Intergovernmental Transfers: Concepts and Policy Issues › upload › 7050 › VI_Yilmaz.pdf · Intergovernmental Transfers: Concepts and Policy Issues∗ Serdar Yilmaz Public Sector

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Intergovernmental Transfers: Concepts and Policy Issues∗∗∗∗

Serdar Yilmaz Public Sector Specialist

World Bank Institute Introduction

Intergovernmental transfer is an essential component of intergovernmental fiscal arrangements.1 Central transfers cover a significant portion of the subnational2 finance in most countries. For example, the share of intergovernmental transfers is more than 80 percent of subnational expenditures in South Africa and 90 percent of subnational revenues in Mexico (see table 1). Thus, the design of the intergovernmental transfer system is of great importance for efficiency and equity of local public service provision and the fiscal health of subnational governments.

Intergovernmental transfers are used to pursue a variety of public policy objectives in different countries. There is a large theoretical and empirical literature as well as policy papers on intergovernmental transfers in various countries. Drawing on the literature and examples from various countries, this paper provides a broad overview of the theoretical issues and practice of intergovernmental transfers in developed as well as developing countries.3

The next section examines the linkages between transfers and other three components of intergovernmental fiscal system (namely expenditure and revenue assignment, and subnational borrowing), an important dimension of intergovernmental transfer system design that often receives insufficient attention. The principal types of transfers and mechanisms used to implement these objectives are also analyzed in the

∗ Prepared for the Developing and Strengthening System of Intergovernmental Fiscal Relations and Fiscal Decentralization: A Joint Conference of World Bank Institute and Korea Development Institute, Seoul, Korea, July 21~23, 2003. 1 The direction of a transfer mechanism can encompass all levels of government, such as central to provincial, provincial to local, or directly central to local. 2 In this paper, I use the term “subnational” to encompass all governments below the central level. 3 The term “transfers” is often used to refer to a number of different kinds of public finance arrangements, including, grants, subsidies, tax sharing and cost-reimbursement. In this paper, I use all these terms interchangeably to refer to transfer of funds from central government to local governments.

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following section. The third section then presents a brief review of the main objectives of intergovernmental transfers. Finally, different criteria in evaluating intergovernmental transfer system design are presented in the fifth section. The paper then concludes with some broad lessons about designing intergovernmental fiscal systems in developing countries. Table-1: Share of Intergovernmental Transfers in Subnational Expenditures and Revenues Revenue Expenditure 2000 2001 2000 2001 Australia 38.36%a 35.33%b 38.83%a 34.50%b Bolivia 48.83% 51.77% 49.81% 51.90% Bulgaria 43.51% 35.28% 42.16% 35.30% Canada 30.50% 32.39% 31.75% 31.80% China 38.79%a 35.01%b 38.94%a 35.39%b Czech Republic 25.80% 35.18% 24.64% 33.12% Denmark 40.73% N/A 40.24% N/A Hungary 49.54% 47.55% 48.82% 47.41% India 52.42%a 52.42%b 38.34%a 38.16%b Indonesia 80.38%a N/A 80.66%a N/A Israel 41.82% N/A 41.94% N/A Kazakhstan 34.94% N/A 36.30% N/A Kyrgyz Republic 30.89% 31.40% 26.60% 30.26% Mexico 88.49% N/A 90.71% N/A Moldova 33.86% 22.40% 34.88% 22.78% Mongolia 46.61% 47.03% 43.11% 47.71% Poland 39.54% 40.32% 39.05% 39.58% South Africa 79.85% 82.85% 80.88% 82.61% Switzerland 40.09% N/A 41.49% N/A Thailand 31.13% 41.07% 31.75% 41.79% Ukraine 30.59% 39.67% 30.81% 39.18% United States 44.96% N/A 49.02% N/A Source: Government Finance Statistics Yearbook 2002, IMF a 1998; b 1999 Transfers in Context: Four Pillars of an Intergovernmental Fiscal Design

The driving factors behind the decentralization of public management system are efficiency, democracy and transparency. The economic argument of efficiency stems from the fact that due to closeness to citizens, local governments are able to meet different views and interests of people and allocate resources more efficiently than a central authority. The rationale behind the democratic participation and transparency argument is to make it possible for people to participate in and influence the decisions made within their geographical area. In a decentralized system, where locally elected governments have the power to pursue the agenda mandated by voters, citizen participation in decision-making process cultivates a culture of democracy and transparency in public management system.

The implications of decentralizing the public management system are far-reaching, and the manner in which public resources and responsibilities are allocated among different levels of government will affect a nation's overall economic and fiscal

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performance. Thus, the challenge in intergovernmental fiscal reform is to design a system of governance that will (i) influence the efficiency of public service provision; (ii) achieve fiscal equity (iii) and promote macroeconomic stability. According to Bird (2001), the most critical aspect of intergovernmental transfer system is not the issue of who gives them or who gets them but its effect on these aspects of the system.

The design of a decentralized system requires "sorting-out" of public sector responsibilities among different types of governments and the process of sorting out entails transfer of some decision-making powers from central to subnational governments (Ebel, Varfalavi and Varga, 2000). However, designing a decentralized system is not limited to the question of assigning responsibilities among different levels of government. The challenge is to design an intergovernmental system that links decentralization reforms to the economic, social, and institutional structures of the society. There are four conditions that are particularly important in designing an effective intergovernmental fiscal system:

1. Presence of accountability mechanisms: Establishing accountability mechanisms requires that the costs of local decisions must be fully borne by those who make the decisions. Accountability is a complex concept, with many dimensions. Political accountability requires political leaders at all levels to be responsive and responsible to their constituents, and those constituents to be fully informed about the consequences of their (and their leaders’) decisions. Administrative accountability requires a clear legal framework with respect to who is responsible for what. On the other hand, economic accountability requires that local residents are responsible for paying for local services, which in turn entails that local authorities can set some tax rates. However, enforcing accountability at the local level is not an easy task. It needs clear incentives from the central government in addition to the provision of adequate information to local constituents and the opportunity for them to exercise some real influence or control over the service delivery system. For political accountability as well as economic efficiency purposes subnational governments should have at least some own sources of revenues, meaning taxes and fees over which they have total or almost total control. At a minimum, local governments should have discretion over the rate of a local own revenue source.

2. Enforcement of hard-budget constraint: An effective intergovernmental system requires an institutional structure that minimizes adverse incentive problems. In the absence of the right incentive structure, subnational governments understate their own revenues, increase their commitments on expenditures and run deficits in the expectation that central government will bail them out. Subnational governments should not depend on central government ‘bail-outs’ of imprudent financial decisions, such as excessive borrowing and unsustainable expenditures.

3. Existence of local capacity: The quality of civil servants is the key dimension of local capacity. Their quality is a function of their skills and knowledge, which are commonly measured by the level of education, training, and on-the-job experience. There are four general skill areas where subnational governments need to demonstrate capability: identification and analysis of local problems in order to plan appropriate

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responses; mobilization and management of resources; communication and coordination of policy implementation; and resolution of local conflicts.

4. Sound budgetary and financial procedures: Subnational budgets, like the central budget, should be comprehensive, accurate, periodic, authoritative, timely, and transparent. Delay in the approval of municipal budgets prevents planning and providing effective service delivery. Thus, the central government should establish a ‘framework’ for budget law and require external audit; however, it should not require subnational budgets to be subject to prior approval.

There are four pillars of an intergovernmental system design: expenditure assignment, revenue assignment, intergovernmental transfers/grants, and subnational debt/borrowing (Bird, 2000). The pillars of the intergovernmental system must be very well linked into these broader decentralization reform goals and intergovernmental fiscal policy objectives. It is important to realize that fiscally decentralized systems are highly interdependent and transfers are just one component of the system. Therefore, the design of a transfer system cannot be separated from the design and evolution of broader public management reform goals and intergovernmental fiscal system.

An intergovernmental transfer system will not perform well if the other components of the intergovernmental system are ill designed or do not perform their complementary roles. The overriding issue in the design of an intergovernmental system is whether subnational governments have sufficient aggregate resources at their disposal to provide minimum level of basic services regardless of their fiscal capacity. This entails the design of a transfer system that guarantees sufficient resources to subnational governments to fulfill their responsibilities at a minimum desirable level. Fiscal transfers have a very important role to play in intergovernmental fiscal relations of a country. At a minimum, this role comprises of:

(1) provision of financing to ensure the fulfillment of national policy objectives and to correct interjurisdictional spillovers at the subnational level;

(2) setting the minimum national norms and standards for decentralized service delivery, financial management (including government accounting), and governance at the subnational level;

(3) producing and disseminating the public information required for accountability mechanisms to function effectively; and

(4) supervising and providing technical assistance to subnational governments to ensure efficient operations in compliance with national guidelines.4

Objectives of Intergovernmental Transfers

Intergovernmental transfers, which compose of a significant portion of subnational governments' revenues in all countries, have three principal objectives: (i) to equalize vertically (improve revenue adequacy); (ii) to equalize horizontally

4 Donald R. Winkler. 1994. The Design and Administration of Intergovernmental Transfers. Washington, DC: World Bank Discussion Paper No. 235. p. 23.

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Figure-1: Vertical Imbalance by Region

0%

10%

20%

30%

40%

50%

60%

70%

Sub-SaharanAfrica (2)

East Asia andthe Pacific (6)

Latin Americaand the

Caribbean (9)

Europe andCentral Asia

(15)

High Income,OECD (20)

South Asia (1)

Note: Measured as transfers to sub-national governments as a share of sub-national expenditures. Simple average of most recent observations in available countries. Numbers in parenthesis indicate number of countries represented.

(interjurisdictional redistribution); (iii) to minimize interjurisdictional spillovers (externalities).

Vertical Fiscal Imbalance

Revenue and expenditure assignments give rise to vertical and horizontal fiscal imbalances within a nation's intergovernmental finances. Vertical fiscal imbalance is the disparity between revenue sources and expenditure needs of subnational governments. A vertical imbalance occurs when the expenditure responsibilities of subnational governments do not match with their revenue raising power. As seen in Figure 1, the issue of vertical imbalance is widespread all around the world. At least 30 percent of the subnational governments' revenues come from

intergovernmental transfers in all countries.5

Vertical fiscal imbalance exists when there is no broad correspondence between the expenditure responsibilities assigned to each level of government and the fiscal resources available to them to carry out those responsibilities (Box 1). The most common source of vertical imbalance is the lack of own revenue sources at the subnational level. Revenue sharing and intergovernmental transfers are typically designed to redress this vertical imbalance. However, there are other ways to close vertical imbalance gap, such as increasing revenue-raising ability of subnational governments (raising local revenues) and/or reducing expenditure responsibilities of subnational governments (reducing local expenditures).

Box 1: Vertical Fiscal Balance Local Revenue Capacity = Local Expenditure Needs

Local Revenue Sources (1) Own Revenues (taxes and fees) (2) Shared Taxes (3) Intergovernmental Transfers

Local Expenditure Responsibilities (4) Own Responsibilities (by law) (5) Delegated Expenditure Responsibilities

5 There is no analytical rationale for an appropriate size of the intergovernmental transfers. According to Bird (2001), “the basic task in transfer design is to get prices right in the public sector in the sense of making local governments fully accountable to their citizens for the actions they undertake—at least at the margin of decision-making.” What matters is to properly design the transfer system to achieve this goal; otherwise the question of what percentage of local government expenditures is financed by transfers does not matter much.

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In general, there are two ways to measure vertical fiscal imbalance. The first one is to look at the surplus or deficit of each consolidated level of government, before borrowing but after all revenue sharing and transfers are implemented. If local governments have their expenditure needs met appropriately, they should not be running deficits. Of course this measurement assumes that all local governments efficiently provide the services under their responsibility. Furthermore, this measure of vertical imbalance is only meaningful under the assumption that deficits are not the results of mismanagement or waste, when expenditure needs are properly measured, gap filling transfers are not being made and local governments fully utilize their revenue basis. Only under these conditions would the presence of a budget deficit suggest the presence of a mismatch between expenditure responsibilities and fiscal resources.

A second way to measure vertical fiscal imbalance is to examine the share of local government expenditures financed with sources of revenues under the control of local governments. With the help of this explanation, a coefficient for vertical imbalance can be operationalized as:6

1 – (total municipal resources not under municipal control/ total municipal expenditures).

This coefficient quantifies the share of the local government expenditures that are financed from sources of revenues that are controlled by the local government. By construction, the coefficient of vertical imbalance takes values between zero and one, with values closer to zero indicating a larger vertical fiscal imbalance.7 Table 2 presents vertical imbalance coefficients for a selected group of countries.

Table 2: Vertical Imbalance Coefficients Country Period Coefficient Indonesia 1990 0.19 Australia 1987 0.43 India 1982-86 045 Colombia 1979-83 0.50 Pakistan 1987-88 0.53 Malaysia 1984-88 0.65 Canada 1988 0.79 United States 1988 0.88 Brazil 1988 0.89 Jordan 2000 0.39 Sources: Shah (1994); for Jordan El Daher et. al. (2003).

Total elimination of vertical imbalance is an impossible task since some degree of mismatch between expenditure needs and revenue capacity is unavoidable. There are only a few countries, which completely eliminated vertical imbalance problem. For 6 Hunter, J. S. H. 1977. Federalism and Fiscal Balance: A Comparative Study. Canberra, Australia: Australian National University Press and Centre for Research on Federal Financial Relations. 7 Of course, technically there is a possibility of having a negative coefficient value, when municipal revenues not under municipal control are higher than total expenditures. Such a scenario requires municipal budget surpluses and all revenues to be outside the control of the municipality, which is highly unlikely.

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example, out of 20 countries for which data on revenue and expenditure shares at the national and subnational levels are examined, only Czech Republic and Israel successfully eliminated vertical imbalances (see table 3). Fifteen of the remaining 18 countries reduced vertical imbalance value to a reasonably small amount (3 percent or less).

The difficulty of elimination of vertical imbalance is related to its estimation, which requires detailed information about local governments’ expenditure needs and revenue raising capacity. Without proper information, intergovernmental fiscal relations will necessarily involve conflicts both between central and subnational governments as well as different levels of subnational and local governments at the same level. Moreover, the lack of appropriate information often leads to interventions by the central government to correct the mistakes resulting from discretionary decisions.

The lack of reliable information related to both the expenditures and revenues of local governments are the most important technical constraints in designing an effective intergovernmental transfer system. To calculate expenditure needs and revenue capacity of local governments, a relatively up-to-date database is needed that cannot be manipulated by the stakeholders. The absence of information on local fiscal capacities normally leads to inequalities among regions and local governments and raises the moral hazard problems, so the central government is forced to intervene on an ad hoc basis.

It is also important to include politically accepted expenditure norms and a fair estimate of the revenue capacity of subnational units in estimating vertical imbalance as well as in transfer formula (Alm and Martinez-Vazquez 2002). The fairness of the allocation is widely questioned by subnational governments even in the systems that use the formula-based method. In most cases, the indicators used in the formula are not relevant and reliable. This situation leads to the establishment of an intergovernmental system without the right incentives where local governments with low revenue effort is better off. Typically, the central government takes away part or all of the “surplus,” giving the subnational governments no incentives to optimize their own revenues.

Horizontal Imbalance

The second objective of intergovernmental transfers is to minimize horizontal imbalance. A horizontal imbalance occurs when own fiscal capacities to carry out the same functions differ across subnational governments. Horizontal imbalances across subnational governments arise from:

• Unequal distribution of revenue bases, natural resources, and wealth across subnational governments,

• Variations in the socio-economic characteristics of population, and • Differences in the geography and climate across jurisdictions that lead to

disparities in economic opportunities at the subnational level.

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If subnational governments were to finance assigned services from their own-source revenues, there would be substantial interjurisdictional differences in the quantity and quality of public services based largely on differences in resource endowments. Intergovernmental transfers are powerful mechanisms to reduce these differences in the fiscal capacity of subnational governments. Horizontal equalization, however, as discussed in a subsequent section, is a complex task in various ways.

Spillovers

A third objective of intergovernmental transfers is to correct for interjurisdictional spillovers. Some local government services’ benefits (or costs) extend beyond the borders of the locality. For example, an outbreak of a disease in one jurisdiction will have an impact on overall health situation in neighboring communities. Local governments may be unwilling to provide an efficient level of certain services if they believe that people who reside outside the locality will enjoy many of the resulting benefits. To ensure that local governments provide a greater amount of those services, the central government may transfer resources to them.

In all countries, these imbalances are handled through a variety of transfer mechanisms in order to allow subnational governments to perform their assigned functions. A well-functioning intergovernmental system should provide all necessary public services to all citizens at comparable tax rates—that is to say, people in different parts of a country should have equal access to public services and the tax burden they are asked to bear should be uniform across jurisdictions. A well functioning transfer system allows countries to reap the advantages of a decentralized delivery of public services, while, ensuring that the design of public services conform to general notions of efficiency and equity.

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Table 3: Vertical Imbalance in Selected Countries Country Level of

government Revenue share Expenditure

share Surplus/deficit

Before Transfers National 0.72 0.64 0.08

Subnational 0.28 0.36 -0.08 All levels 1.00 1.00 0.00

After Transfers National 0.55 0.64 -0.09

Subnational 0.45 0.36 0.09

Bolivia (2001)

All levels 1.00 1.00 0.00 Before Transfers

National 0.84 0.74 0.10 Subnational 0.16 0.26 -0.10

All levels 1.00 1.00 0.00 After Transfers


Bulgaria (2001)





Canada (2001)


National 0.44 0.44 0.00 Subnational 0.56 0.56 0.00


National 0.34 0.44 -0.10 Subnational 0.66 0.56 -0.10

China (1999)





Czech Republic (2001)





Denmark (2000)

All levels 1.00 1.00 0.00

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Table 3: Vertical Imbalance in Selected Countries (continued) Country Level of





After Transfers National 0.65 0.66 0.01


Hungary (2001)





India (1999)





Israel (2000)


National 0.54 0.55 -0.01 Subnational 0.46 0.45 0.01



Kazakhstan (2000)





Kyrgyz Republic (2001)





Mexico (2000)

All levels 1.00 1.00 0.00

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Moldova (2001)





Mongolia (2001)





Poland (2001)





South Africa (2001)





Switzerland (2000)





Thailand (2001)

All levels 1.00 1.00 0.00

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Ukraine (2001)





United States (2000)

All levels 1.00 1.00 0.00 Source: Government Finance Statistics Yearbook 2002, IMF.

Types of Intergovernmental Transfer Design

This section covers the theory and practice of intergovernmental transfers, providing different classifications of transfer system design by looking at four important components:

(1) The purpose of the transfer—unconditional general purpose grant vs. conditional specific transfer;

(2) The rules that determine the total amount of transfer—share of national government revenues, annual budget decision, reimbursement of approved spending;

(3) Distribution of transfer among local governments—origin of collection of a tax, ad hoc, formula based, cost reimbursement.

(4) Management of the intergovernmental transfer system—the role of local governments in making changes in the system.

The purpose of the transfer system

Although the key features of intergovernmental fiscal design are similar across countries, the objectives of their transfer system vary. In some countries, transfer system is designed to provide support to national priority sectors, whereas, in others it provides general financial support allowing local councils to use the funds with total discretion. Therefore, the design of the transfer system depends on the policy objectives of a particular country. There are two design options: conditional and unconditional (see Box 2 for general characteristics of these types of transfers).

A. Conditional Transfers: The transferring authority (central government) specifies the purpose of use for these funds. The use of conditional transfer funds is limited

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to a specific sector that is highly important to the transferring government, such as education, health, housing, environmental. These types of transfers are sometimes called specific purpose grants or categorical grants. There are different applications of conditional transfers:

1. Open-Ended, Matching: For a unit of money given by the donor, the recipient should send some amount and there is no cap on the amount of funds transferred to recipient. Open-ended means as long as the recipient provides co-financing the central government will contribute its share as well.

2. Close-Ended, Matching: Very similar arrangements but transferring authority puts a ceiling on the total amount to be transferred.

3. Non-matching: The recipient is not required to provide co-financing. The donor gives a fixed sum of money with the stipulation that it be spent on a public good.

B. Unconditional Transfers: The transferring authority places no restrictions on the use of funds.

The effect of open-ended matching design on subnational governments’ budget is shown in figure 1, where horizontal axis presents health expenditures (national priority sector; central government conditions local governments to spend transferred resources) and vertical axis is the monetary value of all other local government services. AB is the pre-transfer budget line of the recipient local government. The budget line shifts to AC after transfers and the triangle ABC represents the total amount of transfer. Before the transfers, the local government was providing OX1 level of all other services and OX2 level of health services at E1 expenditure levels. Matching transfer lowers the cost of health expenditures; therefore after the transfers the local government will provide more health services. However, how much more will depend on the income8 and substitution9 effects of the transfer. Although the transfer is for health services, because of the income effects, some of the increase in expenditure levels will go to other services. At E3, more of other services and health services are provided. If the new expenditure level moves to E2, the entire amount of the transfer will be spent on health services. The effect of transfers on local public service provision depends on the preferences of the local community.

The rationale for matching is correcting inefficiencies in public goods provision arising from spillovers. Matching transfers can correct inefficiencies from spillovers by providing a unit subsidy just equal to the value at the margin of the spillover benefits. However, studies have found that spending in the conditioned sector increases less than the total amount transferred for matching transfers (Shah 1985) and that there are very few good examples of matching transfers (Bird, 2001). A reason for this might be poor design of matching transfer system. According to Bird (2001, p. 7), the correct matching rate “should in principle be determined by the size of spillovers…. [and] the optimal way to allocate among localities will be to vary it inversely to the price elasticity of local demand for the service.”

8 Transfer increases the resources available to the local government. Some of this increase will be spend on providing more health services and some will be spend on other services. 9 The transfer reduces the relative cost of health services to the local government.

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Close-ended matching transfers provide funds to a certain limit set by the transferring authority. AB is the original budget line and ACD is the post-transfer budget line (figure 2). The transferring government provides grants up to point C, setting the total health expenditures at OD. Close-ended matching transfers stimulate local expenditures on the conditioned sector more than open-ended transfers (Gramlich, 1977).

Conditional non-matching transfers shift the budget constraint of a local government (figure 3), where ACD is the post-transfer budget line. From the local

A

B C

Other services

Health

X1

X2

E1

E3

E2

O

Figure 1: Open-ended Matching Transfer

A

Other services

Health B

C

D O

Figure 2: Close-ended Matching Transfer

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government perspective, since the subsidy amount is equal to AC, at least XH level of health services will be provided.

In the case of unconditional non-matching transfers, the recipient government’s budget line increases by the amount of transfer (figure 4). The recipient’s budget line increase is equal to AC=BD. Since the recipient is allowed to spend the transfer any way it deems to be appropriate, unconditional transfers do not have effect on relative prices; thus, they do not stimulate local spending on a particular service. However, they tend to increase overall spending; this is called “flypaper effect” (Gramlich, 1977).

A

Other services

Health B

C

D O

Figure 3: Conditional Non-matching Transfer

XH

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There are two different views on attaching conditionality to transfers. Some argue that the primary objective of transfer system is to ensure that all subnational governments have adequate resources to deliver at minimum standards and that there should be no conditions attached to them other than financial auditing (Shah, 1994). On the other hand, others claim that if the central government uses subnational governments in executing national policies, it makes sense to attach conditions on transfers (Bird, 1993).

A

C

B D O

Figure 4: Unconditional Transfers

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Box 2: Intergovernmental Transfers: Summary of Types of Grant and Grant Characteristics Conditional Open Ended, Matching Closed End, Matching Non-Matching

Unconditional

Description For every dollar given by the donor, recipient must send some amount. The grant is “open ended” or there is no cap on amount of funds. The cost of the grant depends on recipient behavior.

For every dollar given by the donor, recipient must send some amount. The grant is “close ended.” There is a ceiling on the amount to be transferred.

Donor gives a fixed sum of money with the stipulation that it be spend on a public good.

Provided for equalization purposes or based functional areas. Funds may be used at the recipient discretion.

Purpose of grant

Encourage spending on production of good or service having positive social and/or interjurisdictional externalities.

Same as open-ended. Encourage spending on a national priority sector. Restriction on its use differentiate it from unconditional grant

Increases overall capacity to spend. May have specific equalization goal (horizontal imbalance) and/or be a way to correct vertical imbalance

Illustration Entitlements; housing, environmental management. The key is that the amount open ended.

Most categorical grants environmental management, housing, substance abuse treatment) have some limit on donor cost (close end)

(US) Community development, job training partnership Act, community mental health, low income home energy assistance, federal transit capital/operating assistance

An equalization grant is designed to address horizontal imbalance of recipient. Block grants have a designated purpose, broadly defined.

Effect on governmental spending

Donor determines amount of spending

Donor up to the point that the cap is reached. Thus the effect on G is shared by donor and recipient.

Donor gives recipient a fixed amount of a grant with stipulation on its use. If the community wanted to consume less of the public good than the grant condition affects behavior. Otherwise this looks like an unconditional grant.

The donor will cap the amount of the grant. As long as the community wants to consume at least an amount of the public good equal to the amount of the grant, then the fact that the grant is conditional or unconditional is irrelevant.

Fungibility Fungibility means that money can be used for more than a designated purpose; or it “frees up” other funds that would be used for a restricted purpose for other uses, including tax reduction. Yes

yes, as with any grant in which behavior is rational (indifference curves concave upward), the reality is the communities often use some portion of non-matching conditional grant money to reduce their own taxes.

Yes Yes -- very clearly.

Other comments

Relative price of public goods declines.

Relative price of public goods declines.

No change in relative prices of public goods in excess of the grant.

No change in relative prices of public vs. private goods.

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Given a choice, subnational governments prefer unconditional transfers, which provide maximum flexibility to pursue their own policies. Since unconditional transfers increase total resources available to subnational governments without influencing their spending patterns, recipients maximize their own welfare. The practice of attaching conditionalities to intergovernmental transfers varies across countries. In countries, like Czech Republic, Romania and Slovak Republic, all grants are given as conditional transfers, whereas in countries, like Bulgaria, Poland and Estonia, a significant portion of the total transfers is unconditional (see table 4).

Table 4: Transfers in EU Applicant Countries Conditional Transfers Unconditional Transfers Total Bulgaria (2000) 9.1 90.9 100 Czech Rep. (1999) 100 0 100 Estonia (1999) 40.2 59.8 100 Hungary (1999) 96.6 3.4 100 Latvia (1999) 90.0 10.0 100 Lithuania (1999) 45.2 54.8 100 Poland (1999) 39.4 60.6 100 Romania (2000) 100 0 100 Slovak Rep. (2000) 100 0 100 Slovenia (2000) 33.9 63.1 100 Source: OECD. 2002. Fiscal Decentralization in EU Applicant States and Selected EU Member States. Report prepared for the workshop on “Decentralization: Trends, Perspective and Issues At the Threshold of EU Enlargement” Octovber 10-11, 2002.

Determining the Distributable Pool

There are three ways to determine the total amount to be transferred: (1) as a fix share of national government revenues; (2) as a part of annual budget decision; (3) as a proportion of approved specific local expenditures to be reimbursed (see table 5 for the illustration of different application of determining the distributable pool in selected countries).

The most important characteristics of an effective transfer system are stability and transparency. A stable transfer system promotes good planning and efficient service delivery effort, otherwise, under instability, recipient governments will neither have good budgeting practice nor will they face an appropriate hard budget constraint. Therefore, a transfer program should have stability and transparency concerning the distributable pool.

The best way to provide some degree of stability and transparency is to establish a fixed percentage of total national revenues to be transferred. However, some governments prefer to decide the total amount in the distributable pool in accordance with budgetary priorities as part of the annual budget decision. With this system, the central government will have a significant amount of control over subnational governments and determination of the pool will become an ad hoc exercise. Furthermore, in a case of financial crunch subnational governments will face big revenue cut.

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There are various methods for determining the distributable pool for reimbursement of certain expenditure items. This type of transfer system is always closed-ended because the central government makes the determination for what kind of expenditure items are eligible for reimbursement. Consequently, in cost reimbursement type of transfer schemes, the decisions tend to be ad hoc.

Table 5: Determination of the Distributable Pool in Selected Countries Country Sources of funds for transfers Description Turkey Fix share of national revenues

6 percent of national tax revenues

In addition, central government provide additional support for certain projects in the form cost reimbursement from different funds; such as Local Authorities Fund, Municipalities Fund, Traffic Services Development Fund, Tourism Development Fund and

Jordan Fix share of national revenues

6 percent of fuel tax.

The “fuel tax” refers to a pool of shared taxes set aside to help finance local governments. Revenue in the pool is drawn from an earmarked portion of customs duties, vehicle licenses, excise taxes on fuel products, and traffic violation fines.

Colombia Fix share of national revenues

24.5 percent of national revenues to departmental governments (second tier); 22 percent of national revenues to municipal governments (third tier).

There are three components of the transfer system: the situado fiscal (SF), the participaciones municipals (PM) and the sistema nacional de cofinanciacion (SNC). The SF consists of 24.5 percent of national current revenues, it is transferred to departments to finance education and health expenditures. The PM consists of a percentage of national current revenues, increasing annually to a scheduled maximum of 22 percent, it is transferred to municipalities for “social investments.” The SNC finances specified subnational projects on a matching basis.

Japan Fix share of national revenues

LAT: Fixed percentages of 5 taxes

The main source of transfer pool is local allocation tax (LAT)—an unconditional transfer system that is a tax-sharing arrangement. LAT is distributed according to a uniform formula based on basic financial need and basic financial capacity of subnational governments. It is paid annually to subnational governments and varies across them inversely with their local fiscal capacity. LAT is not a traditional transfer but a shared-tax system that is similar to surtax on the national income tax base. Approximately 60 percent of prefectural and 40 percent of municipal tax revenues are from the LAT (see annex 4).

Belgium Fix share of national revenues • The full proceeds of radio-television fee collected by the federal government;

• A share of personal income tax (apportioned according to a historic breakdown of the amounts and indexed according to the GNP);

• A share of VAT Spain Fix share of national revenues The major unconditional transfer source is the central

government’s general revenues and PIT collected in each subnationl government jurisdiction.

United States Annual Budget/ Cost Reimbursement

There are more than 600 different federal transfer programs to state and local governments, most of which are conditional transfers. The largest portion of the amounts of federal transfers is used to fund healthcare programs administered by the states.

Distribution among local governments

Once the amount in the distributable pool is determined, the next issue is to distribute among subnational governments. There are four different ways to distribute:

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using derivation principle (allocating the amount to jurisdictions according to where revenues were collected), ad hoc, applying formula and reimbursing costs.

Derivation principle requires that some proportion of the amount collected in a jurisdiction be returned to that local government. Under this principle, local governments have no control over determination of tax rates and bases; therefore this system is considered to be an intergovernmental transfer arrangement rather than an own source revenue system. A shared tax between central and subnational governments is part of intergovernmental transfer system if the tax rate and base are determined by the central government. The advantages of derivation principle are: promotion of fiscal planning by providing certainty, increase of revenue adequacy, and improvement of local autonomy, if provided in unconditional form. However, a major disadvantage is the negative impact on equalization.

An alternative to derivation principle is to distribute the total transfer amount among all subnational governments on the basis of a formula. Compared to making ad hoc decisions on transfer amounts, distribution of funds by formula is an effective system. Otherwise, grant allocation may become a political decision on the part of central government, making the amount of funds allocated to each subnational government uncertain from year to year. This makes fiscal planning impossible for subnational governments. However, in order to have transparency in the system, the formula should not be too complex.

A fourth way to distribute among local governments is through reimbursement of costs of certain expenditure items. The important issue in cost reimbursement scheme is whether it is full or partial reimbursement. In a full reimbursement scheme, there is no incentive given to local governments for improved efficiency in the delivery of the service. On the other hand, partial reimbursement has important implications on allocative efficiency. When transferring government subsidies a certain percentage of an expenditure item, the tax price of that particular service is decreased. The stipulation of expenditures induced by the grant might distort local budgeting practice in favor of subsidized service against other services local resident would have chosen (Bahl and Linn, 1992). Another potentially negative impact of partial reimbursement is that if the local governments’ share of reimbursement is set too high low-income communities might be driven away from the program.

The role of subnational governments in management of the transfer system

The design of an intergovernmental fiscal relations system is a dynamic process. It needs constant adjustments; systematically reviewing legal and regulatory standards for “sorting out” rules and responsibilities among different types and levels of governments and the design of intergovernmental transfer system (see Box 3 for examples of similar structures in other countries). It might be very useful to establish a multilevel government body to avoid possible tensions in making adjustment to the system. This coordinating body would be a mechanism for the central government to improve the design and gauge the direction, pace, and extent of intergovernmental fiscal structure as well as to

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disseminate information, provide training, and directly engage municipal governments in the decentralization process.

Box 3: Institutional Structure For “Sorting Out” Intergovernmental Roles Uganda Local Governments Finance Commission Uganda has implemented decentralization reforms in several practical steps. After initial preparations, the decentralization policy was incorporated into the 1995 Constitution and the Parliament promulgated the Local Governments Act of 1997 in which the roles, functions and powers of central and local governments were extensively detailed to facilitate a smooth and synchronized implementation process. An interesting feature in Uganda’s decentralization policy is the existence of the Local Governments Finance Commission, whose main duty is to advise the President on all matters concerning fiscal transfers and the distribution of revenue between the local governments and the Central Government. The Commission is also supposed to advise on local government taxation and on other revenue sources as well. The Commission has a total of seven members, of which four are local governments representatives (three are nominees of the district councils and one is a nominee of urban local authorities); the Minister of Local Government in consultation with the Minister of Finance nominates the remaining three. State Finance Commissions in India India has seen increasing trends towards decentralization, as seen by the 73rd and 74th amendments to the constitution. As per the amendments, the local governments are entrusted with the responsibility of "identifying, formulating, implementing and monitoring" local developmental programs. The states in turn are expected to enact legislation to endow the local governments with financial powers and responsibilities, as they deem appropriate. They are also required to appoint a state finance commission to recommend adequate devolution of finances from state governments to local governments. The State finance commissions have come up with recommendations on resource sharing, after a thorough study of the responsibilities and available resources.

Tennessee Advisory Commission on Intergovernmental Relations (TACIR) Consisting of public officials from state and local government and private citizen members, the Tennessee Advisory Commission on Intergovernmental Relations (TACIR) serves as a forum for the discussion and resolution of intergovernmental problems; provides high quality research support to state and local government officials to improve the overall quality of government in Tennessee; and improves the effectiveness of the intergovernmental system to better serve the citizens of Tennessee. Of the 25 member Commission, 22 members are appointed to four year terms, while three are statutory members holding membership by virtue of their position. Responsibility for the appointment of four state senators and four state representatives rests with the Speaker of each respective chamber of the Tennessee General Assembly. Other appointments to the Commission include four elected county officials, one official nominated by the County Officials Association of Tennessee, four elected city officials, one development district nominee, two private citizens, and two executive branch officials. Statutory members include the chairs of the House and Senate Finance, Ways and Means Committees; and the Comptroller of the Treasury. In total, 10 members have local government as their primary affiliation; 11 represent the legislature; two are drawn from the executive branch; and two are private citizens.

Commonwealth Grants Commission of Australia The SGC is a quasi-autonomous agency establish in 1993. Its main responsibility is to monitor and coordinate the distribution of equalization grants. The SGC’s decisions are not legally binding but the federal government usually implements its recommendations. When the SGC submits its reports to the federal government, state governments get a copy as well.

Criteria to Evaluate an Intergovernmental Transfer System

Previous discussions on the linkages of the transfer system with the overall intergovernmental fiscal design and illustration of different transfer design options provide the economic rationale for the use of transfers. However, an equally important

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issue is the set of desirable features of an effective transfer system. These include revenue adequacy and buoyancy, predictability, simplicity and transparency of intergovernmental transfer system and its impact on allocative efficiency, interregional equity and incentive structure for sound fiscal management and subnational resource mobilization.

Adequacy and Buoyancy

Revenue adequacy and buoyancy are related to the ability of the transfer system to provide sufficient amount of resources for the delivery of local services. A transfer system provides revenue adequacy when it ensures that subnational governments have enough resources to cover the amount estimated in vertical imbalance exercise. Buoyancy of the transfer system refers to the growth of the transferred resources with the expenditure needs of subnational governments. The term buoyancy must be defined in a relative sense: revenues are buoyant when revenues grow at the rate necessary to allow local governments to finance their services over time. Thus, the system has appropriate buoyancy if revenue growth is at the same rate as expenditure growth. Buoyancy is measured by the growth in revenues relative to the growth in GDP. Thus, a buoyancy coefficient of one indicates that revenues grow at the same rates as GDP, a coefficient of less than one is an evidence of revenues growing more slowly than the economy, and a coefficient of greater than one shows that revenues are growing faster than the economy.

Revenue growth should be at the same rate as the desired expenditure growth. Low buoyancy means that a revenue system that is adequate today will be inadequate in the future, since revenue growth will not keep pace with expenditure needs. The buoyancy of revenue systems comes from a combination of growth in tax base, such as through improvements in tax administration, and rate increase.

Table 6 presents the buoyancy coefficient of intergovernmental revenues in selected countries. If one looks at the yearly change in buoyancy coefficients in table 6, in some countries there is a high degree of instability in the subnational financing system. For example, in Bulgaria, high buoyancy coefficient values in 1998-1999 and 1999-2000 indicate that resources transferred from the center to municipalities outpaced the growth rate of the economy. However, in last period, between 2000 and 2001, the buoyancy coefficient value is negative. The negative buoyancy is an indicator of a high degree of instability and makes it difficult for municipalities to plan and provide consistent service levels.

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Table-6: Buoyancy of Intergovernmental Transfers 1998-1999 1999-2000 2000-2001 Australia -0.835 N/A N/A Bolivia -0.712 -3.497* N/A Bulgaria 2.166 5.998 -2.462 Canada 3.062 0.651 1.158 China 3.409 N/A N/A Czech Republic -9.395* -49.677* 14.761 Denmark 1.853 -4.239 N/A Hungary 1.464 3.617 2.090 India 4.153 N/A N/A Israel 23.658 -9.736* N/A Kazakhstan N/A 15.525 Kyrgyz Republic N/A 10.482 5.904 Mexico 19.940 21.696 N/A Mongolia 5.377 13.016 N/A Poland N/A 2.350 2.624 South Africa -2.043* 19.421 7.361 Switzerland 3.921 4.018 N/A Thailand -4.097* -7.956 22.704 United States 2.878 2.462 N/A Source: Government Finance Statistics Yearbook 2002, IMF * Negative value is because of the contraction in the economy (denominator being negative).

Predictability, Simplicity and Transparency

Fiscal planning requires a high degree of certainty in the flow and timing of transfers from the center. An intergovernmental transfer system that lacks transparent criteria and is conducive to ad hoc bargaining and ex post gap filling would encourage subnational governments to understate their own revenues and to increase their commitments on expenditures and to run deficits in the expectation that their financing gap will be filled by the central transfers. Thus, the criterion of transparency is closely intertwined with predictability and simplicity criteria.

In the absence of predictability, subnational governments will not have a general idea of how much money they are likely to receive from intergovernmental transfers as they plan and budget for the next fiscal year. Subnational governments, and people living in these jurisdictions, should be able to calculate their share of transfers. Such an understanding is facilitated by relatively simple but explicit transfer formula.

The preceding discussions provide information about the desirable characteristics of an intergovernmental transfer system. However, evaluation of the transfer system requires analysis of its impact on intergovernmental public finance as well. Therefore, the remaining of this section focuses on three important criteria for the evaluation of a transfer system’s impact on intergovernmental fiscal design: allocative efficiency, interregional equity and financial management.

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Allocative Efficiency

The first criterion is the impact of intergovernmental transfers on allocative efficiency of the system. The translation of the technical term allocative efficiency in plain language is obtaining better value for taxpayers' money. Allocative efficiency has two dimensions. First, it requires that public services be provided at the lowest possible cost. By being physically closer to people local governments are better stationed to identify and respond to people's needs. Furthermore, local governments' proximity to their constituents will enable them to respond better to local needs and efficiently match public spending to private needs. Thus, intergovernmental transfers should not encourage local governments to spend their resources irresponsibly; on the contrary, the transfer system should promote obtaining better value for taxpayer’s money and local government spending in the most productive way possible. Second, efficiency means that resources should be allocated to services identified subnationally as the highest priority. Unless spillovers exist, intergovernmental system should not distort how subnational governments allocate resources. In the existence of spillovers, the correct way to deal with the problem is to design some form of matching grants.

Interregional Equity The second criterion on the impact of transfer system is interregional equity

consideration. The equity criterion relates directly to the issue of horizontal equalization. Equalization transfers allow countries to reap the advantages of a decentralized delivery of public services, while, ensuring that the design of public services conform to general notions of efficiency and equity. The economic rationale for designing an equalization transfer system is to eliminate or reduce the differences in fiscal capacity of subnational governments. Fiscal capacity is a measure of a government’s ability to raise revenues for provision of services, relative to the costs of service responsibilities. The fiscal capacity of a region can be defined as the potential ability of the government to finance a standardized basket of public goods and services by raising revenues from its own source (see Annex 1). The fiscal capacity measure guides central governments in their efforts to equalize the amount of resources available to each of the regions. Measuring fiscal capacity is essential to addressing interregional disparities and implementation of an equalization program.

However, measuring fiscal capacity is not an easy task. To begin with, there is a controversy surrounding the measure of fiscal capacity. The application of the fiscal capacity measure in some countries, such as Canada, concentrates only on the revenue side. The treatment of fiscal capacity concept solely as the revenue-raising ability of subnational governments can be observed in academic world as well (Martinez-Vazquez and Boex, 1997a & 1997b). However, the United States Advisory Commission on Intergovernmental Fiscal Relations has developed a new methodology to incorporate expenditure side of the public finances into the fiscal capacity concept and updated its 1962 estimates fiscal capacity for U.S. states (ACIR, 1962) in the subsequent publications (ACIR, 1986, 1990a, 1990b).

The overriding concern in designing equalization transfer system is to ensure that subnational governments provide similar bundle of necessary public services to all

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citizens at comparable tax rates. To achieve this goal, most governments design equalization transfer system focusing on either equalization of the capacity of local governments to provide certain level of services or equalization of the performance of local governments. Bird (2001) criticizes performance approach on the grounds that central governments’ policy preferences are dominant and “there is clearly no agreement on either the desirability or the effects of general intergovernmental transfers intended to achieve this goal.” He also points out the fact that if capacity issue is given little consideration, performance approach awards local governments that do not try to raise own revenues. If fiscal capacity is measured accurately, which is not an easy task due to the reasons mentioned earlier, intergovernmental transfers would create very little incentives for local governments’ revenue raising restraint. Although it is not the intention of this paper to discuss how to estimate fiscal capacity of subnational governments, Annex 2 provides a brief summary of main issues in the estimation of fiscal capacity.

Financial Management

The last issue with regard to the impact of transfer system on intergovernmental public finance is related to local financial management. In a decentralized system, fiscal policy becomes a responsibility shared by different levels of decision-making power. Subnational governments may view transfers as substitutes for their own revenue collection efforts, seeking political gains by reducing local revenue collection levels. Then, the financing of subnational governments’ spending through transfers might put strains on macroeconomic position of the country. Intergovernmental transfer system should not adversely affect the willingness of local governments to improve local revenue mobilization. Unfortunately, this is easier to be said than to be done. Certain objectives of intergovernmental fiscal design might be in conflict with each other. A good example of this situation is revenue-pooling arrangements in an equalization scheme. Bird (2001) gives German intergovernmental transfer system as an example that provides poor incentives to local governments to raise their own revenues. In Germany, the proceeds of certain locally collected taxes by affluent Länder are shared with less affluent ones (see Annex 3). In this revenue-pooling system, rich subnational governments receive only a fraction of revenue collected in their jurisdiction, with the rest distributed to poorer jurisdictions, thus, the cost of local taxation to them is higher than the benefit to their treasury. Baretti, Huber and Lichtblau (2000) argue that this disincentive effect has led to reduction in tax revenue of Länder.

Conclusion

In many countries, subnational governments are subject to so many rules, which are conflicting in some cases. Furthermore, they have very little incentive to behave efficiently, not to mention that they have very weak capacity as well. In most of these governments intergovernmental transfers system lacks transparent criteria and is conducive to ad hoc bargaining or ex post gap filling, which encourages subnational governments to understate their own revenues, to increase their commitments on expenditure and to run deficits in the expectation that their financing gap will be filled by

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central transfers. However, the design of intergovernmental transfer system is always a controversial issue and there is no optimal structure (Bahl and Linn, 1992). To make matters more complicated, it is quite difficult to argue one way or another whether a certain arrangement is superior to others:

Indeed, conclusions about the advantages and disadvantages of any program of grants from central to local governments depend on whether a national or local point of view is taken: one level’s uncertainty about the regularity and adequacy of grant flows is the other’s budgetary flexibility (Bahl and Linn, 1992; p. 427).

Discussions illustrate that one type of transfer arrangement cannot accomplish all objectives. A natural solution might be to design a transfer system with different types of transfer instruments, i.e. equalization, cost reimbursement, etc., which might offset shortcomings of a particular instrument.

References: Alm, James, and Jorge Martinez-Vazquez. 2002. “On the Use of Budgetary Norms as a Tool for Fiscal Management.” Working Paper. Georgia State University, International Studies Program, Atlanta. Baretti, C., B. Huber and K. Lichtblau. 2000. "A Tax on Tax Revenue. The Incentive Effects of Equalizing Transfers: Evidence from Germany", CESifo Working Paper Series 333, CESifo, Munich. Bird, R. 2001. “Intergovernmental Fiscal Transfers: Some: Lessons from International Experience” Bird, R. M. (2000). Intergovernmental Fiscal Relations: Universal Principals, Local Applications" International Studies Program Working Paper 00-2, Andrew Young School of Policy Studies, Georgia State University, Atlanta. Bird, R. M. 1993. Threading the Fiscal Labyrinth: Some Issues in Fiscal Decentralization National Tax Journal 46: 207-228. Ebel, R., Istvan Varfalavi, and Sandor Varga. 2000. "Sorting Out Government Roles and Responsibilities in the Hungarian Transition" World Bank Institute Working Paper No. 37156. El-Daher, S. et al. 2003. “A Concept Note on Intergovernmental Fiscal Relations and Municipal Financial Management in Jordan” Gramlich, E. 1977. Intergovernmental Grants: A Review of the Empirical Literature” in W. E. Oates (ed.) The Political Economy of Fiscal Federalism, Lexington, Massachusetts: Heath.

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Hunter, J. S. 1977. Federalism and Fiscal Balance: A Comparative Study. Canberra, Australia: Australian National University Press. Martinez-Vazquez, Jorge and L.F. Jameson Boex (1997a), Fiscal Capacity: An Overview of Concepts and Measurement Issues and their Applicability in the Russian Federation, International Studies Program Working Paper 97-3, Andrew Young School of Policy Studies, Georgia State University. Martinez-Vazquez, Jorge and L.F. Jameson Boex (1997b), An Analysis of Alternative Measures of Fiscal Capacity for the Regions of the Russian Federation, International Studies Program Working Paper 97-4, Andrew Young School of Policy Studies, Georgia State University. Shah, A. 1994. “The Reform of Intergovernmental Fiscal Relations in Developing and Emerging Market Economies” World Bank Policy and Research Series No. 23. Shah, A. 1985. “Provicial Transportation Grants to Alberta Cities: Structure, Evaluation and a Proposal for an Alternate Design” in Roy C. Brown, ed. Quantity and Quality in Economic Research, vol. I., New York and London: University Press of America. Winkler, R. D. 1994. The Design and Administration Intergovernmental Transfers. The World Bank Discussion Paper No. 235. United States Advisory Commission on Intergovernmental Fiscal Relations (1962), Measures of State and Local Fiscal Capacity and Tax Effort, Washington, DC: ACIR. United States Advisory Commission on Intergovernmental Fiscal Relations (1986), Measuring State Fiscal Capacity: Alternative Methods and their Uses, Information Report M-150, Washington, DC: ACIR. United States Advisory Commission on Intergovernmental Fiscal Relations (1990a), State Fiscal Capacity and Effort, Information Report M-170, Washington, DC: ACIR. United States Advisory Commission on Intergovernmental Fiscal Relations (1990b), Representative Expenditures: Addressing the Neglected Dimension of Fiscal Capacity, Information Report M-174, Washington, DC: ACIR.

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Annex 1: Fiscal Capacity A generic representation of the fiscal capacity measure in mathematical notation is

1 1

( ) ( )R Z

i s i s ij j k k

j kFC t B c E

= =

= − ∑ ∑

where FCi is the fiscal capacity in region i. The first bracket is revenue-raising ability of subnational government i. In the first bracket, i

jB is the tax base for revenue item j in i and sjt is the

standard tax rate for item j. The total number of revenue items is R (j=1…R). The second bracket represents the total costs of expenditure responsibilities of the government in region i. In the second bracket i

kE denotes expenditure item k in i and s

kc is the standard cost of expenditure item k. The total number of expenditure items is Z (k=1…Z).

There are two basic approaches to assessing the relative revenue-raising ability of subnational governments. The first one is “macroeconomic approach” where fiscal capacity is estimated with a single aggregate measure. In macroeconomic approach the single most used variable is per capita personal income. The rationale for using per capita income is that the most obvious source of revenue for a regional government is the taxes levied on its residents’ income and per capita income reflects the relative economic strength of regions. The main advantage of using per capita income as a measure of revenue-raising ability is its simplicity. However, there are two main disadvantages of using per capita income as a revenue-raising measure. First, it fails to account for the ability of subnational governments to tax economic resources of people living outside their jurisdictions. For example, if a region is a significant tourist attraction place, that region could collect significant amounts of revenues from the monies spent by tourists (sales taxes, hotel taxes). Second, it assumes that subnational governments make equal amount effort to collect taxes. In fact in all countries subnational governments’ effort to collect revenues from different tax basis vary significantly.

The second approach is “microeconomic approach” which focuses on the actual tax system of subnational governments, with separate measures of revenue-raising capacity for each kind of tax actually levied. Microeconomic approach attempts to develop a representative system where all major revenue sources of subnational governments are included. In microeconomic approach, the representative tax system (RTS) is a widely used measure of revenue raising ability. RTS consists of national average tax rates applied to all commonly used tax or revenue bases. Although, in reality subnational governments' tax rates and tax bases vary from one jurisdiction to another, in estimating RTS measures, these differences are ignored in order to avoid possible efforts of subnational governments to manipulate their own policies to influence the policy outcome of fiscal capacity measure. For example, if the actual difference between revenues and expenditures is used for distributing equalization grants, by decreasing tax rate or by changing tax base definition any particular subnational government might attempt to influence the amount of grant money it receives.

The second component of the fiscal capacity measure is estimating the cost of service responsibility (expenditure needs). Although RTS provides information about revenue raising ability of subnational governments, it is salient about the variation of costs for service delivery across subnational governments. There is a need to estimate a representative expenditure system that factors the variation of service delivery cost across subnational governments into the fiscal capacity measure. A representative expenditure system should take factors that are responsible for the variation of costs among subnational governments. Such factors include:

• The range and types of services subnational governments must provide (by law); • The prices of the inputs used to produce public services, such as wages and salaries, oil prices, etc; • Factors that determine the scope of the services provided, such as demographic structure of the

population (number of school age children, etc.).

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Annex 2: Fiscal Capacity: Representative Tax and Expenditure System

Representative Tax System (RTS)

The RTS may be defined as a hypothetical tax system that is “representative” or “typical” of all the taxes actually levied by subnational governments of a country. As such, it abstracts from the actual tax policy of individual subnational governments, yet it is representative of those taxing practices in the aggregate/average. The purpose of the RTS is to measure the own-revenue-raising-ability of subnational governments. Calculating the amount of revenues that each subnational government could derive from a standard tax system made up of the own-source revenue sources measures own-revenue-raising ability of subnational governments. Own-source revenue sources are taxes and quasi-taxes that are actually levied by the subnational government.

By estimating the tax yield that would result from applying a representative set of tax rates to a representative set of tax base, the RTS enables policy-makers to estimate and compare the relative amounts of revenue that each subnational government could derive from its own sources. In order to make comparisons among subnational governments more meaningful, a common denominator of population is used where the estimated revenues of the RTS is expressed on per capita basis.

The RTS has two broad categories of potential use. The first one is providing information on relative fiscal and economic strengths of the subnational governments in a country. Secondly, it provides information in designing intergovernmental transfers system. The RTS provides yardsticks for measuring the potential ability of each subnational government to raise revenues from their own sources. The system is representative in that their elements—tax bases and rates—are typical of those in use by subnational governments in a country. The RTS caries no judgment as to whether the system is good or bad. Because the representative system is hypothetical, it is not influenced by actual tax policy of a particular subnational government and subnational governments cannot influence their measured capacity by changing their policy unilaterally. This feature of the RTS is important especially if the estimates are actually used as a basis for distributing intergovernmental funds.

Applying RTS tax system in every subnational government yields consistent estimates of the potential revenue that could be raised in each subnational government under a standardized tax policy. These estimates can be compared across subnational governments to ascertain the relative revenue-raising ability of each subnational government.

Five basic elements of the RTS are: 1. The Revenue Coverage is referred to as revenue sources of subnational governments. In order to avoid any bias in estimating the RTS, the comprehensive revenue coverage is very important. The inclusion of all the revenue items at the disposal of subnational governments is essential especially in making comparisons between subnational governments. If revenues from a particular tax base were excluded, the fiscal capacity of a particular jurisdiction with that tax base would be understated. 2. The Classification of Revenues into Separate Sources should reflect distinctive characteristics of the tax base. The capacity of each subnational government to derive revenues from each type of tax is unique to characteristics of the tax base, therefore in classifying revenues there should be a separate source for each tax for which the total amount of revenues of all jurisdictions combined should be significant. For example the revenues from natural resource taxation is directly related endowment of resource where some jurisdictions have more than others. Classification of revenues from natural resource taxation as a separate category would reflect uneven endowment of natural resources where natural resource rich jurisdiction would have more income from this source than natural resource poor jurisdictions. 3. The Definition of a Standard Tax Base for Each Revenue Source is necessary to estimate the amount of revenue that each subnational government could derive from that source. The tax base is the item or economic activity on which the tax is levied. The most commonly used tax bases can be grouped into three broad categories: income, consumption, and wealth. Defining a tax base is the key element of the RTS because it is the basic source of differences among subnational governments. For each type of revenue source, each subnational government would have different tax base reflecting socio-economic characteristics of its residents. Each subnational government has a statutory base for each type of tax and this base varies from one jurisdiction to another. Since the RTS requires that tax revenues be estimated on a uniform basis for all jurisdictions, it is necessary to

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define a tax base for each type of revenue source on a standardized basis. In defining a standard tax base for revenue source, two important points are: (i) the definition should be related to the statutory base and (ii) relevant data must be available for all jurisdictions. 4. The Definition of a Standard Tax Rate for Each Revenue Source involves averaging of the actual rates levied by subnational governments for each kind of tax. The average tax rate is calculated by dividing actual revenues from that particular tax to the total tax base defined for purposes of the RTS. 5. The Estimation of RTS Revenues for each subnational government involves applying the standard tax rate for each revenue source to the defined tax base of the subnational government for that source and by summing the results for all sources.

Pros and Cons of RTS RTS is a microeconomic approach to estimate revenue raising ability of subnational governments.

It is an alternative to per capita income that would more accurately reflect the relative revenue-raising abilities of subnational governments. The main argument against using per capita income to measure subnational government revenue-raising ability is that it fails to reflect the diversity of tax and revenue sources as well as the ability of subnational governments to export taxes. Although RTS can provide very useful information for the purpose of intergovernmental fiscal relations, the usefulness of the method depends on the quality of the data that underlie the RTS. If the quality of data is good, the RTS can provide a sensitive measure of the relative revenue-raising capacity of subnational governments. The RTS has the great advantage of reflecting the realities of public finance despite its shortcomings in measurement of revenue-raising capacity. These shortcomings of RTS are:

(i) the extend to which fiscal differentials tend to be capitalized in the price of land; (ii) the measurement of differentials among subnational governments with respect to expenditure

needs relevant to fiscal capacity not revenue-raising capacity; (iii) the formula is complicated and it requires a large number of tax bases for each subnational

government in a standardized way. If subnational tax bases were defined in a similar way, the use of RTS is relatively straightforward, but if subnational governments define their tax bases differently, the definition and measurement of a common representative tax base becomes difficult.

(iv) If subnational governments’ tax policies greatly vary the meaning of the tax capacity becomes ambiguous. Tax capacity essentially represents the subnational governments choice on how to raise their tax revenues. As long as they do so in a relatively similar manner the use of the RTS approach to calculate equalization entitlements is well-founded. But once tax bases are defined differently, or once subnational governments use substantially different relative tax rates across different bases, this approach becomes suspect. If, say, one jurisdiction relies much more heavily on sales taxes relative to income taxes than others, this might reflect the fact that the subnational governments take very different views about the relative tax capacity associated with sales of goods rather than income. For example, cross-border shopping might be more of an issue in one jurisdiction than others; or mobility of businesses or high-income people might differ in different parts of the country. In these circumstances, the measurement of tax capacity using the same representative tax system will be far from perfect (Boadway, 1998).

(v) The size of a tax base is not independent of its tax rate. In a jurisdiction, the extend of the elasticity of a tax base with respect to the tax rate depends on how responsive the tax base is to changes in the tax rate and how mobile the tax base is across jurisdiction. Under the RTS approach, the revenue that each jurisdiction would derive if applied the national average rate is estimated. If a jurisdiction were in fact to apply those rates, however, the measured base would be different from its actual base. Thus the RTS approach introduces a systematic bias into the measure of tax capacity where the tax capacity for jurisdictions with above the national-average rates is understated and for those with below the national-average it is overstated (Bird and Slack, 1990).

(vi) RTS approach assumes no relationship across various tax bases. In estimating tax capacity for a given tax base, the possibility that the capacity to tax this particular base will be affected by the size of other bases is ignored. Since tax bases are not independent of tax rates, tax capacity measure for a particular base is not independent of what is being excluded (Bird and Slack, 1990).

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Representative Expenditure System (RES)

Fiscal capacity is the potential ability of a subnational government to raise revenues from its own sources relative to the cost of its service responsibilities. The representative expenditure system is the expenditure side of fiscal capacity measure. The RES measures the relative public service need of subnational governments that is the expenditure-side analog of the RTS.

Although representative expenditure approach closely parallels that of the RTS, on the expenditure side, the issue of “representativeness” is moot in the sense that the costs of service responsibilities are assumed to be identical. On the contrary, the prices of goods and services subnational governments buy in order to produce public services vary with climate, with distance from the point of production, between rural and urban areas and as a consequence of local policies (ACIR, 1990b).

Variation in the Cost of Public Services Across Subnational Governments

There can be variations in the costs of public services among subnational governments due to three general classes of factors:

! The range and types of services that must, by law, be provided; ! Variations in the prices of inputs used to produce public services; ! Factors that determine the scope of the services.

The services for which a subnational government is responsible are a key consideration in estimating the RES. If service obligations prescribed by law vary among subnational governments, the cost structure of subnational services will vary across subnational governments. Secondly, the factors that determine the scope of the services provided have important cost implications. For example, the cost of elementary and secondary education is closely related to the number of school-age children.

Therefore, in estimating RES ideally the first step is to identify services that subnational governments are responsible for providing, especially if the service requirements do not apply uniformly throughout the nation and then the next steps are to determine the prices of goods and services purchased by the subnational governments to produce public services and to identify the best possible measure of the workload for each of the major categories of subnational expenditures. However, identification of the cost of goods and services subnational governments buy in order to produce public services is a difficult task to accomplish. For most of the countries such a detailed level of data set is hard to come by. In general, unfortunately, for most countries information on the prices paid by subnational governments is not currently complied in sufficient detail to permit estimation of a comprehensive index of the relative input costs. It is possible, however, to use proxies to estimate the appropriate differences among subnational governments in expenditure needs. Another important step in estimating representative expenditure system is the identification of the best possible measure of the workload for each function. This is equivalent to the identification of prototypical tax bases in the RTS. The workload measure can be as simple as population or more complex, compromising of equally or unequally weighted multiple variables.

Derivation of Workload Measures for Major Categories of Subnational Spending A subnational government’s workload for a service indicates its relative need for outlays on that function. However, to ensure that the workload measures are independent of the actual policies of subnational governments, program-client variables (such as enrollment in public schools or the number of people receiving welfare benefits) should not be used.

Given the set of functions determined to be representative, the crucial step in the representative expenditure approach is the identification of the best possible measure of the workload for each function. The workload measure may be as simple as total population or more complex, comprising multiple variables equally or unequally weighted. A general consideration of overriding importance in the selection of workload measure is its independence from the policies of subnational governments. If program-client variables are used for the estimation of workload measure for a function, subnational governments can influence the outcome through their policies. The representative expenditure per unit of workload is estimated by diving the total actual subnational outlays for the category by the national total for the workload measure. The resulting average cost per workload unit is equivalent to the national-average tax “rate” in the RTS. As the representative tax yield for a subnational government can be calculated by multiplying the value of the state’s base by the RTS rate, so the expenditure for a subnational government can be derived by multiplying its workload measure for a function by the national-average expenditure per unit of workload. This preserves the mix of actual expenditures by all subnational governments as a group.

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The estimates of representative expenditures indicate how much it would cost a subnational government to provide an average level of public services that actually prevailed nationwide. A key assumption is that the representative level of outlays results in roughly the same service level in every subnational government. This assumption shouldn’t imply that the representative levels are necessarily correct or needed in any absolute sense. It shouldn’t be viewed as providing a comprehensive framework for addressing public expenditure policy. The representative approach is intended to promote understanding of the reasons why relative levels of public expenditures differ among subnational governments and is not a substitute for a careful analysis of public spending performance.

Sources: (1) United States Advisory Commission on Intergovernmental Fiscal Relations (1962), Measures of State and Local Fiscal Capacity and Tax Effort, Washington, DC: ACIR. (2) United States Advisory Commission on Intergovernmental Fiscal Relations (1986), Measuring State Fiscal Capacity: Alternative Methods and their Uses, Information Report M-150, Washington, DC: ACIR. (3) United States Advisory Commission on Intergovernmental Fiscal Relations (1990a), State Fiscal Capacity and Effort, Information Report M-170, Washington, DC: ACIR. (4) United States Advisory Commission on Intergovernmental Fiscal Relations (1990b), Representative Expenditures: Addressing the Neglected Dimension of Fiscal Capacity, Information Report M-174, Washington, DC: ACIR.

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Annex 3: Intergovernmental Fiscal Transfers in Germany The Federal Republic of Germany (FRG) consists of 16 states, or Länder, five of which were added upon reunification with the German Democratic Republic (GDR) in 1990. The Basic Law (Constitution) explicitly lists the taxes attributed to the Communes, the Länder, and federal government. In addition, it sets out the rules for sharing the proceeds of personal income tax (PIT) and corporate tax between the federal government and the Länder. The Communes’ share of PIT is determined by the federal parliament (Bundesrat and Bundestag). Under these sharing rules:

• the Communes obtain 15% of PIT (according to place of residence) while the federal government and the Länder share the rest equally (42.5% each) ;

• the federal government and the Länder share corporate income tax equally (according to the location of the head operating or distribution office of the corporation).

Revenue from the value-added tax (VAT) is also shared between the federal government and the Länder. However, in this case, a federal law, requiring the approval of the Bundesrat, determines the rules of sharing. These shared taxes are collected by the Länder on behalf of the Federation, which returns their shares to them according to rules of sharing set out in the Basic Law and in federal legislation. It should be emphasized, however, that the federal government sets, collects and remits the proceeds of two taxes: customs duties, which it remits to the European Union, and duties on beer, which it pays in full to the Länder.

The federal government alone sets and collects excise taxes. The Länder alone set and collect taxes on gambling and gaming, estate taxes, taxes on real estate transactions, and the tax on motor vehicles. The Communes derive part of their revenue from property taxes. They also receive substantial funds from the local property tax (Gewerbesteuer). Prior to January 1, 1998, this tax had two components. One of these has now been abolished, namely the former local tax on ownership of corporations (Gewerbekapitalsteuer), and has been replaced by a share (2.2%) of revenue from the federal VAT.

Germany has a highly developed system of intergovernmental financial relations. Apart from the sharing of tax revenue mentioned above, it includes a three-part equalization system - sharing of VAT, horizontal equalization, additional transfer payments - and a series of shared-cost programs. Taken together, the three components of the equalization system give tangible form, by equalizing the financial capacities of the Länder, to the constitutional principle of uniformity of living conditions for Germans throughout the Federation.

Sharing of the VAT The sharing of VAT revenue is a key component of intergovernmental financial relations in the FRG. The sharing rule between the federal government and the other orders of government is determined by a federal law that requires the approval of the Bundesrat. This sharing is one of the main instruments available to the Federation to balance the “current revenue” with the “necessary expenditures” of the two orders of government.

Currently, 2.2% of VAT proceeds is paid to the Communes (since the elimination, in 1998, of the local tax on ownership of corporations) and 5.63% is earmarked for the federal government as compensation for improving its pension plan. Of the remaining 92.17%, the federal government receives 50.25% and the remaining 49.75% goes to the Länder. Three quarters, at least, of the share of the Länder is redistributed among them according to their demographic weight.

This sharing rule is very different from the one that existed in 1994, before the entry of the Länder of the former GDR into the equalization system (63% for the federal government and 37% for the Länder). This flexibility in German fiscal arrangements eased the entry of the Länder of the former GDR into the horizontal equalization system by ensuring that the amounts exchanged therein did not raise too much.

Equalization Component 1: Sharing of the VAT The portion remitted to the Länder that is subject to the rules of equalization, namely 25% of their share, is paid to the less affluent Länder to raise their per capita income to 92% of the national average. If the objective is achieved with less than the 25% stipulated for this purpose, the remainder is redistributed to all the Länder based on their share of the population. At this stage, only the revenue from the sharing of PIT,

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corporate income tax and the local business tax is considered in the calculations. The amounts paid to seven Länder under this component of equalization amounted to DM17.0 billion in 2000. Component 2: Länderfinanzausgleich (LFA) The LFA, or horizontal financial equalization,10 is a mechanism for equalizing the financial capacities of the Länder and is funded entirely by them. In 2000, almost DM16.3 billion was paid in compensation by the more affluent Länder. There are four stages in the horizontal equalization system: 1) Estimate of the financial capacity of each Land;

• The financial capacity corresponds to the per capita tax revenue of the Länder and to 50% of that of the Communes;

The tax revenue considered in the case of the Länder are: personal income tax, corporate income tax, taxes on gambling and gaming, estate taxes, the tax on motor

• Vehicles, duties on beer and the VAT obtained from the sharing under component 1 of equalization.

2) Calculation of the equalization index, namely a weighted average of the financial capacities of all the Länder;

• The weighting depends on size and population density, it being assumed that needs rise in proportion to these two factors.

3) Comparison of the financial capacity of each Land with the equalization index; • A Land whose capacity, expressed in proportion to the reference index, is greater (less) than 100%

is considered to be in surplus (deficit). 4) Collection of contributions from Länder in a surplus position and payment to Länder in a deficit position of the amounts thus obtained. The LFA seeks to raise their financial capacity to 95% (at least) of the equalization index:

• capacity less than 92%: disparity made up in full; • capacity between 92% and 100%: 37.5% of disparity made up; • capacity between 100% and 101%: 15% of surplus collected; • capacity between 101% and 110%: 66% of surplus collected; • capacity greater than 110%: 80% of surplus collected.

In the event that the total amount to be paid by the Länder in a surplus position is less than that to which the recipient Länder are entitled, the difference is made up in full by the Länder in a surplus position. Component 3: Bundesergänzungszuweisungen (BEZ) The BEZ, or additional transfer payments, are the third component of the German equalization system. Some BEZ were created following reunification with the GDR and, accordingly, meet the special needs of the new Länder that are much less affluent than those of West Germany. The federal government covers the cost of these programs, some DM26.1 billion in 2000.

The BEZ consist of five programs: • transfers to the Länder whose financial capacity index remains under the equalization index after

calculating the LFA payments, to raise their financial capacity to 99.5% of the index (DM7.2 billion in 2000) – these transfers are funded from the federal government’s share of VAT revenue;

• transfers to the Länder of the former GDR (DM14 billion until 2004) to assist their integration; • compensation to the Western Länder that, because of reunification, have suffered a drop in

revenue or transfer payments (declining payments spread over ten years, including DM0.7 billion in 2000);

• transfers to small Länder to compensate for the lack of economies of scale in the provision of services and public management (DM1.5 billion annually);

• assistance to Bremen and to Saarland to facilitate budget restructuring (DM1.6 billion and DM1.1 billion in 2000).

Other transfer programs The federal government and the Länder have developed a number of shared-cost programs, in particular to improve institutions of higher education and develop the regional economic structure (federal share: 50%),

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to support agriculture and its infrastructures (federal share: 60%) and to preserve the shoreline (federal share: 70%). Source: Quebec Commission on Fiscal Imbalance, Intergovernmental Fiscal Arrangements, Background Paper for the International Symposium on Fiscal Imbalance, Quebec, September 13&14, 2001 (available at http://www.desequilibrefiscal.gouv.qc.ca/en/pdf/internationnal_ang.pdf)

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Annex 4: Intergovernmental Fiscal Transfers in Japan The main features of the Japanese intergovernmental fiscal system are centralized tax administration, decentralized provision of public services, and dependence of local governmental transfers. The Japanese intergovernmental fiscal transfer system is based on two types of transfers:

1. Unconditional transfers that are tax-sharing grants on a lump-sum basis financed by the local allocation tax;

2. Conditional matching transfers. Local allocation tax (LAT) is the main source revenue for intergovernmental transfer pool and

plays the key role for equalization. LAT is an unconditional transfer scheme that finances approximately 60 percent of prefectural and 40 percent of municipal tax revenues. The law governing LAT stipulates that it has to be based on a uniform formula and the National Assembly has the final authority to approve the distribution. The law gives the Ministry of Home Affairs (MoHA) the authority to estimate transfer amount for each subnational government. LAT is distributed according to a uniform formula based on basic financial need and basic financial capacity of subnational governments. It is paid annually to subnational governments and varies across them inversely with local fiscal capacity. LAT is not a traditional transfer but a shared-tax system that is similar to surtax on a national tax base. The total amount of the LAT is calculated according to the formula:

LAT Pool= 0.32*(NTy+NTa)+ 0.358*NTc+ 0.295*NTv+ 0.25*NTt where NTy is the total yield of personal income tax, NTc is that of corporate income tax, NTa is that of alcohol tax, NTv is that of consumption tax revenue, and NTt is the total yield of the tobacco tax. The total revenues derived from this formula are apportioned among subnational governments in proportion to the amount of the difference between need and revenue capacity. It is paid annually to those subnational governments whose basic expenditure needs exceed their revenue capacity. Rich localities with revenue capacity exceeding needs are neither eligible to receive transfers nor liable to contribute to the pool. In estimation of expenditure needs, public services for prefectures and municipalities are categorized under 24 different groups. For prefectures, they include police, transportation and primary school whereas for municipalities the expenditure items are city planning, urban services, parks, garbage collection, and so on. Revenue needs of each subnational unit is estimated by using the following formula:

Ni= Σk (Iik*Uik*Mik) where Iik is a measurement unit for service K of the ith region, Uik is unit cost for service K of the ith region, and Mik is a modification coefficient for service K of the ith region. For each subnational unit, revenue needs for each of the 24 expenditure items are calculated by using the above formula. Uik, unit cost is a standard cost for each service item. This standard cost is estimated for “a standard local body,” which is 1.7 million people an d 6,500 square kilometers of land area for prefectures and 0.1 million people and 160 square kilometers for municipalities. On the revenue side, revenue capacity of each unit is determined according to the following formula: Ci= G(Bij*tj)+LTTi where G is 80 percent of the yields of all prefectural local taxes (assuming each is levied at the standard rate prescribed in the local tax law and a reasonable effort is made for collection) or 75 percent in the case of municipalities, Bij is ith region’s jth tax base, tj is the standard tax rate, and LTT is local transfer tax revenue.

The allocation of LAT is made according to LATi= (Ni-Ci)-αNi

where LAT denotes local allocation tax, N is the expenditure needs, C is revenue capacity and α is the adjustment coefficient. Source: Nobuki Mochida, 2001. Taxes and Transfers in Japan’s Local Finances in M. Muramatsu, F. Iqbal and I. Kume (eds.) Local Government Development in Post-War Japan (New York: Oxford University Press).

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