Fiscal decentralization is assuming increasing importance in many parts of the world and in the IMF’s policy dialogue with a number of member countries. At the request of members of the Executive Board, the IMF’s Fiscal Affairs Department (FAD) hosted a conference on fiscal decentralization in November to discuss the requirements for effective service delivery, macroeconomic management, and good governance in an increasingly decentralized world.
Opening the conference, IMF Managing Director Horst Köhler called on participants to identify necessary preconditions for successful decentralization. He asked whether decentralization would enhance transparency and accountability at the local government level and whether it would lead to poverty reduction and better macroeconomic management. He also asked how the IMF’s macroeconomic surveillance role should extend to fiscal decentralization, and about cooperation between the IMF and the World Bank and regional development banks in this area.
Vito Tanzi, retiring as Director of FAD, outlined issues to consider when countries decentralize. Dangers exist if decentralization is pursued without correct initial conditions. But acknowledging that decentralization is here to stay in many countries, Tanzi focused on the appropriate sequencing of measures to minimize the risks.
Does decentralization work?
Albert Breton (University of Toronto) made a clear case that intergovernmental competition must be the primary reason for decentralization—to check the self-interest of policymakers and promote the common good. Decentralization can fail, as can markets, and for similar reasons, involving information, coordination, and diminishing supply costs and a race to the bottom.
In his empirical analysis, Daniel Treisman (University of California at Los Angeles) did not find that competition between decentralized jurisdictions created greater efficiency in governance. Countries with more tiers of government tend to have higher perceived corruption and appear more ineffective at service provision. Joachim von Braun of the University of Bonn found that fiscal decentralization in itself is unlikely to benefit the poor without prior—and effective—political and administrative decentralization. In contrast, Tugrul Gurgur and Anwar Shah, both of the World Bank, found that decentralization supports greater accountability and reduced corruption.
In his discussion, Michael Keen (FAD) pointed out that economic outcomes matter and that corruption may not be a deciding factor against decentralization.
Paul Smoke (New York University and Massachusetts Institute of Technology) and Giorgio Brosio (University of Turin) separately reviewed diverse African experiences, identifying preconditions for successful fiscal decentralization. Viable local political mechanisms are needed to determine preferences and to hold governments accountable to their constituents. Local institutional, technical, and managerial capacity is needed to deliver services demanded by their constituents, and local authorities must have access to the financial resources, including their own tax revenues and transfers, to meet their responsibilities. These conditions are only weakly met in many African countries, which tend to have fragile democratic and administrative institutions. Decentralization processes therefore require careful sequencing and implementation.
Ismail Momoniat of the South African Finance Ministry provided a practitioner’s perspective. In South Africa, the center has been able to retain macroeconomic control by setting clear expenditure responsibilities and closely monitoring budgetary processes. He strongly emphasized that budget management, including expenditure monitoring, audits, and accounting, is critical for the success of a decentralized system.
Ehtisham Ahmad and Ali Mansoor (both of FAD) argued that the current “big bang” decentralization process in Indonesia has been motivated by the political reaction to the end of decades of highly centralized rule. The local emphasis is more on control over natural resources than on effective local service delivery. The absence of effective sequencing poses risks not just to the decentralization process itself but to macroeconomic stability and interregional equity.
Decentralization in India has been a more gradual process, according to Govinda Rao (Institute for Social and Economic Change, Bangalore). The overall deficit, at around 15 percent of GDP, is considerably higher than that excluding district governments. A growing mismatch between expenditure and revenue assignments needs correction. Discussant Ke-young Chu (FAD) pointed to the importance of properly evaluating subnational finances to determine the extent of fiscal deficits and vulnerability.
José Afonso (Brazilian National Development Bank) and Luiz de Mello (FAD) described the most recent fiscal decentralization reforms in Brazil, which concentrated on strengthening the role of third-tier governments (municipalities) in service delivery. These reforms have strengthened revenue sources at subnational levels, but the center took a stronger role in financing key social services (health and education) to achieve equity objectives. The country’s fiscal responsibility act has been instrumental in restoring subnational fiscal discipline by limiting expenditures and borrowing.
Ernesto Rezk (University of Cordoba and Ministry of Finance, Argentina) reviewed the Argentine experience of decentralization with a currency board arrangement. Inappropriate borrowing by provincial governments was based on the ability of subnational administrations to use future shared revenues as collateral for bank loans. Juan-Pablo Jimenez (Ministry of Economy, Argentina) also focused on local government borrowing and the efforts of the administration to implement a subnational fiscal responsibility law and a program of fiscal adjustment and financial restructuring. The discussant, Teresa Ter-Minassian of the IMF’s Western Hemisphere Department, also described some of the decentralization issues that had featured in the IMF’s policy discussions with both Brazil and Argentina.
Jorge Martinez-Vazquez (Georgia State University), John Norregaard (FAD), and Era Dabla-Norris (IMF Institute) focused on Russia, Ukraine, and Kazakhstan; and Jean-Jacques Dethier (World Bank) described the decentralization process in Hungary and Slovakia. These countries tend to show unclear assignments of tax and expenditure responsibilities, they emphasized.
Alexei Lavrov (Russian Ministry of Finance) and John Litwack and Douglas Sutherland (both from the Organization for Economic Cooperation and Development) examined the conditions necessary to make decentralization work in Russia. This assessment had clear parallels with the Chinese case—examined by Ehtisham Ahmad, Li Keping (State Council, China), and Tom Richardson (IMF European II Department). Both papers argued for a centralization of social responsibilities, especially pensions and unemployment insurance; a redefinition of tax assignments; and a proper system of equalization transfers to permit lower administrations to effectively address truly local functions, such as education and health care.
Christine Wallich (Asian Development Bank and World Bank) saw a common trend toward some recentralization, both to ensure macroeconomic stability and to allow central governments to address equity and concerns over nation building and preservation. However, powerful rich regions and provinces could block such trends, she noted. The success of the reforms depends on three assumptions—an effective central tax administration, adequate fiscal resources to finance centralized expenditures and equalization transfer, and local hard budget constraints.
The European Union session included papers on Italy (Piero Giarda, Italian Treasury), Spain (Julio Vinuela, FAD), and Germany (Paul Bernd Spahn, University of Frankfurt). The extent of regional equalization is strongly influenced by national characteristics and history. In Germany, the constitution mandates a high degree of “horizontal” equalization through a system of transfers between states, reflecting the German espousal of uniform standards and readiness to share wealth. Spanish decentralization sought to ease the democratic transition and reduce centrifugal tendencies in some regions. This has led to an asymmetric treatment of regions. Well-off Italian regions also benefit from similar asymmetries. Pierre Salmon (University of Bourgogne) addressed the scope of decentralization in the European Union, given the addition of the supranational layer in Brussels. His paper suggested issues that might be relevant in country and regional surveillance by the IMF.
In the concluding roundtable, Tanzi stated that he was not against decentralization per se, and that where countries are already decentralized it was imperative to seek ways to make it work. However, in setting out on this path, countries needed to be careful about sequencing and implementation.
Robert Ebel (World Bank) stressed that decentralization can bring substantial benefits in governance and economic management. Piero Giarda emphasized that assigning own tax revenue sources to each level of government is particularly important. Successful decentralized systems contain mechanisms for coordination and competition between governments.
Ismail Momoniat argued that a strong central government is needed to regulate and monitor intergovernmental competition and take responsibility for equalization. It should also assist in providing effective public expenditure management systems—including budgeting, classifications, accounting, and audit mechanisms. He stressed the need for technical assistance in these areas. Ehtisham Ahmad suggested that a few principles appear to be generally applicable. Successful systems need to foster transparency and accountability and should be simple and comprehensible. Wherever the political environment allows, the design and implementation of reform programs should be gradual and carefully sequenced. The sequencing should take account of administrative capability—the assignment of function should follow the existence of capacity and should precede the assignment of revenues.