Equalization of Local Governments’ Financial Capacity

1. Equalization of Local Governments’ Financial Capacity Emergency presentation prepared for the Prague Meeting of „Fiscal Decentralisation in South Caucasus Countries”, September 15-18, 2004 By Paweł Swianiewicz

2. Fiscal Federalism – Basic Assumptions • Local governments provide mainly public goods, but their role in provision of redistributive functions is minimal • Local taxes (with considerable local discretion to decide upon rates) are the main source of budget revenues. It means that those who pay are those who benefit from services • Citizens are mobile • Catchment area of local services does not differ significantly from the area of local government jurisdictions („free rider effect” is minimal)

3. Equalization – what for? • Regardless what own revenues are allocated to local governments there are regional disparities in fiscal capacity • Vertical equity – usually own resources allocated to local governments are not sufficient to provide compulsory services • Horizontal equity – citizens in poor region should have access to the same services for the same price (tax paid) • Reduction of „free rider” effect – support for local governments providing services for citizens from other jurisdictions

4. Equalization – what for? (2) • Securing minimal standard of services which is defined nationally (important if local governments play a role in redistributive functions) • Stimulation of the provision of merit goods, which are national priorities (for ex. education) • Reduction of inefficient location decisions caused by the local tax competition • Required by the European Charter of Local Self-Governments

5. Equalization – arguments against • Disturb the most effective (market) allocation of capital (for example influence pattern of variation in costs of properties) • Is in conflict with fiscal autonomy – makes match of local policies to local preferences more difficult • Disincentive for stimulation of local economic development • Transfers stimulate overall amount of public spending • Equalization is rarely full, but it does exist in nearly all systems

6. How much equalization? Political philosophy answers. • Egalitarian – full equalization regardless the cost • Libertarian – no equalization, because it interferes with individual freedom principle • Utilitarian – equalization to the extent which promotes higher economic effectiveness of the system • Rawls – equalization which allows to maximize the welfare of the poorest local government

7. Types of equalization transfers • General versus specific (conditional) • Based on subjective decisions of central administration versus formula base formula is often imperfect, but subjective decisions are: vulnerable to political manipulations, not transparent and unstable • lump-sum versus matching

8. Lump-sum versus matching grants – microeconomic consequences

9. Matching versus lump-sum grants – macroeconomic consequences • Increase of the lump- sum grant – partial substitution of local tax revenues partial because of „budget maximizing bureaucracy” and „fiscal illusion effect”). • Increase of the matching grant – stimulation of public expenditure

10. Matching versus lump-sum grants - conclusions • Matching – better support horizontal equity • Lump-sum – better support macroeconomic fiscal policies • In practice: proportional – often in capital grants schemes (support local effort, macroeconomic consequence not dramatic) • In practice: lump-sum more often in operating expenditure equalisation schemes

11. Types of equalization • Vertical – upper tier provides grants for local self-government (for example UK, large part of the Polish system) • Horizontal – „Robin Hood” tax paid by affluent to support poor (Sweden, Denmark, some elements in Poland)

12. What do we need to equalize? • Revenue capacity • Spending needs (demand for provided services) Examples: snow removal; care of elderly people health care; road maintenance • Unit costs of service delivery Examples: education, road construction

13. Spending needs – a case of big cities • Number of service consumers significantly larger than number of residents • High unit costs of services due to: • Labour costs • Property costs • High externalities (concentration of problems related to environment protection and transport) • Concentration of social problems (spending on social services and security)

14. Factors used in allocation formula should: • Be significantly correlated with spending needs or unit costs • Have differentiated values across jurisdictions • Not be correlated with each other • Measurable and available • Not vulnerable for statistical manipulations by interested parties • Neutral from the point of view of local fiscal policies

15. Equalization in European Countries – typical characterstics • Variation of the local tax base is usually big. Usually the smallest in the most territorially consolidated systems (in Poland 1:277 ratio between the most and the least affluent local government, in England 1:14) • Equalization through general grants, while specific play different role • Usually vertical allocation, but also countries with horizontal equalization systems

16. Equalization in European Countries – typical characteristics (2) • In some countries full equalization (England), but more often partial (Norway – 85% difference to national average, Poland – „progressive” equalization to 92% of national average) • Different number of equalisation factors considered: • „sophisticate” – large number of criteria (UK, Sweden, Denmark, Norway); • Smaller number of criteria (Germany, Netherlands, Belgium) • „simplistic” – number of residents as the main criterion (Spain, Italy, Greece) Usually more sophisticate systems in countries with more functions provided by local governments

17. Examples of UK, Netherlands and Spain – discussed in my LGI publication (in Russian) • New Polish system (in operation from January 2004) – I may present if you are not exhausted yet.

18. Poland – equalization grant for municipalities • Basic amount: • Received by local governments with local fiscal capacity below 92% of national average • Progressive scale of equalization (75-90% of the difference) • Additional amount, for local governments: • with low population density • With local fiscal capacity below 150% of national average

19. Poland – equalization grant for municipalities (2) • Balancing amount: • Financed by „Robin Hood” progressive tax (up to 30% of the „surplus” – horizontal equalization) • Allocation formula takes into account spending needs related to social services (especially housing benefits) • Spending needs component addressed also by „education general purpose grant”