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

3. Understanding the context of fiscal decentralisation

4. 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.”

5. 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)

6. 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

7. 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

8. 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

9. New “consensus” on decentralisation “(Fiscal) decentralization is the empowerment of people by the (fiscal) empowerment of their local governments.” (Roy Bahl, 2005)

10. 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)

11. 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)

12. 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

13. Intergovernmental finance: Four pillars

14. 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

15. Assigning expenditure responsibilities ‘The first pillar of intergovernmental finance’

16. 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

17. 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.

18. But, it’s 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. 

19. 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 

20. 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

21. 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 !

22. 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?

23. 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.

24. Instruments for financing subnational governments Local taxation and user fees Intergovernmental transfers Financing capital investments

25. “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

26. “Finance should follow function” (1)

27. “Finance should follow function” (2)

28. 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

29. 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)

30. 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

31. 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

32. 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

33. 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

34. 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”

35. 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

36. 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.

37. 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.

38. Assessing fiscal decentralisation & monitoring reforms and impact of aid

39. 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.