14 Theory and Practice of Intergovernmental Transfers

Ehtisham Ahmad, Vito Tanzi, and Qiang Gao
Published Date:
September 1995
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Anwar Shah*

The design of intergovernmental transfers in developing countries is often a contributing factor to fiscal imbalances at subnational levels and an impediment to efficient and equitable provision of public services. The structure of these transfers in developing countries usually emerges from ad hoc decisions without adequate consideration of economic criteria and political and social objectives of member units. Thus, basic principles of equity, benefit-cost spillovers, allocative efficiency within government, autonomy, certainty in planning, ease of administration, transparency, neutrality toward grantsmanship, consistency with federal and state objectives, equalization, and so on, often do not receive adequate attention in grant design. Reform of fiscal arrangements at the federal-state and state-local level could be an important step in fiscal adjustment and finding a long-term solution to the twin problems of subnational deficit and debt reduction. Intergovernmental fiscal transfers are also often the single most important source of revenue for state and local governments in most developing countries, and, as a result, they play an important role in shaping expenditure priorities and have implications for the fiscal health, autonomy, and tax effort of recipient governments and for the efficiency and equity of public services provision.

This paper provides a selective survey of the theory and practice of intergovernmental transfers with a view to developing a broad agenda for reform. It discusses the economic rationale for intergovernmental transfers and its implications for the design of transfers. Issues and options in the design of equalization programs to reduce regional fiscal disparities are also presented. Existing mechanisms for fiscal transfers in selected developing countries are also reviewed.

Economic Rationale for Intergovernmental Transfers

Five main economic reasons are suggested as economic rationale for grants (see Boadway, Roberts, and Shah (1993)).

(1) Fiscal imbalance. Unmatched revenue means and expenditure needs at various levels—a fiscal gap—create structural imbalances resulting in revenue shortfall usually for lower-level government. Reasons for this imbalance are:

  • Inappropriate expenditure and tax assignment.

  • Limited or unproductive tax bases available to lower levels of government, making tax rates inefficiently high.

  • Regional tax competition among state and local governments fearful of losing capital, labor, and business to other jurisdictions.

  • Level of federal government taxation limiting state and local revenue-raising potential.

To correct problems associated with the first two kinds of imbalance, joint occupancy of some tax fields or decentralization of some taxes are advocated. Unconditional grants or revenue sharing based on the principle of origin are also appropriate solutions. To deal with tax competition, a higher revenue effort by the federal government and unconditional grants are required. Finally, to deal with the last type of imbalance some form of tax abatement by the federal government is necessary to provide more tax room in fields jointly occupied with the lower levels of government.

(2) Minimum standards of services. For certain services, expenditure assignment to state and local governments may be based on efficiency of public service provision and responsiveness to local needs and concerns, even though it may conflict with national equity and efficiency objectives. Musgrave (1976) argues that the redistributive role of the public sector is best performed by the federal government. In a federation, mobility of factors severely limits the redistributive role of local governments; New York City is a prime example. Redistributive policies adopted by the city in the 1970s created a major fiscal crisis, and the federal government had to reverse these policies to restore the financial health of the city.

Some public services typically assigned to state and local governments for efficient accountability are strongly redistributive. Social insurance, health care, education, and welfare are examples of such services. Health and educational services are quasi-private goods and in terms of technological efficiency are best provided by the private sector. In the United States, health care is by and large treated as a private good. Some economists have advocated private provision of health and education services in developing countries based on this view of economic efficiency. Such a viewpoint completely ignores information asymmetries such as moral hazard and adverse selection. Fiscal federalism literature argues that informational inefficiencies alone do not provide a convincing case for the public provision of health care and education.

Most governments treat health care as a fundamental public responsibility and strive to provide these services on a uniform basis because they are considered redistributions in kind. The case for public provision of these services primarily rests on equity objectives. For example, the incidence of disease is directly correlated with the incidence of poverty and inversely with economic well-being. Thus, public finance and provision of health care enhances the redistributive role of the public sector. Similarly, public education, by improving access for the poor, serves to further equality of opportunity. The relative importance of expenditures on health, education, and social services further suggests that redistribution by the tax system or direct cash transfers pale in comparison with the in-kind redistribution made possible by public services.

In a federal system, lower-level provision of such services—while desirable for efficiency, preference matching, and accountability—create difficulties in fulfilling federal equity objectives. Factor mobility and tax competition create strong incentives for lower-level governments to underprovide such services and to restrict access to those most in need, such as the poor or the old. This is justified by their greater susceptibility to disease and potentially greater risks for cost curtailment. Such perverse incentives can be alleviated by conditional selective nonmatching grants from the federal government. Such grants do not affect local government incentives for cost efficiency but ensure compliance with federally specified standards for access and level of services.

A second justification for common minimum standards for public services in a federation is based on economic efficiency. Common minimum standards help reduce interregional barriers to factor and goods mobility and thereby contribute to efficiency gains. Establishing minimum standards for social services encourages labor mobility and for infrastructure capital, factors and goods mobility. Boadway (1992) has emphasized that harmonization of expenditures improves gains from interregional trade and helps foster a common internal market.

Common minimum standards for public services across different states can be encouraged through conditional nonmatching or conditional closed ended matching programs. Conditional nonmatching programs are preferred because they are nonobtrusive, allowing state governments to spend grant monies as they choose so long as they meet certain minimum standards of service and access. The higher-level government simply monitors compliance with these standards.

(3) Interjurisdictional spillovers. Intergovernmental transfers can be used to increase the efficiency of providing public goods and services. Their major contribution is to correct inefficiencies arising from interjurisdictional spillovers. Spillovers usually occur because the benefits of a locally provided good or service itself spill beyond the local jurisdiction to benefit those not contributing to the costs (air and water pollution control, locally educated students who relocate) and because nonresidents enjoy the services provided (parks; cultural, recreational, and transportation facilities; state universities; state welfare and health care systems). In planning and administering such benefits, state and local governments consider their own benefits and therefore under-provide public services. To compensate, governments may redraw juris-dictional boundaries or create separate jurisdictions for each service (McMillan (1975)), but intergovernmental transfers are often the most practical means of alleviating the inefficiencies of spillovers. Open-ended conditional matching grants that modify relative prices are the most appropriate kind of transfers for implementing these corrections. The extent of cost sharing by the higher level of government should be consistent with the degree of spillover.

(4) Differential net fiscal benefits across states. Net fiscal benefits vary from state to state for a number of reasons:

  • Some states have more valuable natural resources and therefore better access to an enlarged revenue base.

  • Some states or localities have relatively higher incomes and therefore greater ability to raise revenues from existing bases.

  • Some states or localities have inherited higher-cost disability factors (low thresholds for economies of scale, difficult terrain) or higher-need factors (greater proportion of young, old, or poor).

The presence of differential net fiscal benefits encourages fiscally induced migration. Labor and capital may move to areas with positive net fiscal benefits for fiscal considerations alone. In the process, negative externalities, such as unemployment, imposed on the jurisdictions they leave and enter may be ignored. The result of fiscally induced migration is that too many of the factors will move, creating social and economic problems in resource-rich areas. Factor movement in response to fiscal considerations alone creates inefficiency. Treating identical persons differently by the public sector in various states creates inequity. National welfare is reduced by the externalities imposed by fiscally induced migration.

Fiscal equalization grants to eliminate or reduce differential net fiscal benefits across states can enhance the efficiency and equity of a federal system. An ideal form of such transfer is an interstate revenue pool providing negative and positive equalization grants to member states such that net transfers equal zero. Thus, the program by design becomes self-financing. Such a grant system must be unconditional and must not reward strategic behavior to enhance positive grant entitlement or minimize negative transfer by member states. Thus, grant design must incorporate factors over which states have little control. The German system is a fraternal one of equalization among the German states; the federal government simply acts as an observer and occasionally as a mediator. The Canadian and Australian systems are federal programs that are not self-financing. The Canadian system attempts to augment the fiscal capacity of member provinces up to a five-province standard. The system measures the fiscal capacity of a state by the revenue that could be raised in that state if it employed all of the standard revenue sources at the average intensity of use nationwide. The Australian system analyzes expenditure needs as well.

Another infrequently mentioned objective of these transfers is to advance stabilization policies of the federal government.

(5) Stabilization objectives. Intergovernmental transfers can also be used to help achieve economic stabilization objectives. Grants could increase during periods of slack economic activity to encourage local expenditure and diminish during the upswing of the economic cycle. Capital grants would be a suitable instrument for this purpose. Care must be exercised in ensuring that funds are available for operating expenditures associated with such initiatives.

Criteria for Design of Intergovernmental Fiscal Arrangements

Autonomy. Subnational governments should have complete independence and flexibility in setting priorities and should not be constrained by the categorical structure of programs and uncertainty associated with decision making at the center. Tax-base sharing, that is, allowing subnational governments to introduce their own tax rates on central bases, formula-based revenue sharing, and block grants, is consistent with this objective.

Revenue adequacy. Subnational governments should have adequate revenues to discharge designated responsibilities.

Equity. Allocated funds should vary directly with fiscal need factors and inversely with the taxable capacity of each province.

Predictability. The grant mechanism should ensure predictability of subnational government shares by publishing five-year projections of funding availability.

Efficiency. The grant design should be neutral on subnational government choices of resource allocation to different sectors or different types of activity. The current system of transfers in countries such as Indonesia and Sri Lanka to finance lower-level public sector wages contravenes this criterion (Shah (1990)).

Simplicity. The subnational government’s allocation should be based on objective factors for which individual units would have little control, and the formula should be easy to comprehend so that “bargaining” for grants is not rewarded, as appears to occur with plan assistance in Pakistan and India.

Incentive. The proposed design should provide incentives for sound fiscal management and discourage inefficient practices. There should be no specific transfers to finance the deficits of subnational governments. The current system of central transfers to finance subnational government deficits in India, South Africa, and Sri Lanka, and state transfers for the same purpose in Malaysia, clearly violate this criterion.

Safeguard of grantor’s objectives. The grant design should ensure that certain well-defined objectives of the grantor are properly adhered to by the grant recipients. This is accomplished by proper monitoring, joint progress reviews, and providing technical assistance, or by designing a selective matching transfer program.

It is quite obvious that various criteria specified above could be in conflict with each other and, therefore, a grantor would have to assign priorities to various factors in comparing various policy alternatives.

Intergovernmental Transfers in Practice

In general, the existing design of grants in developing countries is not consistent with economic principles enumerated earlier.

General nonmatching transfers, tax base sharing, and revenue-sharing mechanisms to deal with fiscal gaps. Revenue-sharing mechanisms are used in a number of countries but tax base sharing has generally not been tried. Revenue-sharing mechanisms vary considerably. In Brazil, India, and Nigeria, for example, complex grant allocation formulas are employed using factors such as population, per capita income, school enrollments, backwardness (India), and “minimum responsibilities” (Nigeria) indices. In other countries the criteria are quite simple; for example, Mexico and Pakistan use population and derivation (point of collection), while Malaysia and China use derivation as the primary basis for revenue allocation. General unconditional transfers are not popular, but deficit grants have been tried in a number of countries, including India, Pakistan, South Africa, Malaysia, and the former Soviet Union.

Conditional nonmatching or equal per capita transfers to ensure minimum standards of service across the country. Few such transfers are used in developing countries. Central government transfers to provincial and local governments in Indonesia and the capitation grant to Malaysian states come close to the concept of such a transfer.

Benefit spillover compensation using selective open-ended matching transfers. Although benefit-cost spillover is a serious factor in a number of countries, such transfers have not yet been implemented in any developing country.

Equalization transfers to reduce or eliminate differential net fiscal benefits among subnational governments. Despite serious horizontal fiscal imbalances in a number of countries, explicit equalization programs are untried, although equalization objectives are implicitly attempted in the general revenue-sharing mechanisms used in India, Pakistan, Brazil, Mexico, and Nigeria. These mechanisms typically combine diverse and conflicting objectives into the same formula and fall significantly short on individual objectives. Because these formulas lack explicit equalization standards, they fail to address regional equity objectives satisfactorily.

Conditional open-ended matching transfers to encourage certain expenditures. Generally, open-ended matching transfers are not in use in developing countries although India, Pakistan, and Malaysia use conditional closed-end matching transfers.

Revenue-Sharing Mechanisms

In Brazil, one of the main instruments for federal-state revenue sharing is the State Participation Fund. The federal government transfers a specified share of certain federal taxes to a pool, and the Council of States determines state shares using a formula that incorporates population and per capita income as its main components. A proposal currently under discussion extends the components to include such factors as land area, interstate trade, and fiscal effort. In recent years, shares determined by this formula have been unacceptable to the Council, which has resorted to a compromise allocation based on an arbitrary adjustment to formula shares.

The principal merits of this program are the consistency of its design with objectives of transparency, predictability, and local autonomy. The program addresses some fiscal equalization objectives but has design flaws that inhibit achievement of its objectives. For example, one measure of fiscal capacity is state per capita income; this is an imperfect guide to the ability of a state government to raise taxes, because a significant proportion of income can accrue to nonresident owners of factors of production. Furthermore, only a small portion of total state revenues is raised from income taxes. Estimates of state per capita income are subject to significant errors and are available with a long lag. For example, estimates are available only through 1980. These difficulties diminish the usefulness of per capita income as a determinator in a program of fundamental importance to federal-state fiscal relations.

The State Participation Fund further combines diverse and sometimes conflicting objectives, such as revenue sharing and fiscal equalization at the state level, into a single formula in a multiplicative manner and therefore falls significantly short on individual objectives. The program is redistributive in its overall impact but does not assure consistency of individual state shares with the formula objectives, so states with similar fiscal capacity receive widely different entitlements. Since the formula lacks an explicit equalization standard, it also fails to address regional equity objectives satisfactorily. These failings explain why the Council of States finds it easier to strike political compromises rather than accept results of the formula.

The program to channel federal revenue-sharing monies to municipalities is the Municipal Participation Fund (FPM). This program considers municipal population and state per capita income to determine the shares for individual municipalities. The program has two major drawbacks: first, the formula for the program fails to incorporate differential fiscal capacity of the municipalities in a meaningful way, and therefore does not result in a fair and equitable distribution of funds. Because there is no local income tax in Brazil (and none is called for because of capital and labor mobility), per capita income is a poor indicator of a local government’s ability to raise revenues. Furthermore, in each state, rich and poor municipalities exist side by side: state per capita income, by definition, cannot distinguish between the two classes. Second, this program discourages local fiscal efforts by meeting nearly two thirds of municipal revenue requirements from federal revenue sources. Such overwhelming dependence by municipal governments on outside revenues creates a dichotomy between spending and revenue raising decisions, and contributes to reduced financial accountability at the local level.

In 1990, Mexico restructured its assistance to states and municipalities, allocating 18.1 percent of sharable federal revenues to a general fund, 6.5 percent of sharable federal revenues, until 1997, to a contingency fund, and 2 percent of sharable federal revenues to a municipal fund. The allocation criteria for the general fund give equal weight to population and previous state shares adjusted by annual increases in federally administered excises on petroleum, motor vehicles, alcohol and tobacco, and locally administered water charges and property charges. The contingency fund is designed to compensate states that lose allocated funding through this restructuring. The municipal fund uses an inverse of the allocation for the general fund to provide states with pass-through funds intended for final distribution to their municipalities. Using population as a criterion for determining general fund revenues is a welcome change, because it enhances autonomy and equity objectives. Reliance on adjusted historical shares to allocate remaining funds perpetuates anomalies created by high petroleum revenues accruing to certain states in the early 1980s, and will clearly favor oil-rich states. The municipal fund makes only a minor contribution toward rectifying this problem.

Nigeria shares 45 percent of federal revenues with states and municipalities. Ninety-five percent of revenue shared with states uses minimum responsibilities—population, primary school enrollment, and internal revenue effort—as formula factors; the remaining 5 percent is distributed to mineral-producing states on the basis of origin. Transfers to municipalities are based on equal shares (25 percent to recognize minimum needs) and population (75 percent). Several aspects, equalization to a standard and instability associated with resource revenues, require further attention in fine-tuning existing revenue-sharing arrangements. The former can be addressed by adopting some form of the representative tax system and the latter by establishing an oil fund managed jointly by the federal and state governments.

In India, a significant proportion of revenues is returned using population and some measure of income relative to the average; therefore, some degree of implicit equalization is attempted by the formulas. Because the formulas embody factors to get a handle on multiple objectives, the extent to which each of the objectives is accomplished requires further analysis. The formulas do not pay any special attention to fiscal capacity (revenue means) of individual states in grant determination.

In Pakistan, revenue sharing is based on population and revenue collection by origin. Equalization to a standard by considering the revenue means of the provinces has not yet been tried.

In Papua New Guinea, minimum unconditional grants are based on expenditures in the base year, fiscal year 1976. Some revenues are shared using the derivation principle. It is not clear why base-year expenditures should be consistent with the priorities and economic-demographic dynamics two decades later.

In the Philippines, population, land area, equal shares, and derivation are factors used to determine revenue-sharing allocations. While the factors are objective and reasonable, they do not correct for horizontal imbalances. Revenue-raising potential of subnational governments should be incorporated into the formulas.

Federal Transfers

In a federation, specific-purpose transfers support important policy objectives; benefit spillover compensation; bridge fiscal gaps; ensure minimum standards of public services across the nation; fulfill the redistributive function of the federal government; create a common internal market; reduce net fiscal benefits across jurisdictions; and achieve economic stabilization objectives. In most cases, grant objectives determine grant design.

In developing countries, funds for specific-purpose transfers are usually distributed in an ad hoc manner, at the discretion of the central government. The practice of intergovernmental transfers is, therefore, at variance with the economic principles enunciated above and significant opportunities exist for the reform of these arrangements in developing as well as in transitional economies.

In Brazil, the federal and state governments engage in many specific-purpose programs or “convenios.” For many of these programs, program objectives are typically not specified or are specified vaguely, and in some instances, grant objectives are determined after funds are released. In recent years, specific-purpose transfers have increasingly served not to safeguard federal objectives but as vehicles for pork-barrel politics, and only a handful of programs have desirable features. One such program is for unified, decentralized health care, in which federal financing is provided to achieve certain minimum standards of health care across the nation. The intent of this program is for the federal government to specify policies and for state and local governments to implement federally mandated programs. In practice, however, the federal government is heavily involved in program administration, and decentralization has not been fully achieved. The existing program also gives preferential treatment to private contractors over state and local government agencies. New fiscal arrangements are likely to constrain federal funding for this program.

Bangladesh offers a number of closed end matching and nonmatching grants for upgrading infrastructure, with allocation based upon verifiable indicators of general assistance. These grants provide general budgetary support to lower-level governments rather than special incentives for higher spending on infrastructure, as matching rates are small and nonbinding. Bangladesh also provides budget deficit grants that create incentives for running higher deficits.

India offers specific-purpose grants that provide assistance to relatively less prosperous states and encourage tax efforts at subnational levels. The complex review and approval processes work against some of these goals. India also provides budget deficit grants.

In Indonesia, central grants currently finance about 64.9 percent of expenditure at the provincial level and 71.4 percent of expenditure at the district level. There are two kinds of transfers: block grants, for general purpose local spending subject to some broad central guidelines; and specific grants, for expenditure on uses specified by the center and subject to relatively detailed central controls. The former include sectoral block transfers to each of the three main levels of local government: provinces, districts, and villages. The latter include a transfer that covers virtually all local government personnel expenses, and sectoral transfers for specific development expenditures on roads, primary schools, public health centers, and reforestation. As part of its policy of gradual decentralization, the Government has incrementally raised the share of block grants in total transfers (it increased from 15.9 percent in 1986/87 to 20.3 percent in 1993/94) and has also allowed local governments somewhat greater flexibility in the use of some specific grants.

There are several positive features in the design of the Indonesian intergovernmental grant system: the distribution of grants is transparent, determined by formulas utilizing objective criteria; the structure of grants is simple, as both the grants and the criteria used for distribution are few in number; and the grants achieve an overall equalizing effect on regional revenue availabilities. In its transparency and simplicity, the Indonesian grant system compares favorably with the grants systems typically found in other developing countries.

Nonetheless, there are several improvements to consider in the design of the Indonesian grant system that would allow it to achieve its efficiency and equity objectives more effectively. First, the recent trend toward increasing the share of block grants in total grants should continue. Second, regional disparities in overall fiscal capacities (revenue-raising potential) could be better reflected in the distribution formulas for block grants, by including a fiscal capacity equalization factor. The criteria currently used for distribution, area, population, or equal shares, all focus primarily on capturing the differential needs of local administrations. Better capturing of differential fiscal capacities to meet those needs would contribute to making the distribution of grants more equitable.

Third, an element of incentive to local governments to improve their own revenue effort could be included in the grant allocation formulas (the present set of criteria do not include such an incentive element). This could be achieved by supplementing the fiscal capacity indicator by one and capturing the extent to which that capacity is actually being utilized. Appropriately designed matching grants could also stimulate the local revenue effort (the Indonesian grant system includes only a very limited matching element). Fourth, the SDO grant could be consolidated with the general purpose block grants to the respective levels of government. As presently designed, this grant creates strong incentives for a higher government employment/wage bill at the local level. The center tries to circumvent this perverse incentive by retaining major control over government employment at all levels, but this undermines local autonomy and flexibility in allocating budgetary resources between personnel and other expenditures.

Fifth, the main improvement that can be made in the specific sectoral grants is to continue the shift toward using broad guidelines rather than detailed controls and physical targets in influencing the use of these grants. The allocation criteria for these grants are broadly appropriate, as they adequately serve their main objective (ensuring minimum standards of the targeted basic services across regions); one improvement would be to change the allocation of the reforestation grant from a project to a formula basis, as is done for the other specific sectoral grants. Sixth, consideration could be given to assigning provinces a role in the allocation of central grants to the lower levels, by making some of the grants pass through them. The rationale for doing so is that provinces are better placed than the center, especially in a large and diverse country, to assess the needs and fiscal capacities of individual lower-level jurisdictions.

In Malaysia, most transfers are based upon objective criteria except for deficit grants through the state reserve fund, which are only granted in exceptional circumstances.

In Mexico, criteria specific-purpose transfers lack transparent criteria and have often been mired in political controversy and debate.

Nigeria has a mixed record on the design of transfers. Some specific-purpose grants to states follow objective criteria, and the federal government sets standards of service to be achieved. Other programs lack any transparency in the allocation of funds. In China, Colombia, the Philippines, and Thailand, specific-purpose grants lack transparent criteria for allocation.

In Pakistan, federal transfers have worked as vehicles for federal bureaucratic control over provincial spending priorities. Most central transfers do not consider objectives, fiscal needs, or relative fiscal capacities at the provincial level. Examples include deficit grants (discontinued in 1992), which encouraged provinces to run higher deficits in order to have a greater claim on central resources, or education grants, to finance provincial expenditures above their 1983 level, that encourage excessive spending. Most are capital grants with no provision for financing maintenance expenditures. As a consequence, the grant structure encourages capital-intensive technology, which deteriorates because of inadequate funds for upkeep. Central grants are unpredictable and discourage long-term planning at lower levels. Economic criteria, efficiency, equity, spillover compensation, and autonomy are not usually recognized in current grant programs, but additional provincial spending and bargaining for grants is rewarded.

State-Municipal Transfers

The same economic principles govern state-municipal fiscal relations as those for center-state fiscal relations. In many countries, local governments are simply extensions of state governments and are subject to a high degree of interference and control. In turn, the dependence of local governments on state transfers is usually greater than the dependence of states on central transfers. In industrial nations, local governments typically account for more than 20 percent of general government spending and finance, with less than 30 percent of their expenditures coming from higher-level transfers. Property taxes are the mainstay of local governments, which also rely heavily on local income taxes.

In developing countries, local governments typically account for less than 10 percent of consolidated general government spending but derive more than two thirds of their revenues from higher-level transfers. In some instances, increased revenue-sharing transfers contribute to reduced local tax effort. For example, in the early 1980s, Mexico more than doubled its transfers to municipal governments and gave them exclusive access to property tax revenues. Nearly half of these transfers were directed to increased local expenditures; the rest were used as tax relief to municipal residents. As a result, municipal reliance on self-generated revenue declined from 75 percent of total spending in 1980 to 40 percent in 1984. In Brazil, high federal transfers to municipal governments in 1989 and 1990 also led to a lower tax effort (Shah (1991)). In many countries, the property tax is a state responsibility with proceeds shared with local governments and sometimes with the central government. The property tax is generally not a productive revenue source because its base can be eroded by exemptions and dated assessments. In principle, it should be easy for state governments to structure their transfers to local governments objectively, in view of easy access to their economic data. In practice, state transfers to local governments are arbitrary and discretionary. Only a few countries—Brazil, India, and Nigeria—have made serious attempts to structure at least part of their assistance in a nondiscretionary fashion.

Borrowing by local governments remains a major issue in most developing countries, where local governments are not permitted to borrow in credit markets and must rely on transfers for undertaking capital investments. This is an area where possibilities exist for autonomous bodies to supervise and assist local borrowing for capital projects. State governments can establish municipal finance corporations or a municipal loan council to provide technical assistance in project selection and appraisal and to assist in securing loans on preferred terms with state guarantees.

Except for Brazil and Mexico, information on state-local transfers is scant and not suited to detailed analysis. In Brazil, state-municipal transfers have two important components. One is the constitutionally mandated state-municipal, revenue-sharing arrangements, or state-municipal tax transfers. For the most part, distribution of such transfers follows the origin principle: 75 percent of municipal share of state value-added tax revenues are distributed in proportion to the value added in each municipality. For the remaining 25 percent, states have discretion to incorporate other fiscal need factors; population and area are the most common. Some states have also used fiscal effort as a special factor. A major criticism of the existing arrangement is that current formulas do not address fiscal equalization by varying a proportion of funds inversely with fiscal capacity (municipal tax bases). In fact, municipal tax bases hardly enter into consideration. The fiscal effort component is usually poorly designed, benefiting larger municipalities without regard for their fiscal effort.

A second component of state transfers to municipalities is specific-purpose or negotiated transfers. Most states have a large number of “convenios”—usually thousands—to provide project assistance. The sheer number of these transfers defies analysis, but anecdotal evidence suggests that political considerations dominate in the distribution of grant funds.

In Mexico, several states use the derivation principle, while others follow the former revenue-sharing formula of the United States, which varies grant funds directly with population and tax effort and inversely with per capita income. Municipal fiscal capacity is not considered in these formulas, and in some states, grant allocation is arbitrary. In many states, criteria for allocating grants are approved by state legislatures annually, making it difficult for municipalities to carry out a long-term projection of revenues and expenditures.

Concluding Remarks

Industrial countries offer examples of grant programs that recognize some of the economic principles discussed above. German experience suggests that a well-thought-out revenue-sharing system can obviate the need for many specific-purpose transfers. Canadian federal transfers for health and postsecondary education recognize the redistributive, in-kind nature of these public services and provide per capita transfers to provinces conditional on universal access to these services. Canadian experience with federal equalization transfers based on the representative tax system approach suggests that an objective equalization program that helps members establish minimum standards of basic services can endure and strengthen the federation. Australian experience with equalization is also instructive but much more difficult to replicate elsewhere.

The U.S. experience with road transportation assistance holds important lessons in structuring specific-purpose transfers. The program used objective indicators of need in allocating funds among states and established matching provisions to induce local participation.

Switzerland provides spillover compensation and equalization transfers to its cantons (Dafflon (1990)). The Canadian provinces and Australia (the U.K. And Victoria Grants Commission) use objective criteria in their transfers to local governments (Shah (1988)). Many of these models can be readily implemented in developing countries, and ample conceptual and practical guidance is available on the design of these transfers. Specific circumstances in each developing country require tailoring and adapting this guidance. Few developing countries have devoted serious attention to the design of these transfers, and therefore monumental and important work lies ahead.

Blueprint for Restructure and Reform

In this section, the major results of the previous sections are brought together to provide an overview. An analyses of fiscal systems in developing or transitional economies reveals certain common themes.

Fiscal federalism literature states that every objective specified by a granting authority requires a different form of grant. For example,

  • To deal with fiscal deficiencies arising from expenditure needs being greater than revenue means that nonmatching transfers, changes in taxing responsibilities, or revenue-sharing mechanisms are needed.

  • To address differential net fiscal benefits across jurisdictions or horizontal fiscal imbalances, general equalization transfers are needed.

  • To compensate for benefit spillover, open-ended matching transfers are needed with the matching rate determined by the benefit-spillout ratio.

  • To ensure minimum standards of services across the nation, conditional nonmatching transfers are needed.

  • To stimulate public expenditures in areas with high national but low local priority, conditional open-ended matching transfers are needed.

A review of grant objectives and design in developing or transitional economies suggests that for the most part such conceptual guidance continues to be ignored.

Tax-base and revenue-sharing mechanisms are customarily used to address fiscal imbalances or disparities arising from constitutional assignment of taxes and expenditures to different levels of government. Tax-base sharing means that two or more levels of government levy rates on a common base. Tax-base determination usually rests with the higher-level government levying supplementary rates on the same base. Tax is collected by one level of government, generally the federal or central government in market economies and the local government in centrally planned economies, with proceeds shared upward or downward depending on agreements on revenue yields. Tax-base sharing is quite common in industrial countries and almost nonexistent in developing countries.

A second method of addressing vertical fiscal imbalances is revenue sharing, whereby one level of government has unconditional access to a specified share of revenues collected by another level of government. Revenue-sharing agreements typically specify how revenues are to be shared among federal and lower-level governments, with complex criteria for allocation and for eligibility and use of funds. Such limitations run counter to the underlying rationale of unconditionality. Yet revenue-sharing mechanisms are quite common in developing countries. They often address multiple objectives, such as equalization or regional development. If properly structured, specific-purpose transfers can support important policy objectives in a federation. Such objectives include:

  • benefit spillover compensation, where the benefit area for public service is larger than the political jurisdiction;

  • bridging fiscal gaps;

  • ensuring minimum standards of public services across the nation;

  • fulfilling the redistributive function of the federal government;

  • creating common internal markets; and

  • reducing net fiscal benefits across jurisdictions and achieving stabilization objectives.

Grant objectives should determine grant design. Almost without exception, a typical developing country has many specific-purpose programs for which objectives are either not specified or specified vaguely. In some instances, grant objectives are reviewed only after the release of funds.

There are some obvious reasons for this state of affairs. Central governments can exercise complete discretion over these funds without any accountability. Enhanced flexibility is achieved at the cost of transparency, objectivity, and accountability, and specific-purpose grant programs are used for local political expediency rather than in the pursuit of key national objectives. Some specific-purpose grant programs are structured to provide perverse economic incentives. For example, several developing countries provide transfers to cover deficits or public sector wages at subnational levels. Such grants—contrary to the intentions of the grantor—encourage lowering taxation efforts, thereby raising deficits and spending on public sector wages in order to qualify for higher grants. A review of these grant programs should be high on any agenda for public sector reform.

The most striking observation to come from this review is that despite simplicity and practicability of design and a high priority in most countries for limiting interregional fiscal disparities, not a single developing or transitional economy has adopted a program of equalization transfers to disadvantaged subnational governments that takes into consideration their fiscal capacities in determination of their entitlements. More sophisticated attempts at equalization have been adopted in Brazil, India, and Nigeria, but design flaws have made them less successful. Although the formulas adopted by these countries lack explicit equalization standards and fail to address regional equity objectives satisfactorily, most countries do not even attempt to go as far.

Federal-local and state-local transfers in most developing countries need major restructuring. In none of the countries reviewed here do these transfers consider the fiscal capacity or revenue potential of local governments. Allocation of funds is usually on an ad hoc discretionary basis—negating transparency, predictability, and autonomy objectives. Major increases in revenue-sharing funds from national governments to municipalities in Brazil and Mexico have reduced local tax efforts. The cause may be failure to recognize fiscal capacity (tax bases for municipal sources) and inappropriate design of fiscal components in the allocation formulas. Furthermore, the government of a large country usually does not have the administrative capacity to monitor finances of individual municipalities closely, making a weak case for direct federal transfers to local governments. Such transfers should naturally be the responsibility of state governments. State governments can likewise restructure their transfers to local governments objectively, since they have easy access to local economic and fiscal data. Recognizing municipal taxable capacity would also help the state level monitor utilization of local revenue bases, thereby offering corrective action on a timely basis. Much useful guidance on restructuring these transfers is available from the experience of industrial countries.

Reform of intergovernmental fiscal relations requires complementary adaptations in the institutional arrangements for intergovernmental coordination, planning, budgeting, and implementation. Intergovernmental coordination and consultation are critical to improved public sector management. This could be accomplished through regular meetings of officials. The structure of transfers should be periodically reviewed either by intergovernmental committees or by autonomous grant commissions. For decentralized institutions to succeed, it is important to loosen the grip of central planning over subnational governments. Such planning imposes a central view of public investment requirements at local levels and often works as an impediment to innovative responses to local issues by local governments. In general, it is best to avoid detailed central control over local government use of funds and financial management. Instead, there is need to strengthen higher-level monitoring and audit of lower-level government performance. These functions are often conducted by several agencies in an uncoordinated fashion. Consolidation of these tasks in a single agency would improve effectiveness of these audits and inspections.

Decentralization of responsibilities and rationalization of intergovernmental transfers must be further supported by the strengthening of institutional capacities at the local level. Higher-level governments can play a crucial role in this capacity-building effort by identifying training needs, offering training programs, facilitating staff transfers, providing guidance on organizational structure and management issues, and providing technical assistance and operational tools for use of personnel management and service planning, monitoring, and delivery.

In conclusion, there is now universal recognition that the way taxing, spending, and regulatory authorities are determined and the manner in which intergovernmental transfers are structured have an important bearing on the efficiency and equity of the provision of public services. Fortunately, much useful guidance in the design of intergovernmental fiscal relations in developing and transitional economies is available from the theoretical and practical literature on fiscal federalism. It is also apparent from a review of the developing country literature that very few developing countries have paid serious attention to this guidance in the design of their transfers. Making this guidance accessible to policymakers in developing countries and adapting it to suit individual developing country circumstances are essential. This paper takes a small step in this direction. Significant work lies ahead.


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