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Principles for Designing Transfers Jorge Martinez-Vazquez Georgia State University. The Challenge of Designing Intergovernmental Fiscal Transfers in Bolivia The World Bank Institute. Rationales for Intergovernmental Transfers. Vertical imbalances Horizontal imbalances
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Principles for Designing TransfersJorge 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 regioni • 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.