An overview of fiscal decentralisation: theory and practice

1
An overview of fiscal decentralisation theory
and practice

• Harmonisation, Decentralisation and Local
  Governance

2
Session overview

• Understanding the context of fiscal
  decentralisation
• Assigning expenditure responsibilities
• Instruments for financing local government
• intergovernmental transfers
• local taxation and user fees
• investment capital
• Assessing fiscal decentralisation and monitoring
  reforms and impact of aid

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Understanding the context of fiscal
decentralisation
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iDPWGs Specific Guiding Principles

• Strengthening fiscal decentralisation and local
  authorities financing
• Fiscal decentralisation is a key factor and
  driver for successful decentralisation. Support
  to fiscal decentralisation should aim at
  strengthening the long-term financial development
  and sustainability of local governments.

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Decentralisation - Traditional definition

• Decentralisation is the transfer of authority
  and responsibility for public functions from the
  central government to subordinate or
  quasi-independent organizations or the private
  sector.
• (Litvack and Seddon 1999)

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Why (fiscal) decentralisation?

• Inefficient centralisation (largely theoretical)
• Unable to accommodate differences in local needs
  and preferences
• Inefficient taxation poor match between
  government services and tax costs
• Excessive centralisation inhibits growth
• Improve public services, reduce poverty and
  encourage economic development
• Local governments have better info on local needs
  / incentives for more responsive government
• Fiscal incentives for regional development

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Why (fiscal) decentralization? (Continued)

• Governance-driven decentralization Greater
  accountability at the local government level to
  provide
• Local governments have grown up
• Politically driven decentralization Autonomy
  versus dissolution

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Some observations about fiscal decentralisation
around the world

• It is often history and politics -not economics-
  that determines subnational government structure
  and drives fiscal decentralisation reforms
• Many fiscal decentralisation reforms shifted the
  financial resources to the local government
  level, but failed to decentralise the discretion
  to manage these resources
• In developing and transition countries,
  over-fragmentation of subnational government
  structure has been a common occurrence

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New consensus on decentralisation

• (Fiscal) decentralization is the empowerment of
  people by the (fiscal) empowerment of their local
  governments.
• (Roy Bahl, 2005)

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Implications of new definition (1)

• Recognition that fiscal decentralisation requires
  more than just a pushing down of financial
  resources control over these financial
  resources matters just as much
• Decentralisation is tied much more closely to
  governance and poverty reduction (empowerment)

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Implications of new definition (2)

• In order to achieve the benefits of fiscal
  decentralisation, institutions matter
• The quality of the design of intergovernmental
  fiscal systems matters a great deal to achieve
  efficient and equitable outcomes
• Decentralised political systems matter (local
  politicians should serve the community)
• Local officials should have control over the
  local public service (hiring and firing)
• Local corruption exists. Achieving local
  accountability is complex but possible (and
  easier than fighting central corruption)

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Revisiting the Wall of wonders

• The system of intergovernmental fiscal relations
  should be well-designed in its own right
• The fiscal, political and administrative
  dimensions of decentralisation should be properly
  aligned
• For every element of decentralisation (including
  fiscal decentralisation), there is a need to
  balance discretion with accountability

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Intergovernmental finance Four pillars
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Intergovernmental finance Four pillars

• The assignment of expenditure responsibilities
• The assignment of revenue sources to subnational
  governments
• The allocation of intergovernmental fiscal
  transfers or grants
• Rules on subnational budget deficits and the
  incurrence of subnational debt

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Assigning expenditure responsibilities

• The first pillar of intergovernmental finance

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The assignment of expenditure responsibilities

• What functions and expenditure responsibilities
  are (or should be) assigned to each level of
  government?
• Subsidiarity principle
• Multi-dimensional nature of functions
• Accountability mechanisms in place

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The Subsidiarity Principle

• Government services should be provided at the
  lowest level of government that can do so
  efficiently.
• Generally this means that public services should
  be provided at the level of government compatible
  with the benefit area of the service.
• If the benefits area is smaller (or greater) than
  the jurisdiction, the provision choice will be
  inefficient.

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But, its not all or nothing expenditure
responsibilities are multi-dimensional

• Within a certain sector or function,
  responsibility can be assigned separately for
• Policy and regulation
• Financing
• Provision (responsibility) of the service
• Production (delivery) of the service. 

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General application of subsidiarity principle to
different dimensions

• Responsibility for policy and regulation often
  central government
• Responsibility for financing local social
  services should be financed centrally local
  economic functions can be financed locally
• Responsibility for provision of the service can
  often be done by LGs
• Production (delivery) of the service either LG
  or private sector 

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Further stipulations to the subsidiarity
principle

• Local ability to efficiently provide public
  services further requires
• Elected local government Appropriate,
  participatory and accountable local governance
  structures
• Locally appointed officials and local human
  resource capability to deliver adequate public
  services
• Adequate local financial management systems to
  assure transparency and sound PFM

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Different countries have ended up with widely
different practices

• Functions typically devolved to the local
  government level
• Basic education, basic health services,
  agricultural extension, (rural) water supply,
  local roads
• Urban services (public utilities, roads,
  sanitation)
• Note that many of these functions are closely
  related to achieving the MDGs !

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In general

• It is important to have a clear and stable
  assignment, but there is no single best
  assignment of expenditure responsibilities that
  applies to all conditions.
• Open invitation
• To what extent has real authority been
  decentralised to the local level in your country
  of work?

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But in reality....

• Decentralisation reforms most often go wrong in
  expenditure assignments, since the willingness
  across key stakeholders to decentralise real
  authority to the local level is often missing.

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Instruments for financing subnational governments

• Local taxation and user fees
• Intergovernmental transfers
• Financing capital investments

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Finance should follow function

• Local governments provide different types of
  goods and services, including
• Club goods
• Local public goods
• Social services
• Local expenditure functions should be financed
  depending on the nature of the good or service
  provided

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Finance should follow function (1)
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Finance should follow function (2)
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The revenue assignment question (second pillar)

• Which tax sources or non-tax revenue sources
  (including fee revenues) will be made available
  to subnational governments in order to provide
  them with revenue sources?
• The assignment of own revenue sources is
  considered the second pillar of
  intergovernmental finance

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Why have sub-national taxation?

• Sub-national governments are often more
  accountable for controlling spending if they are
  also responsible for revenues
• Reduces excessive demand by sub-national
  governments for transfers from the center
• Allows tax policy (tax levels and structure) to
  be tailored to the conditions and preferences of
  sub-national governments
• Allows decentralised tax administration (when
  local governments are in a better position to
  collect)

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Features of an ideal local revenue source

• Subnational governments should be assigned taxes
  that achieve a correspondence between the tax
  and the benefits from local goverment services
• Relatively easy to administer
• Should not be easy to give perverse incentives
  to taxpayers

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Suitable local revenue sources

• Property taxes
• Market fees and other local user fees
• But also
• A piggy-back personal income tax
• Local business fees (but not CIT)
• Sales taxes (but not VAT)
• Motor vehicle taxes

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Conclusions on fiscal decentralisation and local
revenues

• Local revenues should be an important part of a
  well-functioning intergovernmental fiscal system,
  both for economic and accountability reasons
• But, raising more local revenues is only
  efficient if the revenues are well-spent, and
• Neither central politicians nor local politicians
  have a strong incentive to rely heavily on local
  government revenues
• As a result, local revenues are often an
  under-emphasised part of fiscal decentralisation

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Intergovernmental fiscal transfers (the third
pillar)

• Since own source revenues are (almost) never
  enough to covers local expenditure
  responsibilities, central (or regional)
  governments may provide local governments with
  additional resources through a system of
  intergovernmental fiscal transfers, such as
  revenue-sharing or grants
• In most countries, transfers are (by far) the
  main funding source for local government, esp.
  for social sector services
• But transfers do not have same accountability
  benefits as own source revenues

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Sound reasons for intergovernmental fiscal
transfers

• Improving the vertical fiscal balance of the
  system of intergovernmental relations
• Improving the horizontal fiscal balance of the
  system of intergovernmental relations (in other
  words, equalisation).
• Compensating for the presence of spillovers or
  externalities between jurisdictions
• Funding national priorities or merit goods

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Dimensions of intergovernmental transfer
mechanisms

• Define the purpose
• Determine size of the transfer pool
• Horizontal allocation of transfers between
  government units
• Conditional (specific / earmarked), sectoral, or
  unconditional transfers
• Nature of transfer matching grant or lump sum
  (block) grant

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Finally, the fourth pillar of subnational
finance deficits and debt

• If subnational governments do not carefully
  balance their annual expenditures with revenues
  and transfers, this will result in subnational
  deficits and the incurrence of subnational debt.
• In many developed economies, local borrowing is
  an appropriate way for local governments to fund
  capital infrastructure, since (i) it corrects the
  inter-temporal mismatch between costs and
  benefits, and (ii) there are numerous mechanisms
  that assure responsible borrowing.

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Local capital finance

• In many LDCs, the absence of market-based
  mechanisms to enforce a hard budget constraint
  requires restricting local borrowing
• Rules-based restrictions
• Permission required
• Local government bank / loan fund
• No borrowing allowed
• Instead, capital grants are often relied on to
  fund local capital development.

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Assessing fiscal decentralisation monitoring
reforms and impact of aid
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Useful source of information

• World Bank Fiscal decentralisation indicators
  (derived from the IMFs Governance Finance
  Statistics (GFS)).
• The GFS covers 149 countries on a yearly basis
  and is the only data source with such
  comprehensive coverage, although the number of
  countries with sub-national data is reduced by
  about two thirds.
• It has more than 50 variables for each government
  tier allowing fairly detailed analysis of fiscal
  flows..
• Cautioning note standardisation inevitably leads
  to a loss of detail and data richness that must
  be kept in mind when using GFS data to assess
  decentralization.