Lessons from International Practices of Intergovernmental Fiscal Transfers

Lessons from International Practices of Intergovernmental Fiscal Transfers Anwar Shah, World Bank XVI Regional Seminar on Fiscal Policy CEPAL/ECLAC, Santiago de Chile January 26-29, 2004 Anwar Shah, World Bank

Instruments of intergovernmental finance • Unconditional vs conditional transfers • Unconditional: preserving local autonomy and enhancing inter-jurisdictional equity • Conditional: providing incentives to undertake specific activities • Conditional Transfers • matching vs non-matching • open-ended vs. closed-ended matching • Input based conditionality vs output based conditionality • Input based conditionality often intrusive and unproductive. Output based conditionality can advance grantor’s objectives while preserving local autonomy Anwar Shah, World Bank

Perceptions on intergovernmental finance are generally negative • Federal/Central : Giving money and power to sub-national governments is like giving whiskey and car keys to teenagers • Provincial and Local : We need more grant monies to demonstrate that “money does not buy anything”. • Citizens: The magical art of passing currency from one government to another and seeing it vanish in thin air. Anwar Shah, World Bank

Ironically these perceptions are well grounded in reality in LDCs • Primary focus on dividing the spoils • Passing the buck transfers – revenue sharing with multiple factors (Brazil, Argentina, India, RSA, Philippines and more) • Asking for more trouble grants – deficit grants (Hungary, India, and more) • Pork barrel transfers or political bribes (Brazil, India, Pakistan, USA) • Command and control transfers (most countries) • Overall: Intergovernmental finance is the dominant source of revenue but creates perverse incentives for fiscal management and accountability Anwar Shah, World Bank

No need to despair …. As properly designed fiscal transfers can be part of the solution rather than part of the problem. Anwar Shah, World Bank

Unitary Centralized Center manages Bureaucratic Focused on inputs Command and control Internally dependent Closed and slow Intolerance of risk Federal / confederal Globalized & localized Center leads Participatory Results matter Responsive and Accountable Competitive Open and quick Freedom to fail/ succeed Governance Structure: 20th Versus 21st Century Anwar Shah, World Bank

From Dividing the Spoils to Creating An Enabling Environment for Responsive and Accountable Local Governance • Tax Decentralization • Output based fiscal transfers • operating • capital • Fiscal equalization transfers • Responsible borrowing Anwar Shah, World Bank

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

Anwar Shah, World Bank

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

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

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

Indonesia - Specific Purpose Transfers to Local Governments (now defunct) L2. District/Town Road Improvement Grant • Length of roads • Condition • Density • Unit cost L3. Primary School Grant • School age children (ages 7-12) • Needs for facilities Anwar Shah, World Bank

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

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

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

A Representative Tax System approach to fiscal capacity equalization Equalization from revenenue source i = National Per capita State’s average base in — own base tax ratei all statesi per capitai = Per capita Per capita potential standardized revenue in — revenue in All states (i) state A (i) Anwar Shah, World Bank

A Representative Expenditure System approach to Fiscal Need Equalization Equalization entitlement from expenditure category i EQUALS Per capita potential expenditure of State A for category i based upon own need factors if it had national average fiscal capacity MINUS Per capita potential expenditure of State A on expenditure category i if it had national average need factors and national average fiscal capacity Anwar Shah, World Bank

Federal Fiscal Equalization Program of Canada is enshrined in the constitution______________________________________ Canada Constitution Act 1982, Article 36.(2) Parliament and the Government of Canada are committed to the principle of making equalization; payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of services at reasonably comparable levels of taxation. Anwar Shah, World Bank

An Example of Expenditure Need Determination in Australia: Secondary Education Expenditure Need Factors Anwar Shah, World Bank

Figure 3 - Australia - Relative Cost of Service Provision Ratios - 1995-96 Figure 4 – Australia - Relative Revenue Raising Capacity Ratios - 1995-96 Anwar Shah, World Bank

Denmark: Equalization models and standards Anwar Shah, World Bank

Institutional Arrangements for Fiscal Transfers • Intergovernmental committees: Canada, Germany (with strong role of Bundesrat) • Independent grant commissions: Australia (permanent secretariat), India (limited duration) and South Africa (permanent) • Intergovernmental cum civil society commissions: Pakistan (limited duration) Anwar Shah, World Bank

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

Negative Lessons: Practices to Avoid • General revenue sharing with multiple factors • Deficit grants • Fiscal Effort Provisions • Input or process based or ad hoc grants • Capital grants without assurance for upkeep • Negotiated or discretionary transfers Anwar Shah, World Bank

Positive Lessons: Practices to Strive For • K.I.S. (keep it simple) • Focus on single objective • Introduce sunset clause • Output based conditional transfers with citizens’ evaluations • Fiscal capacity equalization to a defined standard • Political consensus on the standard of equalization • Institutional arrangements for broad based consultation Anwar Shah, World Bank

Lessons from International Practices of Intergovernmental Fiscal Transfers