Fiscal Decentralization: Governing for Results

1. Fiscal Decentralization:Governing for Results Allen Schick Special Course on Impact Evaluation and Results-Based Planning and Budgeting Shanghai,14-18 November, 2011

2. Countries Differ in Key Characteristics of Decentralization • Some give significant political/administrative autonomy to subnational governments: Others transfer money, but little power • Some have intermediate levels between central and local governments: Others have only two levels • In some, SNGs raise a significant portion of their own revenue: In most, they receive almost all revenue from the central government • In some, the central government retains responsibility for key national programs (such as health and education): In many these are devolved to SNGs • In some development countries, SNGs have robust administrative and accountability institutions: In many, they do not • In some, decentralization reduces financial disparities among SNGs: In many, it has little impact on fiscal equality

3. The Country’s Size Affects Decentralized Governance • Decentralization has spread rapidly in recent decades to both large and small countries. Small countries (in population or geography) are more likely to have unitary governments; large countries may have federal systems • Unitary systems generally provide for direct relations between the central and local governments; federal systems interpose an additional layer of government between the CG and LGs • This additional layer complicates the CG’s task in establishing national objectives and in equalizing social opportunities and economic conditions • In very large countries, the allocations made by intermediate governments may run counter to those of the central government. Thus, when the CG transfers (via tax rebates or grants) funds to intermediate governments, it may lack information or control on how these funds are redistributed among lower levels • One option is for the CG to give provinces autonomy in making sub-distributions to their local governments; the alternative is for it to dictate how provincial governments pass through transfers and grants to local units • Regardless of the option selected, CGs should give explicit attention to how funds trickle down to end users, and especially to the impacts on income differentials

4. The Logic of Fiscal Decentralization: Developed Countries • The argument for decentralizing public finances initially emerged in developed countries, then migrated to developing countries • Early fiscal decentralization was justified by the problem of how to allocate public resources when the population is diverse and citizens have differing preferences for public services • The solution was to enable citizens to “vote with their feet” by opting to live in communities that matched their preferences for services and taxes • In this model, inequality in incomes and services is a virtue because it provides citizens with a wide range of choices • This model depends on local jurisdictions having sufficient autonomy and resources to satisfy citizen preferences • But the model does not fit the many developing countries that have low geographic mobility or offer citizens a narrow range of choices

5. The Logic of Fiscal Decentralization: Developing Countries • The key rational for fiscal decentralization in developing countries is to empower citizens by shifting resources and fiscal autonomy from remote, unresponsive central governments to local governments • This concept of decentralization goes beyond the distribution of revenue and spending assignments between CG and SNGs to the distribution of political power and administrative discretion • In this model, the benefits of fiscal decentralization – in particular improved public services and social outcomes – depend on having efficient and accountable subnational governments

6. The Logic of Fiscal Decentralization: Developing Countries, continued • In many developing countries, however, fiscal decentralization has preceded the existence of effective local institutions. In these circumstances countries have not realized the gains expected from decentralization unless they succeed in strengthening local governance • A few countries have combined fiscal decentralization with new forms of participations (such as participatory budgeting) that give citizens a direct voice in allocative decisions that affect their wellbeing • Rather than reinforcing diversity, decentralization in developing countries aims to reduce inequality through transfer policies that favor low-income communities • In practice, however, fiscal decentralization has sometimes preserved or even reinforced inequality

7. Effective Decentralization Requires Strong Central Capacity to Establish Uniform Procedures and Monitor Local Performance • Effective decentralization does not weaken the central government; rather, it transforms what the center does and how it carries out responsibilities • The CG becomes the strategic center for the country, assessing the implications of trends and projections and planning major policy initiatives • The CG establishes uniform policies and standards for nationally-important services, such as health and education that are carried out by SNGs • It also prescribes a uniform system of accounts, audit rules, and financial reporting requirements • In some countries, it consolidates SNG financial reports together with its own finances into a whole government financial statement • Often, during the early period of decentralization, the CG steps in to provide technical assistance to local governments that lack sufficient capacity to manage their own finances • The CG also imposes and enforces a hard constraint on local debt and deficits to protect the country’s macro-economic position

8. The Central Government Retains Powerful Instruments to Influence Local Actions • In a decentralized mode, the Central Government still has effective means of influencing what SNGs do and how they spend public money • Conditional grants aim to induce SNGs to do things they otherwise might not do • These grants earmark funds for particular purposes, and are sometimes conditioned on achieving targeted results • SNGs may have to compete for these grants by promising to carry out certain activities or produce specified results • Unfunded mandates are similar to conditional grants, but with the important exceptions that they take away local discretion and do not provide financial support • Both grants and mandates typically have reporting requirements. An unintended effect of these requirements is to shift the focus of SNGs away from substantive results to the process for filing reports

9. Information is the Critical Link Between the Central Government and Empowered Subnational Governments • In an ideal world, guidelines and policies would flow downward from the CG to SNGs and information would flow upward from SNGs to the CG • Things rarely work out this way, whether in a central bureaucratic structure or in intergovernmental relations • One problem that is especially prominent in newly-decentralized countries, is that SNGs lack timely and accurate information on finances • This problem may be especially serious in forecasting economic conditions, revenues and cash flows • Another problem is the asymmetric relationship between SNGs that have information and the CG that needs that information. In this relationship, SNGs have both incentive and means to withhold or distort information • The problem can be partly ameliorated through extensive training that equips SNG staff with essential financial management skills and impresses on them the need for probity and accuracy in public finance • In some situations, it may be necessary for the CG to intervene by withdrawing some discretion and responsibility from fragile SNGs, or by operating their financial controls and IT systems

10. Revenue and Expenditure Assignments Often are Misaligned • In a perfect decentralization system, revenue responsibilities of local governments would match their expenditure responsibilities • The proper alignment of revenues and expenditures should pertain both to levels of government and to individual jurisdictions • If local governments incur 30% of public expenditures, they should have, either through self-generated taxes and transfers, 30% of public revenues • The same parity should apply to each subnational government that has expenditure responsibilities • In practice, however, there often is wide disparity between SNG revenue and expenditure share • Central governments have much greater incentive to issue expenditure mandates than to transfer revenue • The resulting misalignment occurs both in countries when the CG collects almost all the revenue and in countries where local governments have significant revenue authority • Misaligning revenues and expenditures weakens the link between resources and results

11. The Benefits of Decentralization Increase When SNGs Generate a Large Portion of Their Total Revenue • One of the major arguments for decentralization is that accountability is strengthened when a significant proportion of local services are financed by local taxes • In this way, the argument runs, voters can hold elected officials accountable for the quality and cost of services • Not all revenue sources are good candidates for local taxation. Perhaps the most important characteristic of a good local tax is hat the burden cannot be shifted outside the jurisdiction. • Good local sources of revenue include property taxes and taxes on motor vehicles, include fuels, licenses and tolls • Income taxes may work well if the central government sets the tax base and the national rate, and local governments add a surcharge • In decentralized countries, local taxation must be supplemented by transfers from the CG to counter significant inequality in the revenue-raising capacity of local governments

12. The Transfer System has a Strong Effect on Fiscal Disparities among Subnational Governments • Decentralizing public finances risks enlarging inequality among SNGs because rich local governments can generate more tax revenue than poor governments • The transfer system (return of tax revenue and grants) can either widen or narrow these disparities • Tax rebates (or sharing) returns more to affluent communities with strong tax bases, and therefore has counter-equalizing effects: a formula based system (for example, with the amount transferred inverse to per capita income) has the potential to narrow fiscal differences among SNGs. • Grants also have the potential to expand or reduce inequality. Grants that match local expenditures tend to be de-equalizing, those that compensate SNGs for low income have the opposite effect • It is important for CG to periodically review the total transfer and grant system to assess whether it has the intended effects on equality

13. Stability and Certainty are Essential Elements of Sound Inter-Governmental Financial Relations • In a decentralized system, the central governments make the rules and can change the rules • It establishes formulas and schedules for transfers to SNGs, as well as expenditure responsibilities • In many countries, these rules have been subject to frequent, unilateral revision, leading to uncertainty and to mismatches between revenue and expenditure assignments • Moreover, during periods of fiscal stress, the Central Government often seeks to ease its own predicament by reducing payments to SNGs or by transferring expenditure responsibility to them • There is compelling evidence that uncertainty shortens a government’s time horizon and spurs it to make policy and management choices that enable it to muddle through • Planning, objectives, and results are disregarded by local governments beset with high levels of uncertainty • Some advanced countries have established formal mechanisms for periodic negotiations between the CG and SNGs to discuss intergovernmental arrangements, including revenue allocations, expenditure assignments, and management rules

14. Inter-Governmental Finance Must Reckon with Risks to Macro-Economic Stability • In most countries, the debt incurred by the central government (CG) is vastly larger than the aggregate debt of subnational governments (SNGs). • Nevertheless, by giving SNGs fiscal autonomy, decentralization opens the door to destabilizing expenditure increases and deficit spending • One option for warding off fiscal instability is to establish a hard budget constraint that requires SNGs to balance their budgets without deficit-closing assistance from the CG • Operationalizing this constraint depends on SNGs having a high degree of certainty as to the transfers and grants that will be forthcoming during the year • Some countries have fiscal responsibility laws that span all levels of government within a comprehensive budget constraint • This arrangement depends on periodic within-year fiscal reports from all SNGs to the central finance ministry

15. Should SNGs be Permitted to Debt-Finance Local Activities? • This question does not have a universal answer that suits all decentralized systems • Three important variables are the soundness of the SNGs, financial management system, its fiscal position, and the purposes for which funds are borrowed • It may be imprudent to allow borrowing by SNGs that have untimely financial reports, qualified audits, loose personnel practices, weak internal control systems, are and reputed to have elevated levels of corruption • Caution should be taken in permitting local borrowing that can put the country’s macroeconomic position at risk, especially when local debt has an explicit or implicit CG guarantee • Borrowed funds should be used to finance the acquisition of capital assets, not to pay operating expenses • When they borrow, local governments should have separate and current investment budgets, along with segregated accounts • Developing countries generally have limited access to long-term debt. Borrowing short term requires them to roll over debt frequently, and makes them highly vulnerable to adverse shifts in fiscal conditions and capital market sentiments

16. Budgeting for Results in a Decentralized System • In decentralized countries, significant portions of the national budgt are spent by SNGs • In these countries, SNGs are vital for the delivery of nationally-important services, especially health and education • The interdependence of different levels of government complicates efforts to link resources and results • Problems arise because of asymmetries in information, different time perspectives, and clashing incentives • One level of government has the money; another delivers the services financed by that money • One level has the information needed for effective policies; another level depends on that information to make effective policies • One level wants certainty as to the funds that will be available; another wants flexibility in distributing that money • These problems may be mitigated by introducing budgeting for results tools into the inter-governmental system

17. Budgeting for Results in a Decentralized SystemFocus on Services • Citizens know government through the services they receive (or fail to receive) from government • The absence of government is a common feature of less developed communities • Improving public services is the primary means by which the CG can use to decentralization to reduce poverty • To combat poverty, the central government needs timely and accurate information on services • Performance-based grants are sometimes used to incentivize local governments • These can be difficult to monitor, and may distort priorities if the wrong indicators are targeted • It may be preferable to provide service-based grants

18. Budgeting for Results in a Decentralized System: Time Frames and Data TIME FRAMES • The central government’s MTEF and budget include transfers to SNGs, but they generally do not include SNG expenditures or services • Transfers and grants are decided and distributed annually (sometimes within shorter time-frames). The flexibility retained by the CG spawns uncertainty about the funds that SNGs will receive • It is difficult for SNGs to plan or budget for the Medium-Term, and to undertake service improvements that spread over several years • To spur development, CGs should incorporate SNG finances into Medium-Term plans and budgets

19. Budgeting for Results in a Decentralized System: Time Frames and Data, continued DATA • Many CGs have weak capacity to monitor local expenditures and services • Surveys by Public Expenditure Tracking Systems (PETS) and other monitoring systems often disclose significant discrepancies between intended and actual uses of centrally-provided funds • The CG cannot rely soley on local reports to determine how funds are spent • It is important for CGs to develop independent capacity to monitor expenditures and services

20. CONCLUSION: Fiscal Decentralization is Effective When it Improves Public Services • Fiscal decentralization often is evaluated in terms of the percent of total revenues or expenditures accounted for by subnational governments • In many countries, the subnational share has not been significantly increased by decentralization • A better measure is the effect of decentralization on the volume, quality, accessibility, and impact of key public services, especially in previously under-served communities • Key indicators in each major sector should be used to assess the effectiveness of decentralization: for example, in health services, vaccination rates, distance to the nearest clinic, prenatal visits, infant mortality • It should also be feasible to link service indicators to changes in government policy and administrative actions due to decentralization