Principles for Designing Transfers Jorge Martinez-Vazquez Georgia State University

1. Principles for Designing TransfersJorge Martinez-VazquezGeorgia State University The Challenge of Designing Intergovernmental Fiscal Transfers in Bolivia The World Bank Institute

2. 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

3. 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

4. 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”

5. 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

6. 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

7. 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

8. Funding Approaches • Vertical funding: the center provides the funds) • Horizontal (“Robin Hood”) funding: subnational governments provide some funds

9. Design of a Transfer System: Distribution of Funds • Ad hoc • Formula • Cost reimbursement • Competition • Derivation basis

10. 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

11. 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)

12. 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

13. 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

14. 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)

15. 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”

16. 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

17. 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.

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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).

27. Flexibility in Use of Capital Grants • Project-based grants: closely administered and monitored by line ministries • Use of categorical or block grants

28. 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)

29. 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.