Chapter

chapter fifteen Intergovernmental Fiscal Management

Author(s):
A. Premchand
Published Date:
March 1989
Share
  • ShareShare
Show Summary Details

So foul a sky clears not without a storm

SHAKESPEARE, King John (Act. IV, sc.2)

State and local governments may be inclined to the view that their own budgetary activities have minimal effects on the national economy. But their role, always important, has become crucial during recent periods and the combined financial decisions and fiscal behavior of all of them have a powerful impact on the economy. It follows, therefore, that greater attention needs to be paid to their role, to the broad relationships between the central and other strata, and to the problems of intergovernmental fiscal management. Traditionally, these problems were studied as a part of “federal finance,” which, in fact, paid more attention to the legal and constitutional aspects of the revenue sharing arrangements than to the numerous facets of budgetary or fiscal management.1 While those facets continue to be important, the focus of this chapter is limited and is concerned with the role of the state and local finances in economic management, the instruments available to the center to transfer resources and to ensure fiscal discipline, and consideration of the issues in each sphere.

Division of Responsibilities

The division of responsibilities between the central, state, and local governments has always been one of the major problems that have for a long time intrigued students of both constitutions and economics. Although in the final analysis the functions and resources allocated to these three levels of government may be decided by political expediencies, consideration of economic efficiency also plays a substantial role. The economic rationale for the division of responsibilities can best be examined as concerns of supply, demand, distribution, and macroeconomic management.

The supply aspect deals with the provision of public and merit goods and services and is primarily considered in terms of the externalities and economies of scale involved in their provision. Externalities occur when a good produces benefits or costs that accrue to other jurisdictions, as well as to the residents of the supplying jurisdictions. Such externalities may lead to a tendency on the part of taxpayers to reduce their expenditures in order not to incur expenses for services that benefit other areas. In due course, this would contribute to a reduced supply of public goods and services. To avoid such situations and to sustain the supply of public goods at the level required, two measures are envisaged. The first is the traditional administrative solution to centralize the allocative responsibility for all public goods and services with significant externalities. Such centralization will enable the relevant level of government to incorporate the externalities. From a more mundane point of view, it could be argued that, irrespective of the concern of the taxpayer about the spillover of the benefits of his contributions, certain services may have to be centralized as they are best rendered on a national scale (e.g., defense). The second measure is to provide a grant from a common pool to compensate the recipient jurisdictions for the externalities and to induce an increased supply of public goods and services. Another factor that provides added strength for a greater degree of centralization is the economies of scale. Where there are major investments for providing commodities and services, it is desirable that the latter be organized on a scale so that costs per unit decline as output increases. Production of power, transportation, and communication facilities are provided more efficaciously when they are organized on a national or regional basis instead of on the basis of smaller jurisdictions.

Consideration of the supply factors will, however, have to be tempered by a recognition of the demand side factors, which are equally forceful. The most important consideration is that responsibilities should be so divided that the public will perceive the link between the demand for additional public services and the need for bearing their costs. Viewed from this angle, the decentralized government levels such as state and local have distinct advantages over national levels, particularly in large countries with populations that are divided by language and other factors. Decentralized services have, in theory, better opportunities to reflect the choice and diversity of needs. Preferences for public goods vary among regions and the decentralized government levels, being closer to the people, are more competent in deciding the most appropriate means for providing services. Such close links have the potential for inducing greater involvement of the taxpaying public. The close involvement is not, however, without its problems and brings with it the full play of public interest economics. It may be difficult, for example, for regional and local governments to resist pressures of the economically powerful local groups whose influence may lead to increased expenditures, to the adoption of priorities that may have deleterious effects on contiguous areas and are in conflict with the policy approaches of the national governments, or to considerable reductions in services in selected areas despite a demand for such services. Another limitation is that, if a state or local government were to decide to borrow from the public or from financial institutions, its credit ratings will probably be far less favorable than those of the national government. Some elements of the demand side, therefore, offset the centralizing influences emanating from the supply side, while the play of the power groups and borrowing creditworthiness support a greater degree of centralization.

If expenditures are decentralized to meet demand side considerations, this also implies that each level of government would have to be given its own distinctive revenue sources corresponding to its expenditure responsibilities. But resource endowments, both natural and financial, differ from region to region for historical reasons and, consequently, regional imbalances are a normal feature of reality. These imbalances reflect development already in the regions and may be further accentuated by the fact that opportunities for growth depend on the physical location of resources. The possible reduction in these inequalities requires that, if the ideal of revenue resources corresponding to expenditure functions is to be achieved, central pools be established to make transfers to backward regions. The aim of society is to provide a service, as well as to ensure a certain uniformity in providing such a service to the recipients. The goals of uniformity of services and reduced inequality among regions imply that revenue resources would have to be allocated to each government level in terms of its requirements and there would also have to be central pools of resources to redress the remaining imbalances. The specification of revenue resources for different levels is also needed for another reason. Nonspecification would lead to each level competing with another government at the same level for common revenue sources—a course that might lead to the erosion of each other's tax base. These approaches may lead to firmly entrenched beggar-my-neighbor policies and to situations where some regions will be “islands of prosperity.”

From a macroeconomic management point of view, the major consideration is whether individual governments can coalesce to offer a viable framework to pursue the required policies. Or can these policies be better pursued at a central or a national level of government? Two factors seem to work against a possible coalition of regional and state levels of government. First, because resource levels are different, each region will pursue policies that are conditioned by its resource endowments. Apart from the accentuation of inequalities that will inevitably follow such pursuits, it implies that more resources will induce more expenditures and it would be difficult to limit their rate of growth, if this were desired. Second, the priorities of expenditures will also be subject to influence by the pressure groups, which, in some cases, may be contrary to national ambitions. The management of the economy, therefore, implies a greater involvement at the national level of government. But if that level is not to become a unitary form of government, its role in macroeconomic management should be predicated on the premise that viable regional and local governments are essential in view of their dominant role in the demand group factors. A country's financial arrangements ideally should recognize the supply side economies, the multilevel decision making associated with the demand for and provision of services, and should give proper weight to distributional and economic management aims.

Financial Relationships

Financial arrangements in various industrial and developing countries reveal different combinations of the above factors and the attempts at reconciling economic compulsions and their political acceptability. Two basic types of arrangement may be distinguished—aggregative and devolutionary. In some countries, notably in the United States, federal financial arrangements were the result of the aggregation of different regions that agreed on the division of revenue resources and related expenditure responsibilities. In evolving these arrangements, there were numerous conflicts between the “centralizers” and “provincialists,” which, although gradually smoothed out, left an indelible impression on the division of financial resources. In other countries financial arrangements of a federal type evolved through a process of devolution. Reflecting the legacy of the centralized administrations associated with colonial rule, these countries have financially strong central governments that dominate the regional and state governments in all financial aspects. There is a third group of countries where there are only central and local governments in which characteristically the local governments have only minor sources of revenue but major responsibilities for expenditure. In all groups of countries, however, the responsibility for macroeconomic management is with the central government. The main differences among these groups are to be found in the financial arrangements for raising revenues and expenditures.

Among the aggregative type of federations a distinction may also be made between countries where federal expenditures are substantially more than total expenditures of regional and local governments, and countries where federal outlays are less than the regional and local outlays. In the United States, total expenditures of state and local governments are less than half of federal government expenditures. In the Federal Republic of Germany and Canada, federal expenditures are less than the combined outlays of the state and local governments. In Australia half the total expenditures are incurred by the federal government and the other half by state and local governments. Among the countries that have devolutionary financial arrangements (India, for example), half of total expenditures is incurred by the state and local governments. The significance of these amounts is to be seen more in terms of the role that state and local governments play in the overall economy.

From the central government's viewpoint, state and local expenditures are financed in three ways—by revenue sharing, grants, and loans. In Australia, Canada, India, the Federal Republic of Germany, and Nigeria, for example, there are revenues that are levied and collected by the respective levels of government. There are also levies such as income tax that are imposed and collected by federal governments and the proceeds distributed to states under specified formulas included in the constitution, through quasi-judicial committees, which arbitrate on the claims of the central and state governments, or by voluntary agreements between the central and the state authorities. These revenue-sharing arrangements provide most of the resources of state governments. Federal governments also give grants-in-aid for general or specific purposes to state and local governments. In some countries, loans are also provided by the central governments to other levels of government. In countries that only have local governments, the practice of revenue sharing is much rarer,2 and the general practice is for local governments to receive block and specific grants from the central governments. For this study, however, it is not necessary to discuss the revenue-sharing arrangements, as, from the point of view of budget decision making, these are determined exogenously for both central and state governments and remain relatively stable over a given period. Of greater importance are the discretionary transfers made from the central government.

Transfers from the central government reveal the mutual degree of dependence of the central on state and local governments for implementing programs of a national character, and the dependence of state and local governments on the central government for finances. In some countries, notably in Denmark, nearly half the total central government expenditures is for transfers to local governments. In Australia about a third of the federal government expenditure is for transfers to state governments, while in India, Korea, and the Netherlands, a fourth of the central government outlays is for local authorities. In Canada, Italy, Sweden, Sudan, Thailand, the United Kingdom, and the United States, the transfers range from 10 to 20 percent of the central or federal outlays. Data for these countries are provided in Table 27 for 1972–78. A feature of some importance is that, even in countries where the combined outlays of the state and local governments are more than the outlays of the center (Canada and the Federal Republic of Germany), or where they are about the same, the transfers from the center still have a prominent place. A similar type of relationship is also found between the state and local governments in countries that have a three-tier government structure.

Table 27.Selected Countries: Transfers from Central Government to Other Levels of Government, 1972–781As percent of total expenditure and net lending
Countries1972197319741975197619771978
Industrial countries
Australia25.926.627.328.531.731.031.8
Canada19.919.121.820.820.7
Denmark39.543.842.241.9
Finland13.514.815.015.716.817.619.2
Germany, Fed. Rep.8.47.88.37.67.57.57.9
Italy8.410.111.515.312.319.1
Netherlands25.328.328.729.629.128.8
Sweden15.017.216.416.215.315.715.5
United Kingdom14.916.414.917.418.517.416.4
United States13.314.713.312.713.714.414.6
Developing countries
India23.924.323.424.725.1
Korea27.828.221.221.620.120.119.7
Sudan8.919.223.616.019.316.118.9
Thailand11.710.712.617.518.612.113.3
Source: International Monetary Fund. Government Finance Statistics Yearbook, Vol. 4 (Washington, 1980).

These transfers include taxes collected in an agency capacity and all types of grants on current and capital accounts.

Source: International Monetary Fund. Government Finance Statistics Yearbook, Vol. 4 (Washington, 1980).

These transfers include taxes collected in an agency capacity and all types of grants on current and capital accounts.

The prevailing financial arrangements and the existence of systems with extensive conditional transfers illustrate that practices are far different from the picture of perfect congruence between spending responsibilities and revenue resources. The revenue resources left to the discretion of the state and local governments are often much less than their expenditure needs and are, also, often inelastic. This factor alone has contributed to the growth of financial dependence of state and local governments on central authorities. This dependence has tended to increase during periods of inflation, when lower levels of government are caught in a scissors' effect—when their revenues, being specific and inelastic, do not increase as a consequence of inflation and their expenditures, being more labor intensive, are dominated by the behavior of wage rates and the prices of private goods and services and tend to move with inflation rates.3

The inherent fiscal imbalance in the allocation of revenue resources is further compounded by the dynamics of the day-to-day working of the administrative systems of government. There have been shifts in government functions from one level to another and changes in the relative importance of government functions; these changes were not automatically matched by changes in the tax base assigned or in the tax revenues apportioned to each level. Activities of state and local governments have increased significantly, some on their initiative and some in response to the tasks faced by the central governments. Some of the new functions assumed by national governments soon found their counterparts at other levels, and some functions were shifted from the former to the latter levels. Some of the activities of local governments, even when these were conventional activities, implied higher financing needs because the costs of these local governments were influenced by decisions of central authorities. National wage rates were generally evolved with reference to central government resource structures and the capacity to pay. These wage rates, however, spur demands for increased wages at state and local levels and very soon these levels find themselves spending more for the same services. The above factors tend to increase state and local financial responsibilities without providing a corresponding increase in their revenue resources. In turn, these increases lead to more transfers from the central government. The growth in transfers also reflects the more serious pursuit by central governments of equalization goals and the changes in their financial status. Central governments with more elastic revenues have been obliged to transfer some of their inflation gains and gains from the real growth in the economy to the state and local levels. In sum, the alterations in size and the real developments in the economy and government functions altered the relationships between central and state governments. The manifestation of these changes is found in the magnitude of the intergovernmental fiscal transfers. Independent country studies4 suggest that the fiscal transfers from central governments have grown both in relation to GNP and to central revenues and expenditures. The administrative nature of these transfers, however, has undergone some changes, as in some countries the transfers were mostly for special purposes or were conditional as a result of central initiatives or as part of common financing of development plans. In some countries, however, the conditional grants play a minor role and the transfers for the most part are in the form of bulk grants. The growth of fiscal imbalance and the financial dependence of state and local governments on central government caused changes in the approaches to budgetary decision making.

Approaches to Budgetary Decision Making

The nature of the financial relationships generates different value systems both at the giving and receiving ends. The differences reflect the structural fiscal imbalance between the central and regional and state governments and may be analyzed in terms of the approaches of the central government and those of the regional and local governments. The interests of the central government arise from its responsibility for macroeconomic management and as an agency providing a major part of the resources of the state and local governments. From the point of view of macroeconomic management, the central level seeks a voice in the determination of total expenditures of other levels. It has, however, no independent voice as long as the lower levels of government have attained a balance between their expenditure requirements and revenue resources. However, as this balance is rarely attained from within their own means, the provision of funds permits an opportunity, at least in theory, for the central government to influence the size of expenditures at the lower levels. The relationship in this respect is different from the government's link with its own enterprises. All or most of the capital for enterprises is provided by the government and ownership provides them with the rights of management and related controls. No such rights exist in their operations with state and local governments, for they are endowed with a major degree of coercive power for the levy and collection of taxes and freedom of operations in incurring expenditures. The option available to the central government for influencing the operations of other levels of government is at best marginal and has no legal enforceability about it. The central government may withdraw its resources or reduce them but neither of these approaches may have the desired effect as long as other levels of government may substitute their own resources to finance their chosen level of operations. This is not to imply, however, that the central government should choose a course of inaction. On the contrary, it suggests that macroeconomic objectives are better achieved not by unilateral action, but by coordinated activity. As a provider of grants, central governments play a more active role in ensuring allocative efficiency.5 Provision of conditional or specific grants implies much more attention to the detailed allocation of resources. Also, the central government as a grantor is entitled to require, as it is paying for benefits received, that its funds be used efficiently and to exercise controls over the grantee's operations of all supported programs. These program controls are functional and administrative in nature and have less relevance for macroeconomic management.

The achievement of macroeconomic management objectives assumes that the implications of such objectives are clear to the grantors and that such objectives have, in some degree, been formalized in operational terms. Specifically, this requires that the objectives be translated in terms of increased or reduced programs for the central spending departments. At a higher level, a decision has to be made whether such approaches will be appropriate to maintain the balance between central and regional governments. Experience indicates that neither is given due consideration. The track record for central governments in anticipating the requirements of macroeconomic management and the articulation of related policies is not an enviable one. It appears that the lower levels of government receive conflicting and confusing signals. On one hand, they are urged by central agencies to increase their expenditures even when the central administrative agencies are not yet ready with programs to use such funds. On the other hand, they may urge the state and local authorities to limit their total expenditure, while, at the same time, individual departments demand they give greater priority to particular services and to spend more.6 These conflicts, which are frequently pointed out to the embarrassment of central governments, reveal the extent to which further progress has to be made to develop a more consistent approach toward the lower levels of government. This type of problem does not, however, occur in the financial relationships between state and local governments. Unlike central governments, states are more circumscribed by financial than by economic constraints and their concerns are more with allocation than with stabilization aspects.

The effects of financial imbalance on the approaches of state and local governments are far more significant and extensive and ramify their whole budgetary process. First, the degree of financial dependence on the center is directly indicative of the pivotal role that transfers play in the financial and budgetary plans of the government. The constraint is felt both at the program and aggregate level. Expenditure priorities are determined at the granting level, which, depending on the level of transfers, may even suggest that the budgets of the lower levels of government are formulated by the grantor rather than by the recipient. Some suggest that the constraint may have an unfortunate impact, as greater central control may weaken the sense of local responsibility.7 This is an arguable point.

Experience in the United States and India suggests that greater dependence on central government, far from lessening the responsibility, has engendered a competitive atmosphere for obtaining more funds from the center. The acquisition of grants has become a political status symbol and has gained considerable visibility. States and local governments vie with each other to increase their share of grants, and grantsmanship, defined as the capacity to obtain more resources, has become an art form. More energy is devoted to obtaining grants as they tend to become an easier option than raising resources. In India, where central grants are given to lessen backwardness, a vested interest in backwardness has appeared and each state provides data to claim that it is more backward than others. Although similar resource constraints apply to public enterprises as well, the approaches of the state and local governments differ from them. Public enterprises do not generally compete among themselves in the same sector and, thus, each one is financed from funds set apart for sectors. The states, however, compete for a given sum and are engaged in playing a zero-sum game, for any gain to one state implies a reduced allocation to the others. These approaches are also applicable to revenue-sharing arrangements. The competition is no less even when financial adjustments are made through quasi-judicial agencies, except that the arena shifts from the government to those agencies.

Use of the grants at the receiving end requires preplanning for the use and installation of systems and procedures that would ensure their quick utilization. The experience of the United States shows that special budgetary procedures were used for grants and these were shown separately in the budget to provide the much needed visibility.8 Also, several of the normal procedures for budgetary allocations were scrapped and grants were obtained through a highly politicized process. A similar experience is also found in India, although in using the grant proceeds no distinction was made between states' own revenues and other grants.

Fiscal Management

The overall responsibility of central governments for economic coordination and fiscal management can be translated into material action programs only when relevant provisions of funds or legislation are included in the budgets of the state and local governments. Such action programs need to be examined in terms of mobilization of revenue resources, expenditure management, and government borrowing at the respective levels of central, state, and local governments. In analyzing these, the policy concerns of governments in developing countries for raising more revenues and for devoting them to growth, as well as the policy objectives of short-term economic management that dominate the approaches of the industrial countries, need to be kept in mind.

Revenue Management

Revenue planning in the context of mobilization of resources needed for financing development plans is carried out in developing countries by the planning agencies attached to the central government. These agencies estimate the resources needed for the plans and the resources that would become available from existing and additional avenues. These estimates are shown aggregatively and participating governments are free to choose their own methods and also to determine the timing of the measures. The aggregate estimates are frequently revised, together with revisions of expenditure estimates of the plan. This type of revenue planning has numerous weaknesses, some of which have been noted in Chapter 6. The concern here is with the problems of intergovernmental fiscal management that arise because of the existing approaches to revenue planning.

Ideally, revenue planning should imply a detailed consideration of the fiscal capacity and potential of each state in terms of its economic endowments. Determination of these two aspects is, admittedly, difficult even when viewed purely as an economic task. When political aspects are added, which is inevitable, this task becomes even more intractable. Detailed revenue planning, however, is not undertaken, as is evident in India's experience with development plans. Indications of desirable magnitudes and lack of revenue planning have, therefore, contributed to avoidable problems. First, the required resources were not always raised and greater reliance was placed on the easier option of borrowing from the public or financial institutions. Second, the pattern of resource mobilization suggests that indirect taxes such as sales taxes were heavily used, which in some measure contributed to cost-push inflation and reduced available incentives for some types of industries.9 The revision of rates was far from uniform and there was unhealthy competition to attract capital. In the process the tax base of certain categories of taxes was eroded. Also, there were conflicts between the states' views on their own needs and instruments and the views of the center. States tended to levy duties on their major products (such as tea or oil), which was in conflict with national policy objectives of export promotion or development of domestic infrastructure. Such conflicts, unlike those within a government, tend to be public and, before long, the interest groups join in the debate and the eventual compromises become less efficient from an economic point of view. The problems do not entirely rest with just the regional and state governments. The approaches of the center have, on occasion, added to the already tense situation. States contend that the central government generally chooses to raise revenues by taxes, the proceeds of which accrued only to the center, by surcharges, or by nondivisible revenue sources, so that no part of such resources can be shared by states. As for timing, it appears that the measures of the state governments were less responsive to income increases, as their tax base was limited. Even when taxes on consumption could be used to restrict spending, measures were often delayed and, being far from uniform, only contributed to a geographical shifting of consumption from one state to another.

The practices of the industrial countries reveal a different picture. In the United Kingdom, although there is no revenue-sharing arrangement, a grant element is partly determined in terms of a prescribed National Standard Ratable Value and the actual ratable value per capita in each county. The difference between national standards and the estimated ratable value per capita constitutes the basis for estimating the grant. The local authorities, it is assumed, will not be interested in raising more resources than is indicated by the ratable value. This assumption, however, does not always obtain and when the compulsions of spending become stronger, local authorities may exceed the norms and raise revenues, as has been true during the early part of this decade. Such increases could adversely affect incentives and, as the incidence of rates is mainly on local businesses, they could be particularly harmful during recessions. One way in which the local authorities could be dissuaded from taking this action is by a mechanism that would enable local governments to keep the proceeds of the rates only insofar as increases are within the prescribed standards, and to siphon off the increases beyond the norm to the national treasury. However, no such regulatory mechanisms exist.

In the Federal Republic of Germany two thirds of total tax revenue is divisible and this pool includes the principal sources of revenue, such as the wages tax, turnover taxes, income and corporation taxes, and the municipal trade tax. The remaining less productive taxes are allocated in full either to the Federation (mainly consumption taxes) or to the Laender and local authorities. To minimize tax distortions, legislation for a large part of the taxes (excluding property and transaction taxes, which are administered by the Laender governments) is vested exclusively at federal level. Germany, to that extent, represents a deep fiscal imbalance, in that a major part of the total expenditures are incurred by the Laender and local governments but are financed by taxes that are levied, regulated, and controlled at federal levels. In the United States some allocations are made to the lower levels of government from federal tax revenue, but these are small in comparison with the transfers. Resource mobilization is made by the respective governments in their spheres and there is little coordination between them.

Canada has a far more complex system, but the two main elements insofar as revenues are concerned relate, first, to the collection of income taxes in all but one of the provinces and corporation income taxes in all but two of the provinces, and second and to a lesser degree, to the revenue equalization system. The income-tax sharing arrangements have had some major changes since World War II and now provincial taxes are expressed as a percentage of federal income taxes and are collected by the Federal Government. Income and corporation taxes contribute nearly 60 percent of total taxes, and the legislative power controlling them provides enough authority for the Federal Government in Canada. Cash transfers under the revenue equalization system involve a certain amount of revenue planning at a national level, as these transfers attempt to bring the revenues of the recipient states to a level that they would have received if the national average tax rate had been levied on a share of the national tax base equal to the states' share of total population.

In the Netherlands municipalities receive a share of certain national taxes and also the entire proceeds of real estate tax. Among the countries shown in Table 27, in Denmark, Korea, and Sudan, the local authorities only have some minor sources of revenue and, therefore, little or no capacity to pursue revenue mobilization measures that may be contrary to the aims of national fiscal policy. In summary, therefore, arrangements that involve greater centralization of decision making for levying and collecting taxes may prove more conducive for Stabilization purposes; where the state or local governments have independent sources of revenue, there is considerable potential for the pursuit of disparate tax policies. Some of these could, however, be mitigated by specific arrangements for ensuring coordination but their success is predicated on the quality of more detailed revenue planning at all levels.

Features of Grants: Expenditure Management

Expenditure transfers from the central government are varied and give rise to several economic and administrative issues. By the nature of the instrument, grants may be divided into two broad types—general or unconditional grants and categorical or conditional grants. Within these two groups, however, there are variations on a common theme, all of which are illustrated in Table 28. General grants are primarily given for covering the fiscal needs of the recipient governments and, depending on the requirements, may partly be used for equalization purposes. Three types of grants shown in Table 28 and covered under this category are the grants-in-aid for general purposes given in India primarily to meet the deficits on the current account of the state budgets, the bulk grants that have been a feature of the United States and Canada, and the rate support grants in the United Kingdom. The general grants in India are determined for each state on the basis of its claims for the next five-year period; these claims are scrupulously examined in terms of objective criteria by an independent commission whose recommendations are generally binding on the governments. Similar procedures have existed for more than five decades in Australia, where a Commonwealth Grants Commission determines the magnitude of transfers to the claimant states. The grants given in Australia have a notional equalization basis as the standards of selected services are taken into account. In the Indian context, equalization is sought through the development plans, the patterns of their financing, and central investment rather than through general grants-in-aid. Bulk grants in the United States are determined with reference to an apportionment formula that takes into account population and the financial ability of the recipient state.

Table 28.Features of Grants
Type of GrantEconomic PurposeTechnical Features of SystemsFiscal ImpactBudget Management
Financial compensationFiscal needEqualizationPromotion of specific activity or the maintenance of the quality of serviceStatutoryOpen endedClosed endRecurringNonrecurringContract for the provision of a serviceNeutralSubstitutiveAdditiveConventionalNew mechanisms
General
Grants-in-aid for general purposesXXXXXX
Bulk grantsXXXXXXX
Rate support grantsXXXXX1XXX2XX
Conditional
Grants-in-aid for agency functionXXXXXXX
Matching grantsXXXXXXXX
Specific or targeted grantsXXXXXXXX3X3X

These grants tended to be open ended up to 1980 when they were made more definitive.

These grants are generally additive. When the local authorities wish to provide a service at a higher level they can do so by mobilizing their own revenues. To that extent these are substitutive.

Substitutability or additivity is indeterminate in these instances.

These grants tended to be open ended up to 1980 when they were made more definitive.

These grants are generally additive. When the local authorities wish to provide a service at a higher level they can do so by mobilizing their own revenues. To that extent these are substitutive.

Substitutability or additivity is indeterminate in these instances.

A more detailed procedure is followed for the determination of the rate support grant in the United Kingdom. These grants, which play a considerable role in the system of local finance, consist of elements that are intended for financial compensation as well as for meeting fiscal needs, and, therefore, cannot be classified precisely. The two major elements are a domestic rate relief grant and a block grant. The former is relatively simple in its design and is payable to all local agencies to offset the requirement for them to reduce the rate levied on dwellings by an amount determined by the central government. It is based on the principle of financial compensation. The objective of the block grant, on the other hand, is to allocate sufficient monies to every local authority in order to provide similar standards of service for a similar rate of the pound sterling. The amount of the grant is determined by a two-way process. First, the expenditure needs of each county are assessed by relating spending to average costs of services, with adjustments to take account of indicators having a direct effect on the cost of the services, such as scattered population or other factors. The total expenditure thus arrived at is then related to the amount that a local authority could raise through ratable values applicable in their areas. The difference between the two is given as a block grant that is now subject to the overall cash limits of the central government.10

General grants are specified either in the original legislation or in the annual budget appropriations and are definitive in adhering to these limits. To the extent that they are given primarily to compensate for fiscal deficits or even for equalization, resources becoming available to the lower level of government constitute net additions. The question is, however, if the main purpose is to case the financial burden of the state and local governments, whether the same purpose could not be better served through revenue sharing, which may be administratively more simple and less expensive. The limitation of revenue sharing is that the principles of devolution of federally collected tax revenues have a uniform applicability to all the states and cannot be distinguished by the fiscal capacity of the state. Principles such as population base and origin of taxes take into account the fiscal capacity of the state, but once the principles and percentage shares of divisible pools are established they are applied to all states on the same basis. In this event, states that have fiscal surpluses may add to them, while, at the other end of the spectrum, there may be states that will still be in deficit even after receipt of their share of divisible central taxes. Grants, on the other hand, can be tailored to the fiscal capacity of the state and are useful in bringing some states to the national level.

Conditional or categorical transfers are more varied and each instrument is the result of a relatively complex piece of legislation aimed at a particular set of objectives. At an economic level and viewing the problem in its simplest terms, grants for specific purposes reflect the relative prosperity (or the severity of fiscal imbalance) of the grantor, and the presumption that the use of grants will benefit recipient governments and, in due course, will lead to economic development. Conditional transfers are, therefore, viewed as instruments for promoting a specific local economic activity, to demonstrate the usefulness of a particular social or economic approach, or, more often, to implement some tasks in which the grantor has a special interest. Reflecting these aims, grants are made conditional and the specific purposes or the groups that are to be served are stated at the outset. Their fiscal impact is dependent on the nature of the conditional transfer and may not represent net additions to resources for the programmed objective. This may be true when federal grants contribute only a fraction of the state or local resources utilized for the same objectives. It is likely in such situations that central funds are simply substituted for state and local outlays—funds that would otherwise have been used for the same purposes. By the same token, the conditional transfers may not stimulate any economic activity and their very basic objective may be rendered questionable. In some cases, however, these grants are additive in the short run, but it is somewhat indeterminate whether, by making the lower levels of government more dependent on the central authorities, their own capability for raising extra revenues is being underrated. Evidence in this respect is not conclusive and the dilemma between promoting activities that are considered to be additive and those that become substitutive has always influenced the features of the grant system.

The simplest form of a conditional transfer is the grants-in-aid (variously described in different systems) given for agency functions performed by lower levels of government for the federal government. The nature and purpose of the work is specified and the actual costs incurred are reimbursed by the grantor. By their nature they are open ended and technically provide no inducement for state and local governments to economize within their administrations. Although these approaches are quite plausible, the areas for which such grants are provided are few, the amounts involved small, and, on the whole, any damage is likely to be negligible.

A second form of conditional transfer is the matching grant system, which involves cost sharing by the grantor and the grantee and the respective shares are determined with reference to specific formulas that can vary with the fiscal capacity of the recipient level of government.11 Conceptually, matching grants have a number of positive features. To the extent that the cost is shared, the amount received as a grant represents an additional resource and, to that extent, provides an incentive for the grantee to participate actively and to contain aggregate expenditures within specified limits. It also places considerable emphasis on the complementarity between the center, states, and local governments and has an innate capacity to foster collective working toward common goals. As a logical extension of this approach, matching grants are viewed as an ideal instrument to minimize the overlapping and duplication of effort that is inherent in the division of responsibilities among the various levels of government. These advantages, however, appear to have been more than offset by the problems associated with the matching grant system. The Indian experience suggests that problems were faced in the resource management of the matching grant system, as the cash releases by central government were made only toward the end of the year and, meanwhile, states had to borrow extensively to maintain the rate of program implementation. For this reason alone, this system was abandoned in India. Elsewhere, the matching grant system became open ended and, where initial monetary determinations were made, these were soon out of date because of rapidly accelerating inflation. In Denmark the Government opined that the system of matching grants did not give it enough control, as the system was open ended and, therefore, it was replaced by a system of block grants. The system, however, continues in the United States, where the problem primarily relates to the immense complexity of sharing formulas and the extensive conditionality associated with them. During recent years, however, there has been a consolidation of the different matching grants. The success of the matching system depends, to a large extent, on the ability to prevent any excessive spillovers into the central budget and to ensure that the grants are indeed spent for the purposes for which they were intended.

A most common instrument, however, is the conditional grant that now dominates the fiscal tranfers in some countries shown in Table 27. Similar conditional transfers12 are also made from state to local governments. Frequently, the formulas adopted for conditional grants provide weight for an equalization objective and can be varied inversely with the fiscal capacity of the state. Their effectiveness in this regard cannot, however, be assessed without consideration of the working of other transfers. The greater spread of this instrument also implies that, to the extent conditions are unilaterally attached by the grantor, there is, in effect, a shift of decision making to the federal level. The receiving levels may have no option but to take them, even when the services, which are planned on a national level, have little relevance to their needs.13 This kind of distortion could be minimized, however, when the content of the program is also varied to meet the specific requirements of the recipient.

Budgeting for Grants

Federal transfers have gained the reputation of being unpredictable and as having been used, more or less, as an instant aspirin to assuage the feelings of one state and the claims of another and to promote a specific activity in a third. They are seen as being used to heal politically based hypochondriac claims. This image can be reduced and transfers can function meaningfully only when their goals are specified, the forms of grants are chosen with care, and resources are estimated on the basis of objective criteria. Similar care is also needed for the use, control, and evaluation of the monies provided. These factors clearly underscore the need for budgetary planning and management.

Budget planning practices reveal three ways to coordinate expenditure plans between the central and state or local governments. The first refers to a formal and integrated framework in which a composite view is taken on national requirements. In the United Kingdom and Denmark, public expenditure requirements of local governments are prepared annually on a multiyear basis and are revised each year for successive years. Local expenditures are forecast on the basis of central guidelines and are included in public expenditure forecasts by the central government. The estimates included in the forecasts have no legality or enforceability and no sanctions follow if the local authorities fail to conform to the indicated expenditure pattern. A dialogue, however, ensues whenever there are sizable discrepancies between the actual budgets of local authorities and earlier estimates included in the multiyear budgets. The second way refers to a system where multiyear budgets are prepared by the federal, state, and local authorities in terms of mutually agreed economic objectives and are coordinated with each other rather than being formally included in central government financial plans for the future. The German Economic Stability and Growth Law makes the three levels of government observe the requirements of overall economic equilibrium and budget on the basis of the five-year financial plans. To implement this, a financial planning council has been formed with representatives for each government level to make recommendations for the coordination of financial planning at federal, state, and local levels. Actual plans are drawn up independently and coordination is voluntary.14 The third way refers to a less formal and more aggregative type of financial planning where the role of the central government is limited to a broad review of the plan component of expenditures and to a more detailed scrutiny of the projects and programs financed by it. This practice is observed in India, where the current budgets of state governments are reviewed by an independent commission, while the Planning Commission examines the development plans of the states to ensure consistency and feasibility. A common thread through all the systems, however, is the continuing dialogue among governments, which helps to understand the others' intentions and the extent to which finances are likely to flow from the central government to the states.

Budgetary Controls

The relationship between the central, state, or local governments is a delicate one and that alone is an adequate reason for evolving control techniques that are different from those adopted toward the spending agencies and public enterprises. Intergovernmental control systems are rendered even more vulnerable due to two different problems: (a) problems associated with achieving objectives through activities once or twice removed from the decision maker and (b) problems of administering the process within severe time constraints and under constant political pressures. Both these factors have influenced the design of the grant systems, as well as the features of the formal controls exercised.15 Grants such as the matching type have been evolved to stimulate local enthusiasm and to create a participatory role for local authorities. This offers only limited opportunities to ensure the fulfillment of the program objectives for which finances have been provided and which are, therefore, supplemented by different control mechanisms. These control mechanisms are generally more passive and rely, to a very great extent, on moderating the releases of cash and on obtaining reports about their use. Controls to release funds provide safeguards against their immobilization but are not positive in ensuring their implementation or in changing the course of action, if necessary. The usefulness of the reports is limited to information and even in this regard its success is dependent on the compliance shown by other levels of government. On the whole, controls exercised by the central government are indirect and rely more on the complementary role of other governments in the hope that what is not accountable to them will become accountable to the respective legislatures or county councils.16 This is evident from the commonly observed phenomenon that grants are rarely terminated even when they are inefficiently used. The use of control mechanisms is clearly restrained by the fear that their repercussions will extend beyond the financial sphere to the whole of the community. Where joint financing is involved (as in the Federal Republic of Germany) or where loans are raised jointly (as in the United Kingdom), controls can, in theory, be powerful, for they determine, within narrow limits, the annual amounts that local authorities may allot for capital formation purposes. These controls, too, are financial in nature and depend on hopes that the local authorities will ensure their proper use.17

Issues in Grant Management

The operational aspects of grant management have raised many issues, some technical, some fundamental. To consider the former first, the recipient governments complain that the formulas to determine grants are not updated frequently enough, with the consequence that some of them are adversely affected. This view is based on solid experience and underlines the fact that no formula, however scientific, is permanent and needs to be revised to reflect changing requirements. More important, the working of some of the formulas may be biased toward increasing expenditure and, therefore, need continual assessment.18 Second, negotiations for obtaining grants take too long, lack finality, and, therefore, generate uncertainty on budgetary outcomes. Third, it is suggested that the formulation of mandatory yardsticks, planning and programming procedures, and guidance circulars and instruction manuals impose many restrictions on the use of funds, and these standards are uniformly applied without considering the additional cost that their compliance will involve for some levels of government. Frequently, the insistence on these standards is seen as an excuse to intervene in the affairs of the lower levels of government. Experience in many countries shows that the controlling zeal of the central administrative departments to regulate may have the same effect on the recipient government as the government regulation of business. While some of these criticisms are exaggerated, there is also a substantial undercurrent pointing up the necessity for simpler administrative procedures.

Viewed from the grantor's point of view, a common difficulty is that all financial problems appear to finally land on the grantor, for the reason that there is no effective control to ensure that the lower levels of government adhere to the original estimates or the grant. Consequently, grants that are open ended, such as the central assistance provided for plan purposes in India or the rate support grant system in the United Kingdom prior to 1980, tend to increase expenditures at the center. In both countries the state and local governments had every incentive to spend more and their increased requirements had to be finally met, by loans in India and by additional grants in the United Kingdom. To the extent that transfers of this type dominated the budget, in effect it meant that the budgetary outcome of the central government was dependent on the actions of other levels of government.

The more fundamental problem of the management of grants, as seen from the center's view as well as from the view of the receiving end, relates to the stability in the size of the grant. It is the contention of the lower level governments that their short- and medium-term expenditures are determined by the level of the grants provided by the central governments, and that any changes in these levels, once indicated, will have grave repercussions on the quality of the services provided. This viewpoint is not by any means a unique one; indeed, as has been repeatedly stated earlier, this is a common refrain of spending departments and public enterprises. This view is only natural, for each government level and agency is concerned with its own financial needs and is less mindful of the aggregate impact of such demands on the economy. Unlike grievances of the agencies, however, the demands of state and local governments have greater political overtones. The attitudes of these authorities undergo some changes depending on the economic climate. When the economy is growing and prosperity is being experienced by all levels of government, albeit in differing degrees, the rising tide lifts all boats. In such a context, the concerns of state and local governments are directed more toward the distribution by the central pool than toward the absolute size of the grants received by them. When the economy is stagnating or declining, their endeavors are directed more toward the protection of the size of the grant they had been receiving earlier. When the economy is stagnating and inflation is accelerating, then protective endeavors become even stronger. Some elements of the federal transfers, particularly statutory ones, are generally insulated against annual changes. Specific and conditional grants, however, are dependent not only on the broad policy intentions of the granting government but also on the economic and financial constraints of that level and they are, therefore, liable to vary. If state and local governments are to be protected from the influences of those constraints, the burden of adjustment should shift to the grantor. Such a course may not be possible, even if the argument is conceded in principle, for the reason that the transfers may be the dominant feature of the federal budget and, once excluded, there would be little left for making the adjustments. The U.K. Layfield Committee suggested a variation on this theme; its view was that a limit should be placed on the grant payable so that the local authorities could realize the extent to which they could draw on national resources. This approach has, however, the same limitation as noted above, for the limits would become immutable, thus preventing further adjustment. It is arguable whether more operational freedom be provided for the central authorities in view of their responsibility for fiscal management or for the local authority in view of their proximity to the public. In any event, the choice cannot be made by economic factors alone. It is apparent that central governments consider necessary changes in the size of new transfers, while state and local authorities tend to believe all such exercises to be metaphors for the search of new control mechanisms.

Borrowing

The magnitude of borrowing by state and local authorities is important not only as a barometer of the financial condition but also as a factor in macroeconomic management. In the Federal Republic of Germany, for example, borrowing by the local authorities, which was responsible for about two thirds of public investment, was a matter of grave concern and the 1969 finance reform was directed at establishing improved procedures for borrowing. In India unplanned borrowing by the state governments through extensive overdrafts from the Reserve Bank of India has been a continuing source of fiscal instability for more than two decades. The institutional arrangements for borrowing by state and local governments reveal two approaches—total freedom, on the one hand, and coordinated and centrally controlled programs, on the other.

In the United States, states are prohibited from borrowing to cover operating expenses. They may, however, borrow for capital expenditures—an avenue that was exploited more by them than by the Federal Government, as was evident during the 20-year period from 1959. During this time, the state and local debt grew at an average annual rate of about 8 percent, while the federal debt grew at an average of a little more than 5 percent. In France the public works programs of local authorities are financed by loans from the Caisse des Dépôts et Consignations, which manages the funds from the national chains of savings banks. They may also borrow from other quasi-public credit institutions and under strict conditions from commercial banks or the market. More important, the Prefect of each administrative zone is expected to exercise controls to prevent local authorities from incurring budgetary deficits.19 In the Federal Republic of Germany borrowing by the states and local authorities (as well as by the Federal Government) has to be approved and the timing of issues coordinated by the Financial Loans Committee (represented by the three levels of government) and the central bank. In the Netherlands the local governments can borrow up to a specified proportion of their budget, but the central government reserves the right to impose controls if they are considered essential. The capital expenditure of the municipalities, except housing, is funded by loans from the Bank of the Netherlands Municipalities. In Denmark local authorities can borrow within limits set by the central government. In Australia the combined borrowing of the Commonwealth and state governments is decided by a loans committee (represented by the two levels), which also agrees on the apportionment of the proceeds. In India the states are technically empowered to borrow from the market, but the amount of borrowing and the timing of issues are determined in consultation with the central bank and the central government. The National Loans Fund in the United Kingdom is responsible for raising loans both for the central and local governments.

Independent borrowing by the states and local governments has both positive and negative aspects. In a positive way, borrowing encourages the states to cultivate the markets and to develop them. In theory, it could also generate greater financial responsibility. There is, however, no guarantee that such responsibility will always be used wisely and experience suggests that excessive reliance on borrowing, which anyway is considered as an acceptable expedient and a preferred political alternative to taxation, may promote undesirable competition for loanable funds within the public realm and increase interest rates. This, in turn, may work against the stabilization objectives of government. More important, states that are economically less developed and have no capital markets may find it difficult to have their loans contributed. These negative aspects have dominated the government outlook and it is for these reasons that efforts are made for coordination of debt issues. Centralized borrowing, which represents a sophisticated form of institutionalized coordination is considered appropriate for stabilization purposes, for it enables the central government to keep a firm hand on the tiller. The distribution of the amounts so borrowed, however, becomes a political issue and, as experience suggests, could even be subject to threats by some states of separation from the federation. When the debate shifts to the political level, the relatively technical considerations of economic stabilization pursued by the fiscal troglodytes receive short shrift.

Another source of borrowing by the state and local governments is from the central government itself. In some countries, for example, France, Denmark, and the United States, there is no lending by the central government to the state and local authorities. Such loans are, however, quite substantial in Australia, Canada, and the United Kingdom, and represent loans organized by the central governments on a central basis for purposes such as housing and hospitals. In developing countries loans arise in the context of on-lending funds received from aid agencies from abroad. Central lending in India, however, is different and essentially reflects common financial resources organized by the central government for financing the development plans. The transfer of resources, therefore, is by both loans and grants. During the first four plan periods such loans were substantial and a stage was reached when the repayments by the states was largely arranged by fresh borrowing from the center. Thus, amortization became a technical accounting matter rather than a fiscal issue. This situation was the result of policies of providing funds without first determining the relative shares of loan and grant elements and, in some measure, was due to a lack of inquiry into the productivity and repayment capacities of the projects and programs financed by loans. The Indian states viewed these loans as an easier option for financing their own budget deficits. They also resorted to sizable overdrafts from the central bank, which, in turn, contributed to considerable credit expansion. The Indian authorities considered three options for avoiding resort to inflationary financing by the states. One option that was utilized from the beginning of the planning period was to consider the state budgets at a preliminary stage and agree on the size of the budgetary deficits. This practice, which still continues, has not proved of much avail, as the actual budgets and their outcomes have usually differed from the agreed ones. A second course available to the government was to establish a separate bank from which states could borrow for financing projects. This was expected to ensure the financing of only those projects that are economically viable and, therefore, to fulfill the financial obligations. This step was not considered appropriate, as it effectively converted an intergovernmental relationship into a commercial transaction between a bank and its clients. There was also apprehension that a part of the planning process itself would be shifted from government to the banks. The third option was to place restrictions on overdraft facilities—an approach that was adopted by the Government and was sought to be implemented many times but to date with negligible effect.20

Central borrowing, however, raises an important question: when and in what circumstances should there be lending from the center to the state and local authorities? Lending by the center from its own resources implies that it has more resources than are needed for its purposes. If such a presumption is correct, it may be more appropriate to reallocate the prosperity of the center so that the severity of the fiscal imbalance at the lower levels of government can be reduced. This, however, is not true, for the loans given to the states represent the borrowed resources of the central government. It may then be argued that if the resources transferred to lower levels of government are from public borrowing, a more appropriate course may be to make the states direct partners in borrowing from the public, instead of providing the central government with more control, by channeling the loan proceeds through its budget. This viewpoint gains added strength where states are borrowing from the public anyway.

Problem-Solving Approaches

The preceding analysis indicates that anything approaching uniformity cannot always be attained in a diversified universe. The responsibilities for macroeconomic management are, however, as much facts of life as the Atlantic Ocean is a fact. The key issue is how can these responsibilities be fulfilled with minimum distortions while being consistent with the division of responsibilities envisaged in the constitutions? In answering this question, it should be remembered that a system of well-distributed responsibility by itself will not promote stabilization but will have to be preceded by an appropriate set of policies. It is, therefore, assumed here that such policies are pursued and that the issue is one of ensuring improved liaison among the three levels of government.

The first solution, which is autosuggestive in the light of the problems enumerated earlier, is that there should be greater responsibility and a larger role for the center. It may be argued that such a role would only be appropriate given that the center is more like a runner in a relay race who has to do not only his share but is also obliged to compensate for the delays or slowness of the other members of the team. The greater power for the center, as envisaged in this view, is not through additional powers for the levy and collection of taxes but by an improved managerial role. The enlarged function could involve detailed scrutiny of the budgets of other government levels and specification of the extent to which resources are to be mobilized, funds to be allocated, and instruments and size of the annual borrowing delineated. The lower levels of government would formulate these budgets and submit the relevant information to the federal government, but their actual operations would be subject to approval at the higher level. In order to ensure that the implementation of the budget is in conformity with the original estimates, the central government could also be empowered to issue directions to terminate its transfers and selected expenditures of the state and local governments. Such dominant central responsibility, even if desirable for macroeconomic management, has obvious limitations. If implemented, it will in effect be a vertical integration resembling the operations of a holding company and, viewed from the states and local authorities point of view, is a road to serfdom. Even at an operational level, it may clearly be a very formidable job for the central government to function, in effect, as the budget agency for the whole country.

An alternative is to provide greater responsibility for state and local governments by making them responsible for their expenditures by raising the revenues needed to finance these expenditures. Their accountability would be to their own legislatures or to elected councils. The fiscal decentralization implicit in this approach is that there would be greater fiscal balance between revenues and expenditures at the local level and the role of federal transfers would be minimal. This view, in a way, reverses financial trends and ends the fiscal dependence of the states on the center. It is, however, arguable whether such decentralization would help macroeconomic stabilization if responsibility continues to be with the center. Also, decentralization will depend on the skill, discipline, and administrative competence of the state governments and there will be the usual quota of anomalies and errors that inevitably accompany decentralization. Moreover, considering that the problems experienced are also due partly to the decentralization already existing, it could be argued that they will be further aggravated by the proposed broadening of local responsibility.

Both the above approaches represent extreme positions and essentially reflect the subjective preferences of those seeking greater or lesser centralization. It is more appropriate that improvements are envisaged in the context of the available institutional framework. The primary problem in the relationships between central and state governments and in achieving appropriate intergovernmental fiscal management is one of articulating policy and communicating it to the members of the team. While there is some difficulty in formulating correct policies, there is also no denying management is part of the problem. A better understanding among the governments about their respective requirements is an obvious necessity. State and local governments must have a better appreciation of their role in the national economic management. Controls, however strong, cannot work in an atmosphere that is characterized by lack of trust. If central agencies persist with their controls, they will only end up encouraging resort to escape mechanisms. Trust is subjective but there is a possibility of increasing its usefulness when there is improved understanding. Experience of industrial and developing countries suggests that this could be improved through consultation, which is recognized as a two-way street.

Such consultations are formally institutionalized in some countries such as in Australia, the Federal Republic of Germany, and India, while in some countries, for example, in Denmark, gentlemen's agreements have played an important role.21 The previously described problems have their origin, not in the lack of consultation, but in the way in which the consultation machinery operated. In the long run institutional factors cannot compensate for lack of policies. Solutions for intergovernmental fiscal management may, therefore, have to be found in the accommodation, cooperation, empiricism, and balance shown by the partners.

The definition of a federation itself has not been without problems. Wheare defined a federal government thus: “By the federal principle I mean the method of dividing powers so that the general and regional governments are each, within a sphere, co-ordinate and independent” (K. C. Wheare, 1963, p. 10). So defined, however, it could be criticized by those who believe in a law that limits the discretion of government, for Wheare's approach implies that either party is ultimately subordinate to another, or both are subordinate to a supreme power. In partial recognition of this, Wheare amplified his statement to the effect that “[i]f a government is to be federal its constitution, whether it be written, or partly written and partly unwritten, must be supreme…. If the general and regional government are to be coordinate with each other, neither must be in a position to override their terms of their agreement about the power and status which each is to enjoy” (Wheare, 1963, p. 53). If this definition is to be strictly applied, few countries would qualify as a federation. Wheare's definition emphasizes the legal aspects, which, however, are not the concern of this chapter. It has to be noted that separation of powers may not be accompanied by a separation of finance. Moreover, instead of there being entities that are independent, there may be more that are dependent on the central government.

Neither does this chapter aim at presenting an analysis of local finance. It is concerned with the implications of intergovernmental relations for fiscal stabilization and budgetary management. For a detailed discussion of other aspects, see George F. Break (1980); C. C. Foster, R. A. Jackman, and M. Perlman (1980); and Wallace E. Oates (1977).

In France local authorities receive a share of national taxation. In Denmark local authorities levy income taxes in addition to the federal income tax. These are collected by the central government and distributed to local authorities. The central government does not claim any share in the income tax levied by the local authorities.

In an analysis of the situation in the United States, Levin pointed out that purchases of goods and services were only 34 percent of total federal expenditures, but 56 percent of state and 96 percent of local expenditures. The service components of total direct expenditures were 40 percent federal, 90 percent state, and 96 percent local. See David J. Levin (1978), pp. 15–21.

For example, for India see A. Premchand (1966b), pp. 176–204; for Canada, see Richard M. Bird (1979), pp. 56–58.

It is because of this concern for allocative efficiency that governments prefer transferring resources by grants rather than by revenue sharing. The latter is done with reference to selected formulas that are uniform in their application. Grants are discretionary and can be adjusted to reflect the changing objectives of the grantor.

For an illustration of this type of experience in the United Kingdom, see Local Government Finance (1976a), p. 241.

The Royal Commission on Local Government in England, 1966–69, observed that “the central government ought, we think, to recognize that a reasonable measure of financial independence is an essential element in local democracy & and that each control weakens the sense of local responsibility.” See United Kingdom, Report of the Royal Commission on Local Government in England, 1966–1969. Vol. I, (1969b), p. 134.

The importance of sales taxes in the overall revenue structure has grown considerably during recent years and, together with union excises, contribute nearly one third of the total revenue in India.

For a more detailed account of prevailing and past systems of Rate Support Grants, see United Kingdom, Local Government Finance (1981).

In the United States the matching formulas have an equalization objective and are, therefore, varied for each state in terms of its Fiscal capacity. In India, however, when the matching grant system prevailed, the principles of cost sharing did not distinguish the capacities of the recipients.

In India such conditional transfers also have a loan element.

This has been true for assistance for the malaria eradication program in India. Similar instances are found in other countries.

This was not without problems, however, when financial plans were initially organized in the early 1970s; one Laender government did not present any financial plan at all.

It has been argued, however, that these are at best economic rationalizations of what is, in effect, a formal legalistic process reflecting the superior money power, as well as national concerns, of the central government.

This aspect is frequently disregarded by the federal legislatures and they demand mote controls on the states' use of the transfers.

Such isolated control of capital expenditure that is partial in its application can be unsatisfactory and can have distorting effects on resource allocation. For an elucidation of this point in the context of the United Kingdom, see United Kingdom, Report of the Royal Commission on Local Government in England, 1966–1969, (1969b), p. 242.

For example, the system of Rate Support Grants in the United Kingdom relied on the statistical technique known as stepwise multiple regression analysis, which led, among other things, to excessive spending by groups of authorities with similar characteristics, leading to further increases in the amount of their grants.

This is likely to change, in view of the recent proposals for decentralization.

The measures were partly negated by lags in the reporting systems. Overdrafts were only known long after they occurred, and the central government had to regularize them by converting them into loans.

This seems to have been successful in Denmark for two reasons. First, there is an implicit threat that legislative measures will be taken by the center if agreements are violated by local governments, and second, the agreements have provided an insurance for local politicians for implementing them by passing on the responsibility to the central government. The second feature, however, does not appear to yield the same results elsewhere and, in any event, it is only likely to be successful in the short run.

    Other Resources Citing This Publication