of grants
  funds and termination
• Incentives Retention of savings

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Indonesia - Specific Purpose Transfers to Local
Governments (now defunct)

• L2. District/Town Road Improvement Grant
• Length of roads
• Condition
• Density
• Unit cost
• L3. Primary School Grant
• School age children (ages 7-12)
• Needs for facilities

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Federal financing of health care in Canada

• Per capita transfers tied to rate of growth of
  GDP (plus transfer of tax points - for health and
  post secondary education in 1977,13.5 points of
  PIT and 1 point of CIT)
• Conditions
• (1) Universality
• (2) Portability
• (3) Public insurance but public/private
  provision
• (4) Opting in and out
• (5) No extra billing
• Penalties
• Threat of discontinuation for breach of the
  conditions (1)- (4) above.
• Dollar for dollar reduction for breach of the
  condition (5).
• Sunset clause Parliamentary review every 5
  years.

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Fiscal Equalization Transfers Rationale

• Political Large regional fiscal disparities can
  be politically divisive. May even create threat
  of secession. Fiscal equalization grants to
  create a sense of political unity
• Makes it possible for all citizens to be treated
  alike regardless of the places of residence.
  Thereby advances social justice ( fiscal equity)
  and efficiency in market resource allocation
  (fiscal efficiency).

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Transfers to reduce regional fiscal disparities

• Design General non-matching fiscal capacity
  equalization transfers.
• Better practices Fiscal equalization programs
  (sources of data CGC, Finance Canada, Lotz, Shah
  Spahn)
• Paternal Australia (fiscal capacity plus fiscal
  needs) and Canada (fiscal capacity only)
• Solidarity, Fraternal or Robin Hood Germany
  (fiscal capacity), Sweden, Denmark
• Practices to avoid General revenue sharing with
  multiple factors e.g. practices in Brazil, India
  and South Africa.

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Fiscal Equalization Program Australia Canada Germany
Legal Status Law Constitution Constitution
Paternal or Solidarity Paternal Paternal Solidarity
Total Pool determination Ad hoc Formula Formula
Allocation Formula Formula Formula
Fiscal capacity equalization Yes, RTS Yes, RTS Yes, RTS
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Fiscal Equalization Program Australia Canada Germany
Fiscal Need Equalization Yes, RES No No
Program Complexity High Low Medium
Political Consensus No Yes May be ?
Who recommends Independent agency Intergov. Committees Bundesrat
Dispute resolution Supreme court Supreme Court Constitutional court
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A Representative Tax System approach to fiscal
capacity equalization
Equalization from revenenue source i
National Per capita States average base
in own base tax ratei all statesi per
capitai

Per capita Per capita potential standardized rev
enue in revenue in All states (i) state A (i)
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A Representative Expenditure System approach to
Fiscal Need Equalization

• Equalization entitlement from expenditure
  category i
• EQUALS
• Per capita potential expenditure of State A for
  category i based upon own need factors if it had
  national average fiscal capacity
• MINUS
• Per capita potential expenditure of State A on
  expenditure category i if it had national average
  need factors and national average fiscal capacity

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Federal Fiscal Equalization Program of Canada is
enshrined in the constitution____________________
__________________

• Canada Constitution Act 1982, Article 36.(2)
• Parliament and the Government of Canada are
  committed to the principle of making
  equalization payments to ensure that provincial
  governments have sufficient revenues to provide
  reasonably comparable levels of services at
  reasonably comparable levels of taxation.

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An Example of Expenditure Need Determination in
Australia Secondary Education Expenditure Need
Factors
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Figure 3 - Australia - Relative Cost of Service
Provision Ratios - 1995-96
Figure 4 Australia - Relative Revenue Raising
Capacity Ratios - 1995-96
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Denmark Equalization models and standards
Equalization type Counties Metropolitan areas Local Govts.
Fiscal capacity 85 Robin Hood 90 Robin Hood 50 central grant
Fiscal Needs 85 Robin Hood 60 Robin Hood 35 Robin Hood
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Institutional Arrangements for Fiscal Transfers

• Intergovernmental committees Canada, Germany
  (with strong role of Bundesrat)
• Independent grant commissions Australia
  (permanent secretariat), India (limited duration)
  and South Africa (permanent)
• Intergovernmental cum civil society commissions
  Pakistan (limited duration)

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Fiscal Equalization Grants Some Lessons

• Fiscal capacity equalization with an explicit
  standard is desirable and do-able in most
  countries.
• Fiscal need equalization is much more complex
  desirable but may not be worth doing. Rough
  justice may be better than precise justice.
• For local equalization one size does not fit
  all.
• Important to have societal consensus on the
  standard of equalization
• Must have a sunset clause and provision for a
  review and renewal
• Institutional arrangements for a continuous
  review and periodic revision

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Negative Lessons Practices to Avoid

• General revenue sharing with multiple factors
• Deficit grants
• Fiscal Effort Provisions
• Input or process based or ad hoc grants
• Capital grants without assurance for upkeep
• Negotiated or discretionary transfers

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Positive Lessons Practices to Strive For

• K.I.S. (keep it simple)
• Focus on single objective
• Introduce sunset clause
• Output based conditional transfers with citizens
  evaluations
• Fiscal capacity equalization to a defined
  standard
• Political consensus on the standard of
  equalization
• Institutional arrangements for broad based
  consultation