Design and Management of Decentralized Expenditures and Transfers

1. Design and Management of Decentralized Expenditures and Transfers Underpinnings for successful decentralization Ehtisham Ahmad November 2012

2. Key questions • Why do countries decentralize? • Keeping the country together—political economy objectives • Improving service delivery; generating sustainable growth • Tradeoffs between local discretion and minimum standards • Subsidiarity principles versus political economy of inter-jurisdictional competition? • Expenditure management and accountability • How to prevent “game-play” and leakages? • What are the underpinnings for transparency, coordination and efficiency? • How to design coordinated budget frameworks, information systems and tracking of cash? • How to prevent PPPs from degenerating into postponement of liabilities? • Designing and managing transfer systems • How to ensure effective equalization or generating disincentives through transfers? • How can performance based transfers be used without overriding accountability? • Scope for financing investment needs?

3. Spending and accountability

4. Making decentralization work: Subsidiarity and competition? • Can one achieve accountability solely through spending devolution? • Is there a clearly defined role for the “level at which services are delivered”? • Externalities in provision: climate change; health care; national standards • Do voters care unless they pay, at the margin, for clearly defined services? • Accountability needed for effective decentralization • But can voters compare and punish badly performing local governments (yardstick competition)? • Role of information on budgets, use of funds and outcomes available to electorates and governments

5. Modified subsidiarity principles • Centralization needs • Cooperation • Coordination • Harmonization • Factors • Economies of scale • Spillovers • Congestion • Political economy • Equalization • Interpersonal equity • Decentralization • Devolution • Participatory democracy • Control • Accountability and effective provision • Political economy • Yardstick competition • Supranational (EU) • Rules; regulations • Common policies • National/federal • Policy • Financing • Equalization • Provincial • Financing at margin • Accountability • Local • Financing at margin • Accountability Adapted from Dafflon, in Ahmad and Brosio, Handbook of Fiscal Federalism

6. Whose responsibilities? • Major problems in poorly designed assignments: • Lack of clarity in assignments (overlapping functional and economic responsibilities) or excessive earmarking complicate accountability • See Dafflon (2006; Handbook of Fiscal Federalism); • Assignments without: • Adequate financing; or • Ability to implement • Attempts to “unload” responsibilities in Big Bang, especially without own-source revenues and adequate financing—may backfire: • Nigeria: local governments stopped paying primary teachers • Pakistan: inadequate financing for devolved responsibilities—functions either not carried out, or performed badly • Indonesia: effectiveness of service delivery—incentives for LGs? • Bolivia and Colombia (until recently); overlapping functions

7. Can Minimum Standards offset Assignment problems? • Minimum standards represent central objectives superimposed on local preferences • Should be financed by special purpose transfers • In a decentralized framework, could use these as part of the “social contract” leading to local autonomy • Rationalization in terms of “outcomes”: e.g., years of schooling; immunization standards • Sanctions if not met through shared and equalization funds • But not detailed input norms (like Soviet Gosplan) • These are contrary to effective decentralization and reduce local accountability

8. Expenditure management and accountability Information Generation and institutions

9. Incentive structures and accountability • With incomplete information: • Incentives to hide spending and liabilities • Off-budget operations • SoEs • PPP may be a problem without proper accounting for liabilities • Weak prudential management of systemic private liabilities • Mexican roads (1990s); • Spain and Irish property development • Well within limits set by rules (Spain and Ireland formally compliant with Maastricht) • Irrational private spending at local level condoned by local power elites (Spain, Portugal) comes home to roost • In both cases, liabilities can be shifted to future governments; or higher levels—accountability not guaranteed

10. Game-play on spending, debt and liabilities? • Hiding spending, assets and liabilities • Reduce deficits in cash (C)or financial assets (F), without affecting all recognized liabilities (R) or extended net worth based on future flows (E) • Selling non-financial assets in R, for cash in F • Assuming future pension liabilities in E, for cash and financial assets in F • Securitization C of future revenue streams F (common in Latin American local governments • Treating borrowing F as revenue C (several US States) • Solution: maintain parallel reporting on C, F, R and E • New accounting and reporting standards for PPPs (IPSAS32); • Plus the design of contracts, involving firm-level commitments

11. Rights and obligations associated with all future cash flows, E All currently recognized assets and liabilities, R FF Financial assets and liabilities, F Cash C

12. Need for standardized information: Who does what and what outcomes? • Clarify functions (UN-COFOG) • Economic components (GFSM2001) • Wages, O&M; Capital, etc… • But distinguish between decentralized and deconcentrated operations • Outcomes can be added onto the Chart of Accounts • But distinguish between own-account and deconcentrated operations on both spending and revenue sides • Programs and sub-programs as components • Budget, accounting and reporting critical for “yardstick competition” • Focus on outcomes (performance budgeting) useful, but insufficient without the component building blocks

13. Economic Classification

14. Preventing game-play Need harmonized medium-term budget frameworks, for all levels of government Standardized framework (GFSM2001), with multiple criteria, for accounting and reporting Follow the cash (TSAs at each level—or correspondent arrangements)

15. Follow the cash: why the resistance to TSAs? • Regardless of budgeting model, TSA is a critical element of good management • Track sources and uses of funds; • Separate “pots” complicate cash management; more importantly facilitate rent seeking; • International best practice is appropriate • Even if there is a Central TSA, what about sub-national entities? • Should there be subnational TSAs? Chinese example • Role of donor agencies: • Use of correspondent accounts within a TSA? • Zero-balance arrangements?

16. TSA with donors/local government

17. Designing and Implementing Transfer Systems

18. Transfers to ensure accountability? • Need for own-revenues at the margin • Important for incentives • Does not always require sub-national tax administrations • Avoid debilitating ‘gap-filling’ transfers • Minimize earmarked transfers, • address monitoring and reporting capabilities • Combination of specific purpose and general (equalization) grants • See Ehtisham Ahmad (ed.), Financing Decentralized Expenditures (Elgar, 1997)

19. Design of transfers • Equalization principles (mainly for current spending) • Revenue capacities only (Canadian model), or • Also expenditure responsibilities (Australian model) • Cost of service provision • Modeling • Institutional design (grants commission) • Information flows • Need standardized factors—actuals lead to “gap filling” • Minimum standards in areas of local competence? • Inimical to decentralization • Could be undertaken directly by center • Financial or physical inputs (e.g., wages or capital); or outputs (e.g., number of years of school); or outcomes (e.g., literacy rates). • Selected performance based transfers, especially for capital spending?

20. Equalization Frameworks and Institutions • Need to be designed in incentive-compatible manner • For sub-national entities not to play games: • Full information should be made public on the formulations and data used to make the assessments • Independent agency with representation by the provinces/subnationals • Commonwealth Grants Commission formulations • Indian Finance Commission • Or government body, under the direction of the Ministry of Finance? • Issues of credibility and trust

22. Managing performance-based transfers: need for information flows and sanctions • Increasing emphasis on “performance-based” transfers, including by international agencies • Difficulty if the object of the transfer falls in areas of LG competence • Diversion of resources; not just transfers, but own revenues • Dilution of accountability • Potential distortions, if outputs rather than outcomes targeted • (standardized tests in US “No Child Left Behind”, while deterioration in standards • Could be useful to address externalities—including for investments • Contract federalism (Spahn, 2006; OECD, 2011) • Repeated games and credibility of sanctions

24. Central government conditions or objectives • Typical problem: supra-national, or donor country objectives, sub-national administrations • Capital transfers (DAK in Indonesia) • Standard solution: conditional transfers, often with matching grant provisions • often ineffective: the poorest regions unable to meet matching requirements • With weak information on the uses of funds, scope for diversion of resources • Extreme example (infrastructure): • China: grain silos, central government responsibility, • financing channeled through provinces and counties, • county-level administration • How to ensure that central funds will be used to build silos?

25. Possible solution • Use local monitoring and sanctions for efficient outcomes • Use standardized information on the sources and actual uses of funds • Permits the use of inter-jurisdictional competition to sanction non-performance • And if performance below minimum standard—use of central sanctions • Plus use of performance-based transfer to meet infrastructure gaps in a cost-effective manner