Intergovernmental Fiscal Relations: A Framework Introductory Lecture Migara De Silva World Bank Institute (WBIPR)

1. Intergovernmental Fiscal Relations: A FrameworkIntroductory LectureMigara De SilvaWorld Bank Institute (WBIPR)

2. Let’s Start with Four Questions • What is decentralization? (Intergovernmental Fiscal Relations) • Why decentralize? – The main goal of decentralization and three questions • Who is doing what? • How to reduce inter-regional and intra-regional imbalance? • Why institutions – formal & informal rules – matter? • What can we learn from history? • Why are reforms in intergovernmental fiscal relations important for Russia? – (Significance of this course)

3. 1. What is Decentralization? • Decentralization involves the transfer of political, fiscal and administrative powers to sub-national units of the government. Three variants of decentralization: • Deconcentration –dispersion of central government responsibilities – decision-making powers, etc. - to regional branch offices or local administrative units. For example: moving some central government units from capital city to a province. This is the weakest form of decentralization and may take different forms: • “Field Administration” – local administrative units/branches of central ministries have responsibility for service delivery but the staff remains under the direction and control of the central government. • “Local Administration” – local units have more responsibility for policy & program implementation but remain under the supervision of the center. • Delegation – sub-national units are given selective responsibilities for delivering services and executing assigned functions on central government’s behalf, thus acting as “agents” for central government. They are supervised by and are accountable to the central government. This is the intermediate form of decentralization.

4. 2. Why Decentralize? The main argument for decentralization in economic terms is that central government is unable to deliver goods & services – at least the right goods & services – in the right quantity to the right people (see: Richard Bird’s paper on “Fiscal Federalism in Russia: A Canadian Perspective”, 2002, World Bank). Intergovernmental reforms are introduced to achieve exactly this. In more specific terms, intergovernmental fiscal relations have one major goal and that is to achieve efficient resource allocation: The process could be outlined by formulating three main questions: • Who is doing what?: Revenue & expenditure assignment and their political & macro economic implications. • How to reduce both inter-regional (horizontal) and intra-regional (vertical ) fiscal imbalance?: Equity implications. • Why institutions matter? – Importance of formal & informal rules and issues of transparency and accountability. • Political & macro stability are essential preconditions for achieving efficient resource allocation goals. • An inter and intra-regional equity reinforce efficient resource allocation efforts. • A poorly designed system could pose a great threat to political stability, worsen macroeconomic stability, and cause significant fiscal imbalances leading to unsustainable inter and intra-governmental inequality.

5. 2. Why Decentralize? Cont… Who is doing what? - Revenue & Expenditure Assignment • By virtue of their proximity and ready access to local population, sub-national units have superior information on local services and thus are better placed to respond to local demand for services and problems of service delivery. • Local officials are more accountable to the citizenry they serve and with whom they have closer and repeated interactions. However, local officials are susceptible to capture by the local elites in the absence of social capital (effective groups, public voice and monitoring which guarantee transparency). • The basic requirement for an effective and efficient sub-national government is to be able to match expenditure responsibilities with revenue resources and revenue capacities with political accountability. • Sub-national units could raise local revenue and taxes more efficiently, finance local infrastructure, and effectively deal with the delivery of social services – such as education, health services – at the local level by developing monitoring mechanisms, performance benchmarks, private sector involvement, etc. • Better intergovernmental coordination reduces confusion over who is responsible for what. Where such coordination is lacking, there may be tendency for central government to ‘re-centralize’. Example, Chinese reforms in 1994. Russia also seems to head in that direction.

6. 2. Why Decentralize? Cont… • There are instances where decentralization has negatively affected the quality of local services. However, this is due mostly to design errors which include the lack of appropriate institutional mechanisms in place. • This often happens when resources and responsibilities granted to local units are not clearly matched with the tasks assigned to them. Example: The central government can override the decisions of the local units, or revenue assigned for local services fall short of basic levels of demand. • It is critical to provide sub-national governments both incentives and sufficient authority to manage revenue & expenditure of their budget within a consistent and a comprehensive framework. They should also be able to predict with some certainty the amount of inter-governmental transfers (Bird, 2002, World Bank). • It is also important to transfer responsibilities to local units which are best positioned to make the desired changes. Example: in Central America, decentralization of management responsibilities from central to provincial and local governments had little effect on primary education; but when these responsibilities were transferred directly to the schools, education performance improved (WDR, 1999/2000) • Quality of public services can also become worse when responsibilities are transferred to local government without introducing proper institutional mechanisms. Power may be simply transferred from national to local elites. Example: India’s caste system - local participation depends on caste and poor have little or no voice.

7. 2. Why Decentralize? Cont… • In sub-national taxing, the important question is who is politically responsible for setting the tax rate. In Canada, most provinces have not levied their own taxes but imposed surcharges. Where as in countries such as Brazil, states impose their own VATs but the tax rate is centrally and uniformly set by the center. • Two basic principles of revenue assignment: (I) Sub-national units should be allowed to finance locally-provided services (benefiting local residents) by using “Own-source” revenues; (2) Where possible, sub-national revenue should be collected only from local residents in relation to the benefits they receive from local services. • Regional disparities exist in all countries and transfers will reduce the gap to some extent. Differential treatments of areas also exist – for example, in Russia this is common (Martinex-Vazquez and Boex, 2001) – sometimes in the interest of political stability and national survival. • Sub-national governments may attempt to extract revenues from sources for which they are not accountable. E.g: taxes on natural resources, enterprises (Russia), etc. which mostly fall on nonresidents. These taxes by sub-national governments violate the efficiency criterion (the justification for their existence).

8. 2. Why Decentralize? Cont… • Size of the sub-national unit: There is an optimal size which maximizes the efficiency of the local unit (like a firm). Further fragmentation may most likely diminish the capacity of the local units to function efficiently due largely to fiscal and administrative constraints. • When fragmentation becomes a serious impediment, sub national units could (a) create districts to supplant some functions, or (b) form intergovernmental agreements to share service delivery responsibilities such as municipal federations in Nordic countries. Political & Macro Economic Stability • A major implication of intergovernmental reforms is to maintain political stability when there is pressure for ‘localization’ – especially when there are long-standing ethnic and geographical divisions (examples: South Africa, Uganda, Sri Lanka, Nigeria, Ethiopia). • If handled poorly, decentralization can threaten macro stability. Examples: the Philippines. The Philippine government is required to share nearly 50% of its tax revenue with sub-national governments. This limits the central government’s ability to adjust the budget when responding to macro shocks. • When substantial decentralization of public finances to sub-national units takes place without appropriate institutional mechanisms, the tendency of these units is to succumb to popular demand to spend more and tax less, creating more macro instability (ex: Argentina and Brazil). Therefore it is important to impose hard budget constraints on sub-national borrowing. It is also extremely important that responsibilities granted to sub-national governments be matched with financing.

9. 2. Why Decentralize? Cont… • The risk is greatest when revenues are decentralized without building requisite organizational capacity such as local government’s ability to mobilize local resources and carry out corresponding expenditure responsibilities. • Macroeconomic instability is caused by the inability to impose hard budget constraints. However, imposing hard budget constraints require political will. Ironic as it may sound, some times, past crises provide an incentive for political actors to embark on a sound economic policy package. • Another advantage of a properly designed decentralization structure is that it can instill competition among local/regional governments and other sub-national units. Example: competition between Karnataka state (Bangalore) and Andhra state (Hydrabad) in India for IT investments (foreign and local) and professionals. • Due to perennial demand to achieve political stability through various forms of decentralization and yet retain ability to respond to economic crises, some central governments have tended to support decentralization de jure and not de-facto. • India may be an important case in point. Its federal constitution grants states substantial fiscal and regulatory powers. However, due to (i) unitary features of the constitution, (ii) central planning, and (iii) dominant one party system, center still retains large powers. • In contrast, China relies more on negotiations between the center and four sub national tiers (provinces, prefectures/cities, counties and towns) rather than on rules which define specific powers granted to each tier. It has been pointed out that China’s constantly changing revenue-sharing arrangements, I.e., lack of pre-commitment, has seriously discouraged local collection efforts (Jun Ma, 1996).

10. 2. Why Decentralize? Cont… • Countries which de facto grant substantial autonomy to sub-national units have macroeconomic stability. Examples: US, Germany, Canada, and Switzerland. • Several studies show that decentralization has not posed a serious threat to stability especially in the US and Western Europe. Even in Latin America, with the exception of federal states, sub-national governments’ contribution to national deficit has been quite negligible (WDR, 1999/2000). • Argentina provides an important case in point on why hard budget constraints are important. Before 1991, when Convertibility Plan was introduced, provinces were able to borrow large amounts from their own provincial banks which were later discounted to the central bank. In 1990, there were 20 provincial banks which provided more than 60% of the credit to provincial governments. Central Bank had to lend large amounts of new rediscounts to prevent the collapse of a number of these banks. • After 1991, with the introduction of the Convertibility Plan, the central bank was effectively transformed into a currency board – which required it to maintain 100% reserve requirement. In 1992, central bank’s charter was revised, restricting it to take any new domestic assets and prohibiting the guarantee of bank deposits. (Dillinger & Webb, World Bank, 1999). These institutional reforms imposed a hard budget constraint on provincial banks and helped the country avert macroeconomic crises in the 1990s.

11. 2. Why Decentralize? Cont… • In Morocco, for instance, the government changed subsidy scheme for local government from one of budget-balancing, in which both capital and interest payment on loans increase transfer receipts, to a formulae-based equalization transfer which does not take into account the amount of borrowing done by local governments. Lenders were explicitly told that they should not count on financial bailouts (Richard Bird & Francois Vaillancourt, 1998) • There are instances where the central government bails out sub-national governments when these units are too politically important to fail. In such situations, the central/provincial governments may keep the ‘door to the treasury’ under lock and key to avoid any possibility of financial profligacy. In Canada for instance, provinces severely restrict local government borrowing and under no circumstances the local governments are allowed to borrow as they wish (Bird, 2002, World Bank). • The main lesson to be derived from this discussion is that fiscal decentralization should be carried out with the requisite institutional reforms and hard-budget constraints. For hard-budget constraints to be effective, there should be credible rules/procedures preventing bail-outs. In addition, there must be transparency - allowing full information to the creditors and residents, as well as full accountability.

12. 2. Why Decentralize? Cont… Reducing Imbalance: • Two factors determine whether decentralization exacerbates or improves regional equity. They are: horizontal and vertical fiscal balance. • Horizontal balance refers to the fiscal capacity todeliver a minimum level of services at a certain cost across all sub-national governments. This means that individuals from poor regions will not have to pay more (as a % of income) in order to receive the same level of services as individuals in rich regions. The amount of per capita revenue raised from each region varies as tax bases across regions differ significantly. To address this inequality, most decentralized fiscal systems provide equalization grants. • In Australia, Canada, and Germany, these grants guarantee minimum level of services. In Vietnam, even though per capita income of low-income provinces are only 9% of those of richer provinces, expenditures in these low-income provinces are equal to 59% of the expenditures in rich provinces, due to transfers from the central government (WDR, 1999/2000). • When equalization grants are improperly designed, i.e., based on discretion and negotiation rather than on fiscal capacity, these grants provide perverse incentives for sub-national governments to (a) refrain from raising local taxes as this will be politically unpopular, and (b) understate their tax base in order to receive larger amounts of revenue (grants) from the center.

13. 2. Why Decentralize? Cont… • Vertical balance (‘gap’): This refers to the difference between expenditure and revenue responsibilities allocated to sub-national governments. If expenditure outweighs revenue, then transfers from the central to sub-national governments are in order. • One of the reasons for worsening fiscal gap in countries is that central governments devolve more “responsibilities” – federally mandated programs - to sub-national units without guaranteeing adequate funding to carry out these tasks [“To do more with less”]. These are called unfunded mandates. • Problem of unfunded mandates is not limited to Russia but is common to all federal countries. The problem is an indication of ill-defined jurisdiction of respective governing bodies in a changing environment of intergovernmental relations. However, the magnitude of the problem as well as institutional mechanisms introduced to address the problem differ among countries.

14. 2. Why Decentralize? Cont… • Large number of federal laws in Russia mandate sub-national governments to provide social services at levels (standards, norms) which are established by the Central government. However, the sub-national governments were rarely given taxing powers, and transfer system remained limited, ad hoc, and was based largely on negotiations. The outcome was sometimes counter equalizing. • In Germany, the federal government is not obligated to provide funds to sub-national units when imposing new mandates. However, disputes are rare due to consensus building approach which acts as a major safeguard. What is important to point out is that there is an extensive consultation process. Federal government extensively consults regional governments through various councils and carefully evaluate the impact of a proposed mandate on equity. • The reverse could also occur, at least in principle. That is a sub-national governments voluntarily transferring their excess revenue to the central government. In practice, however, obligation for ‘reverse transfers’ creates a major incentive for sub national governments to overstate/increase their expenditure, or to be lax on tax collection. • Revenues from natural resources make matters complicated. There is a debate on whether sub-national government should keep a portion or transfer the entire flow to the central government. This is an issue with large political implications.

15. 2. Why Decentralize? Cont… • Transfers – closely reflect a country’s political system and is inherently political in nature. One way to design an effective transfer system is to focus on the effects on allocative efficiency, distributional equity, and macro stability, rather than on the instruments used to achieve them (Bird and Smarts, 2002). Transfers should not be used to bail-out sub-national units with poor performance and accountability. • Discretionary or negotiated transfers will most often lead to negative outcomes. In Canada, for instance, negotiated or discretionary transfers do not exist at the federal-provincial level. A formula-based transfer system is remains the better alternative. • How to design a better transfer system? There are three factors to consider: • Size of the Distributional pool – fixed percentage of all the central taxes for a specific period (for example, 3-4 years). In Russia, for instance, the amount is set a a percentage of taxes, the percentage is changes each year, causing more uncertainty at the sub-national level. • Basis for distribution – formula-based as opposed to discretionary or negotiated • Conditionality – on the basis that sub-national units will provide certain year-marked services at an acceptable minimum standard (in this case, an unconditional lump-sum transfers may be used); or on the basis that actual funds are spent on the year-marked services (expenditure conditionality). For instance, transfers are conditional upon they being spent on education or health at the sub-national level. Third type is performance conditionality which is based on ‘outputs’ rather than ‘inputs’. The percentage of students entering university rather than the amount spent on education.

16. 2. Why Decentralize? Cont… Why institutions matter? • Institutions are the ‘rules of the game’ which include, inter alia, both formal and informal rules such as legal edict, procedures, incentives & constraints, ethos, and conventions, etc. Institutions should encourage trials and eliminate errors. For example, a system of decentralized decision-making will allow a society to explore a number of alternatives of solving problems. • In the present context, institutions should provide proper incentives and reduce moral hazard. Sub-national borrowing is an important case in point. Since it is difficult to introduce formal bankruptcy procedures in the public sector, other institutional mechanisms may be introduced to limit sub-national borrowing. Politically important sub-national units may continue to borrow. Some constraints and procedures could be introduced such as: • Explicit prior approval; requirement for regular and full information of sub-national borrowing to the public; credible reviews and control systems; monitoring and evaluation (both ex-ante and ex-post); clear and simple bankruptcy procedures, etc. • Establishing explicit criteria for borrowing – such as the system of “traffic lights” in Colombia where sub-national governments could borrow when debt is below a certain threshold but require explicit prior approval when debt levels are higher (Dillinger & Webb, 1998); or “Maastricht criteria” for EU under which deficits and borrowing cannot exceed certain numerical limits (Bird, 2002). Similar mechanisms will limit recent foreign borrowing (Eurobonds) by some sub-national governments in Russia. • Organizational reforms with proper incentives which discourage inefficiency and corruption. Ex: recruitments based on merit; promotions based on performance and not on seniority • More ‘formal’ role for citizens. Example introducing ‘participatory budgeting’ where the public has a role to play at each crucial level of budget formulation. Example: St. Petersburg City Government where citizens involvement in the budget formulation has been effective.

17. 3. What can we learn from history? • Tolstoy said that what we learn from history is that we do not learn anything from history. He is wrong. Some general lessons/guidelines could be distilled: • Institutionalize balance of power between national and local governments by putting in place a coherent set of explicit rules in place of hierarchical system of governance. • A stable and transparent system of intergovernmental fiscal relations will require a well-defined institutional framework to resolve conflicts that will arise when assigning expenditure responsibilities among different levels of government. • A well-defined institutional framework will, inter alia, limit moral hazard problems (e.g. unconstrained sub-national borrowing); provide proper incentives; enhance transparency and accountability, and reinforce organizational capacity to implement reforms. • A system of intergovernmental fiscal relations based largely on negotiations, i.e., soft budget constraints, will definitely fail.. • Transfer system should be determined based on fiscal capacity, expenditure needs and tax base. • When decentralizing functions, revenue sources should also be decentralized. In other words, expenditure responsibilities should be matched with revenue resources. • Most importantly, revenue capacities should be matched with political accountability – a goal which seems so far difficult to achieve in Russia. • Decentralizing revenue before expenditure is similar to putting the cart before the horse. Central governments will be left with a smaller revenue base (as in the Philippines) • Central governments are better placed at funding and designing redistributive efforts, while sub-national governments could more effectively implement and administer standardized national policies.

18. 4. Why are intergovernmental reforms important for Russia? • Starkly diverse terrain in terms of resources: Five richest regions – Khanty-Mansisk, Yamalo-Nenets, Tyumen, Tatastan, and Yakutia (Sakha) accounted for about 6% of the population but collected nearly 53% of all regional revenues from taxes, fees, and charges from natural resources (1997 data). A autonomous region in Siberia, Khanty-Mansisk, has 1/50 of the population of Russia, is as big as France in size, and produces 80% of the oil. • Unbridled borrowing powers granted to sub national governments could lead to macro instability. It is not clear yet whether such borrowing (through bonds, veksels) led to August 1998 devaluation. Sub-national governments using borrowed funds for current expenditure (as opposed to capital investment expenditure) could lead to dire macroeconomic and political consequences in the future. • Unfunded mandates which increase vertical (fiscal) imbalance remain a major issue of concern in the intergovernmental budgetary relations in Russia. • Horizontal fiscal imbalance among regions remains another major vexing problem, leading to growing inequality across regions.

19. How will course modules address the three main goals of decentralization? Three Questions How to reduce imbalance? Why institutions matter? Who is doing what? (horizontal and vertical imbalance) Expenditure & Revenue Assignment Political Economy Intergovernmental Grants Module 2 Module 5 Module 7 Local Revenue; Infrastructure Finance Constitutional & legal framework Unfunded Federal Mandates Module 3 Module 6 and 8 Module 11 Budgeting; Credit & Debt Poverty Alleviation & Financing Social Infrastructure Transparency & Accountability Module 13; 13. 1; 13.2.& 13.3 Module 9, 10, 15 & 10.1; 10.2; 10.3. Module 12; 16.1; & 16.2 Measuring Fiscal Decentralization Module 14 Macro Stability & Growth Module 4