Earmarked Grants and Accountability in Government

1. Earmarked Grantsand Accountability in Government Richard Bird and Michael Smart University of Toronto Copenhagen, 17-18 September 2009

2. Introduction • What explains recurrent demands for earmarking and other forms of conditionality in intergovernmental grants? Standard view: earmarked grants are Pigouvian subsidies for interjurisdictional spillovers. But this does not explain either extent of earmarking or its evolution over time. Alternative “second generation” views emphasize role of earmarking to address information and incentive problems between governments, and with voters.

3. Earmarking: Definitions • An earmarked grant -- sometimes called a categorical or specific-purpose grant -- is defined as any grant for which the amount received is conditional in some way on the spending decisions of the recipient government. • Earmarked grants may be (closed-ended or open-ended) matching, or categorical block grants. • Earmarked grants of all types may or may not carry with them other conditions less tightly tied to the amount spent and more related to how it is spent.

4. Traditional Views • Usual perspective – matching grants to address spillovers, unconditional block grants to close vertical gap – accords a limited role for earmarking. • In practice in OECD, use of matching is broader and larger than justified by Pigouvian considerations • This view also does not explain the extensive use of categorical block grants and closed-ended matching grants • no marginal subsidy • fungibility often makes conditionality meaningless

5. Rethinking earmarking • Alternative perspectives suggest a broader and deeper role for earmarking: • Target grants to expenditure need • Commit to grant rules; foreclose bailout problem • Make central government expenditures more transparent to voters

6. Targeting fiscal needs Earmarked grants may substitute for block grants that seek to redistribute on the basis of differences in costs, needs, or local demands for public services. When centre is imperfectly informed about cost drivers, matching actual expenditures may improve equity, albeit at the cost of distorting local spending Such grants should be most prevalent when central government taste for interjurisdictional redistribution is large; the move to block grants in some countries may largely reflect changing regional politics.

7. Block grants and soft budget constraints • In periods of fiscal retrenchment, a move from matching to block grants is perceived as a way to harden local budget constraints, reduce spending. • Is it? • Block grants leave recipient governments exposed to fiscal risks they are often ill equipped to handle. • Central governments may find it difficult to commit not to adjust block grants to “bail out” subcentral government deficits

8. A Canadian Example Move to block grants for health, social services during 1990-95 to address federal deficits, reduce provincial spending In face of rising health costs, provincial governments repeatedly demanded new transfers so that federal government “pay its share” Federal spending for health transfers were repeatedly revised upwards during 1997-2006 period – effectively restoring health matching grants ex post Were provincial arguments effective despite provincial access to essentially all federal tax bases – or because of it?

10. Earmarking and electoral accountability • One role for conditionality is when local governments are considered inadequately accountable to local voters • Perversely, however, such grants may further weaken accountability: • transfer dependency inhibits fiscal adjustment • fiscal illusion of voters may insulate local officials from electoral accountability

11. Accountability: A contrary view • Even where local accountability mechanisms work well, grant conditions may enhance accountability of central government to voters: • earmarking signals spending priorities of central officials to voter • earmarking is one mechanism of vertical competition among governments • even if grants from the centre merely close the vertical gap, earmarking makes role of the central government transparent and tangible to voters

12. Concluding Remarks • Earmarking grants may occur for a variety of reasons • This practice may often, properly understood, make sense • But there is much we still do not understand about the motivations and effects of earmarking