Principles for Designing Transfers

Jorge Martinez-VazquezGeorgia State University

The Challenge of Designing Intergovernmental Fiscal Transfers in Bolivia

The World Bank Institute

Rationales for Intergovernmental Transfers

Vertical imbalances Horizontal imbalances Externalities (inter-jurisdictional spillovers) Enhancing national objectives at the

subnational level Paying for national programs implemented by

subnational governments

Features of a Good Transfer System

Promote budget autonomy at the subnational level – Lump-sum versus conditional transfers

Provide adequate revenue to subnational governments– Transfers are not a substitute for revenue

assignments– The role of revenue sharing

Features of a Good Transfer System (cont.)

Provide positive incentives– Encourage tax effort and revenue

mobilization – Promote expenditure efficiency– Discourage fiscal deficits or a “soft budget

constraint”

Features of a Good Transfer System (cont.)

Enhance equity and fairness – Overall, transfers increase with fiscal

(expenditure) needs and decrease with fiscal (revenue) capacity

Stability Transparency Simplicity

Types of Intergovernmental Grants Unconditional or lump-sum Categorical or conditional (for capital

and/or recurrent expenditures) – Non-matching– Matching

• Open-ended• Close-ended

Direct cost reimbursement

Designing Transfer Systems: Determining Pool of Funds

Ad hoc at budget time Using rules

– Percent of central government total revenues

– Percent of some types of central revenues Direct reimbursement

Funding Approaches

Vertical funding: the center provides the funds)

  Horizontal (“Robin Hood”) funding:

subnational governments provide some funds

Design of a Transfer System: Distribution of Funds

Ad hoc Formula Cost reimbursement Competition Derivation basis

Design of a Transfer System: Institutional Requirements

Data requirements Institutional responsibility for design and

monitoring – Central government agencies (micromanagement) – An independent “Grants Commission”

Developing subnational capacity Phasing-in to hold (partially) harmless Periodic evaluation

Economic Impact of Grants Potentially substantial impact on level and

composition of subnational spending Lump-sum grants tend to increase spending more

than an equal increase in aggregate local income (“flypaper effect”)

Unconditional grants have an income effect Conditional grants have a restricted income or

“voucher” effect Matching, conditional grants tend to be most

stimulative because of an added price effect (matching rates can be made to vary across jurisdictions by fiscal capacity, etc)

Types of Conditional Grants Recurrent versus capital expenditures Transitional or special purpose versus

permanent needs Block grants versus restricted grants Spend the funds any way you want to as long as

they are spent on a particular type of good Impose service standards, minimum expenditure

requirements, access levels and other restrictions on the use of funds

Conditional grant programs often spell out in great detail how funds must be spent

Issues in the Design of Conditional Grants Pursuing too many conflicting objectives:

explicitly address priorities or use different grants Local spending is most responsive to matching

arrangements and minimum expenditure mandates: which to use?

Without matching arrangements, minimum expenditure mandates may be needed to prevent retrenchment in expenditure effort

Use of fiscal capacity in the formulas helps leverage central government resources

What are Equalization Grants?

Unconditional, general purpose transfers

Total amount of fund typically determined by a funding rule

Total amount or divisible pool of funds distributed among regional and local governments based on a formula that considers expenditure needs and/or local revenue-raising ability (fiscal capacity)

Purposes of Equalization Grants

Restore horizontal balance by equalizing fiscal conditions among subnational governments

Contribute to closing vertical imbalances (the differences in expenditure needs and revenue availability for the central and subnational governments)

Contribute to “nation building”

How Simple: Why Not Give Local

Governments “What They Need”?

Can’t we just do the following?

Transfer regioni =

Actual expenditures regioni – Actual

revenues region i

Center may not have funds to fill entire gap

How Simple: Why Not Give Local

Governments “What They Need”? (cont.)

Actual expenditures generally do not equal needs

Actual revenues generally do not reflect ability to collect revenues (fiscal capacity)

Negative incentives will be provided: local governments will collect lower revenues on their own and will not use prudence in establishing expenditures.

Components of an Equalization Mechanism Determine exact objective(s) of equalization:

what should be equalized and by how much

Determine sources (central government revenues versus fraternal [“Robin Hood”] contributions)

Determine size of equalization fund (vertical allocation of resources): stable rule versus ad hoc determination

Components of an Equalization Mechanism (cont.)

Determine the equalization mechanism (formula)

Determine the variables or allocation factors that will be used (i.e., measures of fiscal capacity, fiscal need, fiscal effort)

Adjustment of actual payments for other transfers?

Simulation, implementation, and evaluation

Universal Principles for Equalization Grants Fund should provide adequate

resources; balance national priorities and local autonomy

Fund should be distributed in equalizing manner

Allocation should be predictable over time

Universal Principles for Equalization Grants (cont.)

Mechanism should be simple and transparent

Mechanism should use reliable and generally accepted data

Approach should avoid negative incentives

Universal Principles for Equalization Grants (cont.)

Grants should be unconditional

Reform should avoid sudden large changes (or use a “hold harmless” or a phase-in approach)

Use separate funds for regional and local governments

Desirable Characteristics for Allocation Factors

Accurately reflect specific characteristics (i.e, statistically sound)

Regularly updated in the future (every 1-2 years)

Come from an independent source respected by all stakeholders

Desirable Characteristics for Allocation Factors (cont.)

Be drawn from a source that cannot be manipulated by the central government or one or more local governments

Reflect needs or demands for public goods (e.g., number of clients) rather than outputs such as infrastructure

Goals for Capital Transfer

Address externalities across local governments

Assist in financing “lumpy” capital investments

Offset significantly different infrastructure endowments (when these are not the result of voluntary decisions)

Pursue sectoral objectives

Capital Transfers: Issues and Constraints

Is there a bias? Do central authorities believe capital expenditures are always more efficient than recurrent expenditures?

How to achieve “additionality” or “maintenance of effort”? (Earmarking and the fungibility of funds)

Will local governments take ownership and maintain the infrastructure? (The use of matching arrangements).

Flexibility in Use of Capital Grants

Project-based grants: closely administered and monitored by line ministries

Use of categorical or block grants

Allocation of Capital Grants

Ad hoc decisions and negotiation (e.g., Italy until recently, many countries in transition)

Use of a pre-established formula (e.g., Australia funds schools building by no. of students and price/cost factors) (not always feasible)

Use of a competition process with defined application procedures (possibly subject to manipulation)

Design of Capital Transfers: Summary

No single best approach to design capital transfers.

However, non-transparent, highly detailed and discretionary procedures should be avoided.

Matching requirements carry many benefits.