Chapter

15 Implementing and Managing Grants—Institutional and Data Requirements

Editor(s):
Ehtisham Ahmad, Vito Tanzi, and Qiang Gao
Published Date:
September 1995
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Author(s)
Ehtisham Ahmad, Jon Craig and Dubravko Mihaljek* 

The previous chapters have described the principles for the establishment of grants, along with illustrations from a number of diverse countries. In this paper, we seek to describe the alternate administrative and institutional mechanisms that would be needed to determine grants on an analytical basis and to list the main information flows and data requirements that would be needed for effective management of a grants mechanism.

Reformed Revenue-Sharing Arrangements

It is the intention of the Chinese government, as described in the papers by Gao Qiang and Xu Shanda, to generate levers of macroeconomic control. Thus the new revenue-sharing system, to be implemented over time, requires that the share of the central government in the total revenue collection increase from 40 percent to 60 percent. To enhance the feasibility of the above measures, reforms would also have to be introduced in the system of grants and transfers from the central to local governments.1

While the revenue shares accruing to central and local governments are likely to change over a relatively short period of time, changing expenditure assignments and responsibilities may take somewhat longer to implement. This is because clarity in expenditure assignments requires the completion of price reforms as well as the delineation of property rights—defining the role of the state—that would enable a more meaningful discussion of expenditure responsibilities at each level of government than at present. A flexible role for grants can be seen that would facilitate the required changes in revenue shares with the existing expenditure assignments, thus avoiding a major dislocation in investment and activity levels. The grants mechanism introduced should be capable of adapting to changing expenditure assignments over the medium term.

Options for Grants and Revenue Sharing

This subsection summarizes some key features of a grants and revenue-sharing system (see also Chapter 14), and the associated policy instruments available to a central government.

Some General Principles

The revenue and expenditure assignments adopted in a country may lead to deficits at various levels of government, which stem from inadequacy of own revenue sources assigned to a particular level of government. Such deficits are termed vertical imbalances (see Chapter 16, for an algebraic formulation). The estimation of vertical balances should be done against an established benchmark level of revenues and expenditures that smooths out short-term or cyclical fluctuations in revenues or expenditures. Grants (including tax-sharing arrangements) are needed to resolve differences in fiscal capacities between different levels of government.2 Thus, deficits at some levels are compensated by surpluses at others, in a manner that meets the government’s distributional and macroeconomic objectives.

In formulating grants and revenue-sharing arrangements, the central government’s objectives may include efficiency in resource allocation,3 support for backward regions, and assuring the equity of access of various regions to public services. In the short term, the central government may also seek to pursue stabilization goals, such as by making payments designed to offset regional differences in unemployment during a general downturn in activity.

The main transfer mechanisms used to tackle these various goals can be grouped into the following transfer categories (see also Chapter 14):

ConditionalUnconditional
  • Matching grants

    open-ended or subject to limits

  • Specific purpose grants

    open-ended or block grants

  • Specific purpose grants

    open-ended or block grants

  • General purpose equalization grants

  • Revenue-sharing arrangements

The choice of transfer mechanism involves three choices. The first choice is whether the central government wishes to impose conditions on the use of funds, or the performance achieved in the programs, or both. Clearly, imposing conditions detracts from the autonomy of regional or local governments. It may be seen, however, as an essential means of imposing central government influence over spending for items of vital national concern (e.g., air or water pollution control) in areas that are primarily the responsibility of regional or local governments. Similarly, the central government may seek to attain national minimum standards in some areas of public concern (e.g., access to types of health or education programs). One of the major risks with conditionality is that it can distort decision making by lower-level governments, requiring them to allocate funds and administer programs in ways they would otherwise not do. In turn, this can lead to an absence of accountability for funds spent, resulting in waste and inefficiency. Conditionality thus places a heavy onus on the central government to specify its objectives clearly and ensure that it has the capacity to enforce and audit performance criteria.

Second, within the category of conditional transfers, the central government might require some matching of program funding by lower-level governments. While some cost sharing by lower-level governments may induce a greater effort in areas considered to be of particular importance by the central government, there is a risk that cost sharing will simply lead to lower expenditure elsewhere. If the objective is to boost net spending through incremental effort on particular programs, then it may be necessary to impose additional provisions to ensure that other spending is sustained. Such provisions are often difficult to enforce. A further disadvantage of matching arrangements is that they do not work well when there are large differences in the relative fiscal capacities of different regions. Matching may impose severe constraints on poorer regions, while richer regions can meet the requirements with little, if any, additional effort.

Third, within both conditional and unconditional transfer mechanisms, there is a choice of whether the grants should be open ended or subject to some limit. While open-ended grants may be favored by proponents of central government programs seeking to expand central government influence in areas of particular concern, budget control considerations often favor some limit on the size of grants.

An Equalization Framework?

A major question running through each of the choices outlined above is the degree of equalization of fiscal capacity that is to be attempted in a country. The objective is not to equalize regional incomes, but rather to equalize the fiscal capacity of each region to provide for a basic range of public services, taking into account its own revenue resources. Specifically, full equalization would require that each region should have the capacity to provide the same standard of public services as the other regions, provided it makes the same effort to raise revenue from its own sources and conducts its affairs with an average level of operational efficiency. This concept is known as horizontal equity across regions.

The absence of equalization grants in large and regionally diverse countries (particularly those with limited labor and capital mobility) may lead to a fracturing of a unified economic space, since local governments may be tempted to secure their own interests by erecting additional barriers to interregional trade. The United States is the only large industrial country that does not utilize explicit horizontal equalization; instead it relies on factor mobility (particularly for labor) to achieve the same objectives.

The relative importance attached to equalization can have a major bearing on the form of unconditional grants from the central government to lower-level governments. If a specific equalization goal is set, then two alternatives are available. First, an unconditional block “equalization” grant can be made from the center and distributed to regional governments on the basis of formulas that calculate regions’ relative fiscal capacities. This is the approach used in Australia and Canada. Second, the equalization of fiscal capacities can be achieved through interregional grants from regions with above-average fiscal capacity to regions with below-average fiscal capacity. This approach is used in Germany.

Unconditional block grants from the center are generally to be favored when large vertical imbalances exist at lower levels of government. This is because efforts to resolve the vertical imbalance will inevitably have an impact on the horizontal fiscal capacities of different regional governments. In this context, it should be observed that revenue sharing on a derivation basis (i.e., according to amounts collected in each region) is equivalent to an unconditional transfer that does not equalize fiscal capacities across regions. Revenue-sharing arrangements on a derivation basis tend to favor relatively prosperous regions.

Interregional grants are favored where the vertical fiscal imbalances at different levels of government are small. Given the central government’s limited ability to finance grants, horizontal balances are achieved by transfers from richer to poorer regions. Cooperative transfer arrangements, as in Germany, would be involved.

Regardless of the institutional approach used, a method of estimating equalization grants can be formulated (see Chapter 16 for an algebraic formulation).

International Perspectives

The extent of the transfer problem depends on the magnitude of the structural vertical fiscal imbalances at different levels of government. As Table 1 shows, there are substantial differences in these vertical balances in some major countries.

Table 1.Vertical Imbalances in Some Countries, 1990(Ratio of Own Source Revenues to Own Source Outlays)
Level of Government
CentralStateLocal
Australia1.510.560.83
Brazil0.840.770.27
Canada1.110.880.53
Germany1.090.980.74
India10.960.99na
Switzerland1.000.730.87
United States0.921.260.66
Source: IMF, Government Finance Statistics Yearbook (Washington: IMF, 1993).

Data relate to 1988.

Source: IMF, Government Finance Statistics Yearbook (Washington: IMF, 1993).

Data relate to 1988.

The industrial country experience covers a whole spectrum, from countries, such as Australia, with a large vertical imbalance favoring the central government and requiring grants from the center to the regions, to those countries, such as Germany, which have small vertical imbalances with interregional (rather than central) transfer mechanisms to tackle horizontal equity and related issues.

In Australia, the major taxes accrue to the national government. As a result, about 75 percent of the national revenue is collected by the central government, and central expenditures account for only about half the national expenditures. Own account revenues of lower levels fall well short of the expenditures assigned to these levels of government in the Constitution. The vertical surplus at the center is then used to finance a wide array of function-specific and general revenue grants to the state and local governments. The grant structure is formulated within an equalization framework designed to enable state and local governments to achieve the fiscal capacity to provide a standard level of basic public service.

The Indian federal system has some similarities to the Australian system. Most of the major taxes are assigned to the central government, yet many of the expenditure responsibilities rest with the state and local governments. The central government collects two thirds of national revenues, yet undertakes less than half the national expenditures. The central government therefore makes both general revenue and specific purpose transfers to state and local governments. The general revenue transfers take the form of grants and tax shares, which are allocated on the basis of recommendations by two bodies—the Finance and the Planning Commissions. Neither body employs an explicit equalization formula, although both use criteria such as population, per capita income, and fiscal performance indicators to allocate grants to the states. As a result, the Finance Commission’s allocations have been related more to filling actual fiscal gaps than to an assessment of relative fiscal capacities.

Canada has a small vertical imbalance at the center, because the central government shares its tax bases with the provincial governments through overlapping income and sales tax.4 Nevertheless, the central government makes substantial transfers (in the form of both grants and tax shares) to the provinces for various purposes. For the provinces as a whole, transfers amount to close to 30 percent of resources. Included among the transfers made from the center are equalization grants, to ensure that each province can provide reasonably comparable levels of public services at reasonably comparable levels of taxation.

In Brazil, the revenue assignments and tax-sharing arrangements are specified under the Constitution and have tended to provide an advantage to the regional and local governments relative to the center. The central government has a relatively unfavorable vertical balance and uncontrolled local expenditures have handicapped overall stabilization efforts. The central government does make special purpose grants to the regions. Some grants include provisions that may be construed as having an equalization element; however, there is no formal equalization process in Brazil.

The United States has a system of overlapping bases, whereby the central government shares income and sales tax bases with state and local governments. As a consequence, each level of government may be seen as virtually self-funding. Indeed, for a number of years in the 1980s, the state governments experienced a favorable vertical balance. Notwithstanding its large structural deficit, the central government has continued to make a number of specific purpose grants to state and local governments. While there is no formal horizontal equalization process in the United States, some of the provisions of the specific grants, for example, school grants, have embodied elements of equalization through assurance of minimum needs.

As noted earlier, the Federal Republic of Germany can be seen as lying at the opposite end of the spectrum of revenue sharing and grants arrangements to Australia. While the central government does make some grants to its regions (Lander) the need for such grants is minimized by three mechanisms. First, a careful attempt has been made to align revenue powers to expenditure needs. Second, the share of the centrally collected value-added tax going to the regions as a whole has been varied over time to minimize the vertical imbalances at the regional level. Third, the German equalization process primarily involves payments by the regions with “above-average” fiscal capacity to those with “below-average” fiscal capacity, with a minimal involvement by the central government.

China’s Current Grants System

A combination of different types of grants have been used in China. The central government has typically made the following grants to the regions: quota grants, also known as general or system grants; special purpose grants; and final accounts or settlement grants.

Quota grants are unconditional transfers to local governments, used for financing of local governments’ base-year budget deficits. The legal basis for quota grants is a 1980 regulation of the State Council that defines the (subordinate) financial relationship between the central and local governments and specifies the division of revenues and expenditures between them based on 1979 budgetary figures. The size of grant is determined by the difference between expenditures and revenues in the base year and is fixed in nominal terms for a period of five years. The local government does not have to return any fraction of the grant if its financial position improves within this period. Quota grants were provided to 18 provinces and autonomous regions in the total amount of Y 10.1 billion in 1992. Of this amount, about 80 percent went to five autonomous regions and three ethnic-minority provinces.

The financial system regulation of 1985 allocated quota grants to regions where own (fixed) and shared revenues were inadequate to meet expenditures. Until 1987, such grants were subject to a nominal annual increment of 10 percent to the eight regions and minority provinces mentioned above. In 1988, the State Council implemented six revenue-sharing arrangements in 37 regions—and the quota grants method applied in 16 regions.5

Special purpose grants are given to local governments in order to finance specific tasks that arise in the execution of local governments’ budgets. The following are examples of such grants:

  • Routine grants for financing various administrative expenses. These grants are given uniformly to all provinces (e.g., a fixed nominal amount per administrative worker or retired military officer);

  • Grants to assist provinces in the construction of enterprises and regional infrastructure. These grants have a fixed and a variable component, which can be changed at the central government’s discretion;

  • Reimbursement of local expenditures on price subsidies for food, oil, cotton, and coal. The amount of these subsidies varies from year to year depending on the pricing policy. The Ministry of Finance reports that such subsidies will be eliminated in the near future;

  • Grants for relief of serious natural disasters;

  • Matching grants for specific welfare and social purposes;

  • Interest subsidies on loans given by the People’s Bank of China to poor provinces. Such subsidies operate as grants.

Special purpose grants are included in the budgets of recipient local governments as a revenue item and in the budget of the central government as an expenditure item. The legal basis on which they are given is the 1980 regulation of the State Council mentioned above. This regulation stipulates that (1) the central government shall not give random instructions to provincial governments in respect of expenditures on production, education, and culture, so that provincial governments are made more responsible for their spending policies; and (2) in executing the budgets of different departments, a special procedure has to be followed for transfers from central departments to the same department at the local level. Since 1980, the relative share of special purpose grants has increased: the amount of special purpose grants in 1992 was five times as great (in nominal terms) as in 1980. In general, the amount of special purpose grants varies considerably from year to year because of changes in the pricing policy. Special purpose grants have been incorporated in the budgets of central and provincial governments for 1994.

Account-settlement grants are transfers between different levels of government that are given for settling of final fiscal accounts. In 1992, a total of 40 such grants were made, of which 29 were from the central government to local governments and 11 from local governments to the central government. There are three types of final accounts grants. The first refers to the revenue sharing from certain taxes. This type of grant could disappear following the implementation of a new tax system. The second type refers to the settlement of accounts following the change in ownership of certain assets (from central ownership to provincial ownership, or vice versa). The third type refers to grants given in compensation for the impact of certain central government measures on local governments’ financial positions relative to guaranteed base revenue shares. For example, the tax on cigarette production normally belongs to the provinces. If the central government wants to limit the output of cigarettes in any particular year, then this may result in a revenue loss for the provincial government, which is compensated through settlement grants. Final accounts grants are not included in the budget plans submitted for approval by the relevant authorities. They are normally calculated in February and March for the preceding fiscal year.

Under existing laws, local governments cannot have budgetary deficits. Local own revenue and grants received must equal local government expenditure. If a local government cannot get sufficient grants to cover the deficit, it must adopt legislation on extraordinary measures to increase own revenues or reduce expenditures. Implementation by local governments has tended to be at variance with the legal stipulations. The main avenue used to circumnavigate the formal laws appears to have been extrabudgetary financing, often in the form of direct or indirect services provided by local state enterprises, which falls outside direct budgetary controls.

The main problem with the existing system of grants is lack of transparency, both in regard to the objectives of the grants and the basis of their calculation. In turn, these weaknesses appear to translate into some lack of control over the growth of some grants.

Special grants appear to lack well-defined objectives and are largely formulated on an ad hoc, gap-filling basis. The open-ended nature of some special grants, especially the various food and related grants to cover subsidy payments by local government, also undermines efforts at budget control. Quota grants, as well as special purpose grants, are expected to be reviewed with the introduction of a new revenue-sharing system in 1994.

Vertical Imbalance

A vertical imbalance at the central level preceded the introduction of contracting arrangements in 1989, whereas local governments had a vertical surplus in 1985 and 1987 (see Table 2). With the onset of a period of austerity in 1988/89, the central government’s vertical imbalance fell, whereas that of provincial and local governments increased markedly. Since 1990, the vertical imbalance of the local governments has declined as a proportion of GNP, whereas that of the central government has continued to increase as a proportion of GNP. Note that Table 2 uses the Chinese definition of revenues (including borrowing). Thus the table underestimates the true vertical imbalances, particularly at the central level, since only the central government has formal access to borrowing.6

Table 2.China: Revenue and Expenditure of the Central, Provincial, and Local Governments, 1985–931
198519861987198819891990199119921993

Budget
(In billions of yuan)
Own revenue (excluding transfers received)2186.6226.0236.9262.8294.8331.3361.1415.3443.5
Central government (Chinese definition)69.091.790.6104.6110.6136.8140.0164.9177.3
Provincial and local governments117.6134.3146.3158.2184.2194.5221.1250.4266.2
Own expenditure (excluding transfers made)184.5233.0244.9270.7304.0345.2381.4438.9472.7
Central government79.996.2103.2106.0110.5137.3151.8181.7200.4
Provincial and local governments104.6136.8141.7164.7193.5207.9229.6257.2272.3
Transfers
From the central government to provinces56.258.555.459.758.3
From provinces to the central government45.248.249.055.957.4
Net transfers made (-) or received (+)
Central government−110.0−10.3−6.4−3.8−0.9
Provincial governments11.010.36.43.80.9
Total revenue (own revenue + transfers received)
Central government69.091.790.6104.6155.8185.0189.0220.8234.7
Provincial and local governments117.6134.3146.3158.2240.4253.0276.5310.1324.5
Total expenditure (own expenditure + transfers made)
Central government79.996.2103.2106.0166.7195.8207.2241.4258.7
Provincial and local governments104.6136.8141.7164.7238.7256.1278.6313.1329.7
Pure vertical balance (Own revenue—own expenditure)2.1−7.0−8.0−8.0−9.3−13.9−20.3−23.6−29.2
Central government−10.9−4.5−12.6−1.50.0−0.5−11.8−16.8−23.1
Provincial and local governments13.0−2.54.6−6.5−9.3−13.4−8.5−6.8−6.1
Overall balance (including transfers)
Central government−10.9−4.5−12.6−1.5−11.0−10.8−18.2−20.6−24.0
Provincial and local governments13.0−2.54.6−6.51.7−3.1−2.1−3.0−5.2
Memorandum items
(In percent of GNP)
Total revenue (net of transfers)21.823.321.018.718.418.717.917.316.2
Central Government8.19.58.07.56.97.76.96.96.5
Provincial and local governments13.713.912.911.311.511.010.910.49.7
Total expenditure (net of transfers)21.624.021.719.319.019.518.918.317.2
Central government9.39.99.17.66.97.87.57.67.3
Provincial and local governments12.214.112.511.712.111.711.410.79.9
Pure vertical balance (Own revenue—own expenditure)0.25−0.72−0.71−0.57−0.58−0.78−1.01−0.98−1.06
Central government−1.27−0.46−1.12−0.110.00−0.03−0.58−0.70−0.84
Provincial and local governments1.52−0.260.41−0.46−0.58−0.76−0.42−0.28−0.22
Overall balance (including transfers)
Central government−1.27−0.46−1.12−0.11−0.69−0.61−0.90−0.86−0.87
Provincial and local governments1.52−0.260.41−0.460.11−0.18−0.10−0.13−0.19
Transfers received
Central government2.82.72.42.32.1
Provincial and local governments3.53.32.72.52.1
Net transfers made by central government−0.69−0.58−0.32−0.16−0.03
Sources: Ministry of Finance; and IMF staff estimates.

Revenue and expenditure data compiled according to Chinese definitions.

Own revenue collections by the central government and local governments, excluding transfers received from another level of government.

Sources: Ministry of Finance; and IMF staff estimates.

Revenue and expenditure data compiled according to Chinese definitions.

Own revenue collections by the central government and local governments, excluding transfers received from another level of government.

Horizontal Imbalance

Regarding the horizontal fiscal imbalances, only limited indirect evidence is available. Data on per capita provincial revenue and expenditure indicate that the deterioration in the fiscal position of the deficit provinces outpaced the improvement in the fiscal position of the surplus provinces.7 This result, along with indirect evidence from other studies, lends support to the hypothesis that the fiscal contracting system has contributed to the widening of regional disparities. Of course, some of these differences in fiscal performance may reflect policy differences rather than underlying variations in fiscal capacities.

It is evident that the amounts transferred to the central government since 1989 have been entirely redistributed to the provinces, with an additional transfer from central government resources. Net transfers received by provincial governments, however, declined in both absolute and relative terms since 1989, given the increasing vertical imbalance of the central government, central government own revenues that have declined in relation to GNP, and a falling revenue share received from the provinces. In essence, fiscal contracting between the center and provinces worked as a clearing mechanism through which the central government redistributed a part of provincial fiscal surpluses to deficit provinces. Thus, the central government’s role in horizontal redistribution has become increasingly difficult to sustain.

The proposed tax assignments and revenue-sharing arrangements (see Chapters 2 and 9) are designed to increase the proportion of revenues accruing to the central government to 60 percent. In the short run, the provinces are assured at least their 1993 levels of revenue.8 Incremental central government revenues may not be adequate in achieving the 60 percent target, and further revisions to tax assignments and revenue sharing may be needed. The establishment of an effective grants mechanism would assure the provinces that their capacity to provide assigned expenditures will be protected. Thus, the speed at which an effective grants mechanism is established will govern the pace at which the objectives of the fiscal reforms are achieved.

Institutional Arrangements

In establishing the grants mechanism associated with the reformed tax system, it will be necessary to carefully consider the appropriate changes in institutional arrangements. Such arrangements will have a decisive impact on the credibility of the reformed fiscal system by ensuring that legitimate interests of local governments and the minimum needs of the population in general are consistent with macroeconomic constraints. It is important to avoid piecemeal change, so that confidence in the institutional framework is quickly established.

It should be kept in mind that grants are given for many purposes, of which equalization is just one. Special purpose grants may continue for a range of activities, including inter alia environmental purposes. The options below focus on the equalization aspects of a grants system.

Options for Equalization Grants

Three broad institutional options are generally available to support the new system of intragovernmental fiscal relations in China.

First, the work could be entrusted to a specially created section of the central Ministry of Finance, reporting directly to the Minister of Finance, and through him to the Executive. This option would be relatively easy to implement but may be seen as imposing a solution on the provinces—which may not be politically desirable.

Second, a special ministerial committee could be established, including representatives of the local governments, possibly with its own secretariat. This option would generally be preferable to the first. It is sometimes argued that this option has the best possibility of implementation, since officials from all levels of government are represented. However, provinces may still feel that the process is “manipulated” by the Ministry of Finance, and the objection to the first option may continue to apply.

Third, an independent grants commission could be established. This option has the advantage that the proceedings are generally seen to be “fair.” It is important for the credibility of any future system of intergovernmental grants that the recommendations adopted be seen as having been calculated on an informed, objective, and transparent basis. While the other options may in fact adhere to these criteria, it will always be more difficult to convince outside observers, or aggrieved provinces, that this is the case. A grants commission would “insulate” the central government from “recriminations” from some provinces.

Under all the options, the central Ministry of Finance will play an important analytical and educative role. It will participate in a key manner even if a grants commission is established.

If an immediate decision is taken to establish a grants commission, it will take some time to become fully functional. An independent chairman and members will have to be appointed, offices established, and staff recruited. It will also take time to establish procedures and grants calculation mechanisms, especially if—as might be expected—the commission decides to conduct hearings in each region about relative budget needs. Thus, in the short run, it is likely that the decisions concerning the composition and structure of grants will have to be taken by the Ministry of Finance.

Interim Arrangements

In the initial phase of development, it will be important that the Ministry of Finance establish a workable system of grants that can be seen to embody the main principles of equalization likely to underpin the longer-term grants framework. It will take time, however, to develop fully the methodology and statistical bases likely to be incorporated in the longer-term framework. In the short term, the grants recommendations made by the Ministry of Finance could be seen as interim arrangements, with the understanding that the allocation (but not necessarily the overall level) of the grants may be subject to retrospective amendment once a grants commission is fully operational.

Steps for Establishing a Grants Commission

The establishment of an independent grants commission would require a number of institutional measures. The scope of the work to be undertaken should be clearly defined. International experience suggests that the role of the commission might best be focused on horizontal equity issues, leaving taxation and expenditure assignments and resultant vertical fiscal balance, revenue-sharing, and borrowing issues to be resolved by the Ministry of Finance.

The emphasis of the commission should be on technical issues, including the development of an objective methodology and supporting calculations, with tightly defined terms of reference established by political leaders and their official advisers.

The personnel appointed to the commission should have a technical and professional background and orientation. Former senior public servants, trained academics, and other professional persons may offer the best recruitment pool for the commission. Clearly, a broad-based regional and central government representation is an important consideration.

In many, but not all countries, the grants commission holds public hearings on the issues set down in its terms of reference. The commission often prepares a publicly available report for the consideration of the government, setting out its recommendations and the reasons for its judgments, including an explanation of any uncertainties in its deliberations. Where disagreements between members of the commission exist, both majority and minority views might be published. To facilitate this process, it is often useful for the terms of reference provided to the commission to request a technical analysis of various options.

The final decisions on whether or not to accept the commission’s recommendations will be taken by the government. Thus, it should be made clear to all parties at the outset that the commission’s role is solely to examine technical issues and make recommendations to the government.

Ultimately, the success of the grants commission will be judged by the quality and relevance of its work and the seriousness with which its recommendations are taken. While governments should not feel bound to accept the recommendations of such institutions, it is important that they be given serious consideration, and that explanations be provided where recommendations are not followed.

Information Requirements

The first task in developing any future program of grants to regional governments must be to develop a comprehensive data base on (1) vertical and horizontal budget balances under present arrangements; (2) transfers under the existing system of grants and tax sharing; and (3) the means used to finance capital spending within the state budget and state corporations. This data base can then be used to produce simulations of how the fiscal structure at different levels of government will look after the proposed reforms of the tax system, revenue sharing, and tax administration. Those simulations, in turn, will serve to provide the information within which a revised system of grants can be formulated.

Calculation of Vertical Imbalances

As explained earlier, the calculation of the vertical fiscal balance in China would initially involve a study of the proposed revenue and existing expenditure assignments, and the resultant own account structural budget balances. Once expenditure assignments are revised (this exercise may take a number of years), the vertical imbalances would need to be reassessed.

Own account revenues are defined as those revenue items that accrue to the level of government concerned. This “beneficiary based” definition seeks to allocate revenues, not according to the collecting agency, but according to the government benefiting from the revenue source concerned. As a general rule, it may be useful to attribute tax and other revenue to a noncollecting beneficiary government where (1) when such government has exercised some influence or discretion over the setting of the tax or distribution of its proceeds; (2) when the provisions of the tax laws provide that the government concerned should receive a given percentage of the tax collected or arising in its territory; or (3) when the government concerned receives tax revenue under a tax law leaving no discretion to the collecting government. Own account revenues do not include revenues collected by another government that has some overriding claim over the determination or use of the revenue collected.

Own account expenditures are similarly defined as those spent on activities that benefit the level of government concerned, such as wages paid to its own employees, purchases of equipment or supplies used by the government concerned, or pensions and transfers to persons or enterprises that are beneficiaries of the government concerned. Grants paid to other levels of government, which then become the property of that government, should be classified accordingly.9

The purpose of this exercise is to identify the magnitude by which the central government’s own account revenues are likely to exceed its own account expenditures on an ongoing structural basis (i.e., after abstracting from surpluses or deficits arising from the impact of cyclical swings in economic activity on the budget), and the likely structural deficit on regional and local government activities. The assessment of the two sets of fiscal imbalances will provide a framework for constructing a system of grants to be paid from the center.

To construct such a picture within China, it will be necessary to obtain the data covering the operations of central, regional, and local government budget and extrabudgetary operations for the most recent three-year period. These data can then be used as a base to project the likely outcomes of different fiscal arrangements over the next three to five years. Ideally, the information should be compiled within the consistent framework provided by the IMF’s Manual on Government Finance Statistics. The main items may be characterized as follows:

Central Budget

Revenues (excluding Debt-Issue Receipts, which should be included below under Financing)

  • Budget Sector

    • Central Fixed Revenues

    • Central Revenues from Shared Taxes

    • Transfers from Lower-Level Governments

      • —Central Taxes Collected by Local Governments

      • —Adjustment Grants Arising from Transfer of Ownership of Public Enterprises from/to Central Government to/from Regions

    • Grants and Contributions from Enterprises

    • Extrabudgetary Revenues

Expenditures

  • Budget Sector

    • Final Spending on Goods and Services

    • Capital Spending

    • Transfers or Grants

      • Recurrent Transfers

        • To Households

        • Subsidies to State Corporations

          • For Urban Transport

          • For Water and Sewerage

          • For Other Purposes

        • To Other Levels of Government

          • For Specific Projects

            • Matching Grants

              • For Price Subsidies

              • For Social Relief Operations

              • For Health, Education, and Other Purposes

            • Budget Deficit Grants

            • Equalization Grants to Regions

            • Adjustment Grants Arising from Transfer of Ownership of Public Enterprises

        • Interest Payments to/from Central Government from/to Regions

      • Capital Transfers

        • To Households (for housing, etc.)

        • To Enterprises (for capital spending, etc.)

        • To Other Levels of Government

    • Lending Minus Repayments = Lending from the Budget to State Enterprises and Others Minus Repayments of Such Loans

    • Extrabudgetary Expenditure

Deficit = Revenues Less Expenditures

  • Financing of the Deficit

    • From Other Levels of Government

    • From Overseas Sources

    • From Domestic Sources

      • —Banking System

        • Central Bank

        • Other Banks

    • —State Enterprises

    • —Other Sources

Local Governments

(For each provincial government, and also on a consolidated basis for all provincial governments. If possible, this information should also ultimately be collected for all sub-provincial governments within a region, with a view to determining intraprovincial vertical balances.)

Revenues (excluding Debt-Issue Receipts, which should be included below under Financing)

  • Budget Sector

    • Local Fixed Revenues

    • Local Shared Taxes

    • Grants from Higher-Level Governments for Specific Projects

      • Matching Grants

        • Price Subsidies

        • Social Relief Operations

        • Health, Education, and Other Grants

      • Budget Deficit Subsidies

        • Equalization Grants to Regions

        • Adjustment Grants Arising from Transfer of Ownership of Public Enterprises to/from Regions from/to the Center

      • Grants and Contributions from Enterprises

    • Extrabudgetary Revenues

Expenditures

  • Budget Sector

    • Final Spending on Goods and Services

      • Capital Spending

    • Transfers or Grants

      • Recurrent Transfers

        • To Households

        • Subsidies to State Enterprises

          • For Urban Transport

          • For Water and Sewerage

          • For Other Purposes

        • To Central Government

          • Central Taxes Collected by Regions on Behalf of the Center

        • To Lower-Level Governments Adjustment Grants Arising from Transfer of Ownership of Public Enterprises to/from the Center to/from Regions

        • Interest Payments

    • Capital Transfers

      • To Households (for housing, etc.)

      • To Enterprises (for capital expenditure, etc.)

      • To Lower-Level Governments

      • Other Transfers

    • Lending Minus Repayments = Lending from the Budget to State Enterprises and Others Minus Repayments of Such Loans Extrabudgetary Expenditure

Deficit = Revenue Less Expenditures

  • Financing of the Deficit

    • From Other Levels of Government

    • From Overseas Sources

    • From Domestic Sources

      • Banking System

        • Central Bank

        • Other Banks

      • State Enterprises

      • Other Borrowers

Horizontal Imbalances

Much of the data used for an initial assessment of vertical balances in revenues and expenditures will be useful for calculating horizontal imbalances—including the breakdown of the main tax revenues collected at the local level (i.e., a breakdown of the local fixed revenue aggregate). Similarly, a functional breakdown of recurrent expenditures in the form of final spending on goods and services, capital spending, and capital transfers would be important in assessing differences between fiscal performance across regions. Interprovincial comparisons are facilitated if expressed on a per capita basis—thus local and regional data on population will also be required. Ideally, this information should be collected from population census data supplemented by frequent sample surveys. However, approximate estimates may be prepared using birth and death statistics to obtain net movements in regional populations provided that interregional migration is not large.

It would also be desirable to obtain information on the costs of those enterprise activities that result in uncompensated benefits. One example is urban public transport, which generates spillover benefits in the form of lower levels of traffic congestion and pollution. A case can be made for sustaining losses of public transportation companies to compensate them for providing such benefits that cannot be included in the price of tickets.

In order to translate the information collected above to a basis that will allow interprovincial comparisons, it will also be important for the Ministry of Finance to obtain data on population in each province.

Estimate of Fiscal Capacities

The analysis of the relative fiscal capacities of regional governments for an equalization exercise will require the compilation of a body of information as described above. A needs-based approach would require much more information than a purely revenue-based option. The former might become feasible in China over a period of years, while the latter could be made operational relatively quickly. However, the arrangements chosen should be flexible enough to accommodate adjustments to the changing role of the state in China, the clearer definition of expenditure responsibilities, and better availability of information flows in the future. The main information flows are briefly outlined below.

The information should be prepared in the context of a “standard budget,” which will enable per capita comparisons covering all the regional revenues and expenditures deemed to be subject to the equalization exercise. This must include all transfers and grants from the center to the regions and those from the regions to the center. It should also cover all revenues shared between the regions and the center.

Usually the standard budget will cover something less than the full gambit of existing budgetary and extrabudgetary activity. There will be some expenditures that are judged not to be relevant to the equalization exercise. As noted earlier, in a market economy the definition would be restricted to “public goods,” such as education, health services, and the like, and would often exclude measures such as subsidies to assist enterprises. It may also exclude capital spending, which may be seen as too bulky and one-off to be included in the equalization exercise.10

Once the coverage of the standard budget is defined, the analysts must (1) collect information on all budgetary and extrabudgetary regional revenues and expenditures, and ensure consistency of this data; (2) define methods to estimate “horizontal” equalization (alternative models are discussed in Chapter 16); (3) establish the “standards” against which regional fiscal capacities will be assessed; and (4) develop methods to assess relative revenue capacities and relative expenditure needs.

With regard to item (1), the revenue information to be included in the standard budget follows that outlined above for regional governments. However, the expenditure information must be collected within broad functional rather than economic groupings, such as education, health, culture, sports, law and order, judicial services, and economic services, which are to be included in the equalization study. It should be noted that the definitions adopted in the standard budget must be the same in all regions. For example, if the education function is defined to include the cost of supplementary items, such as bus transport to and from school, milk supplements for diets, research work by teachers, or curriculum development by regional headquarters, then information on expenditure needs must be assessed for these items (together with information on actual spending) for all regions under the common definition. In this context, it will be important to obtain information on quasi-fiscal activities performed by state enterprises or state financial institutions. For example, if state enterprises provide schools for students of their own workers and are allowed to deduct the cost of such schools for purposes of calculating taxation liabilities, then it would be important to include such information with the “standard budget’’ used in the equalization calculations. Similarly, if state financial institutions provide free or highly subsidized housing to certain groups of people within some regions, then it would be important to include such information within the standard budget calculations.

For item (3), two approaches are possible—a performance standard or a capacity standard. Performance standards involve the exogenous determination of a set of standards, typically minimum standards, which are seen as “warranted” for various revenues and expenditures.

On the revenue side, the standard, Rs, may involve judgments about the number of taxpayers in a region and the amount of tax that they should be able to pay. On the expenditure side, the standard, Es, may depend on the product of the number of units (e.g., students) the region is required to serve, and the standardized unit cost. The standardized unit cost is equal to the standard cost determined for all regions as a whole, plus an adjustment for the differential cost to the particular region arising out of its own special circumstances.

The fiscal capacity approaches followed in Australia and Canada do not require a region to meet specific standards. Rather, the purpose is to ensure that each region receives an equalization payment that enables it to provide an endogenously determined “standard” of revenue raising and expenditure. Typically, the standard is some per capita “average” of the actual measured fiscal performance of the regions. The “average” may be a simple or some weighted average covering all or some selected regions. In Canada, for example, the “standard” used is a weighted average of the five eastern provinces. In Australia, the standard used is a simple average of all the states and territories subject to the equalization exercise.

One advantage of the capacity utilization approach is that it usually does not involve the conditionality normally associated with performance equalization models, which would be attractive to local governments. Regions would be given grants that allow them to achieve certain standards, but they can choose to do more (by taxing at above-standard rates and spending those funds on above-standard expenditures) or less. Moreover, capacity utilization models are not usually concerned with minimum expenditure standards. The aim is to obtain an average standard based on the actual revenue performance and expenditure patterns of the regional governments. This “endogenous” derivation of the standard should avoid concerns that the standards might be dictated by the central government.

An example of the operation of a capacity equalization model is set out in Chapter 16.

Once the standard is determined, assessments must be made of the relative revenue-raising capacities of a region (e.g., existence of relatively less industry, lower incomes, higher unemployment, etc.) as well as its relative expenditure needs (e.g., relatively greater proportion of dependent aged or young persons, relatively harsher weather, etc.). In the case of China, separate calculations of relative revenue-raising capacities and relative expenditure needs would be required for each own revenue source and each expenditure item selected for equalization, for each region. The effective weights would be determined by the “standard” budget that brings together the various revenues and expenditures judged to be relevant to the equalization exercise.

The analysis of relative revenue capacities and expenditure needs can proceed in two ways. One is to identify location-specific relative disabilities, for example, the higher cost in region A relative to the standard. Such disabilities might be derived by applying factors thought to be important in underlying the differences in costs relative to the standard (e.g., differences in scale, climate, etc., that are derived from indicative supporting statistics). The second method is to observe actual revenues or expenditures and attempt to identify policy differences between regions that could explain all or part of the actual differences, thus deriving a cross-sectional series reflecting underlying revenue or cost disabilities. In concept, both approaches should yield similar results. In practice, this is rarely so. Experience suggests that identification of location-specific disabilities is a more fruitful course. However, calculation from each approach provides a double check on what may sometimes have to be a broad judgment on the differences in regional fiscal capacities.

The measurement of relative revenue capacities will involve a definition of the regional tax bases, over the period for which the equalization exercise is to be determined. For example, the number of and value of cars underlying motor vehicle taxes the value of property underlying property taxes, the value of taxable profit underlying corporate income taxes, and the personal income underlying personal income tax will have to be calculated. In the case of new taxes introduced under the tax reform process, which did not exist in the equalization period, it may be necessary to estimate their current tax bases and then project backward the tax bases (i.e., estimate what the tax bases would have been in previous years had the new taxes applied then). The calculation of relative expenditure needs will also require estimation of a number of the underlying factors. In the education area, for example, one may include the number of children by age group, the number of teachers, the size of schools (a scale factor that may differ by regions), the ethnic background of the children (possibly involving added expenditures on language training and other factors), and climatic differences necessitating different heating or cooling needs of schools in different regions.

Sequencing and Initial Simulations

The work program involved in preparing a system of equalization grants can be thought of as involving three phases.

The first, exploratory, phase involves the construction of some simple simulations (described below), which attempt to gain initial impression of the magnitude of the vertical and horizontal fiscal imbalances within China, and some indication of the factors explaining those imbalances. It serves as a framework for determining areas where additional or improved statistical data are required, and where a better understanding of the factors driving revenue or expenditure need to be developed.

To summarize, this phase can be conceived as involving (1) some approximate calculations of the vertical fiscal balance between the central and regional governments, (2) some initial calculations of the actual horizontal balance between provinces, (3) a preliminary “standard or model budget’’ that brings together the public goods and services over which it is judged that some equalization of public provision is required, and (4) initial calculations to see if broad patterns can be discerned that “explain” observable differences in revenue capacities and expenditure needs between regions.

These initial calculations do not have to be very precise but should seek to link revenue performance to the underlying bases determining collections. Thus, wages and personal consumption in each region may drive sales taxes and VAT collections, and the gross value of industrial output may help to explain differences in the enterprise profits tax. Similarly, in this initial phase one might gather data on population characteristics, such as the age, sex, density, and ethnic breakdown of the population, in each region. All of these factors might serve to provide clues as to the differences in per capita expenditure needs between regions.

In the second phase of preparing a system of equalization grants, the detailed problems identified in the first phase would be tackled, with assistance from experts in the respective fields of revenue collection and expenditure determination.

The final phase would involve bringing the details of various analyses together into an overall assessment framework, which might be used as a basis for any grants scheme to be implemented. The focus at this stage will be on methodology and consistency of the overall assessments.

Of these steps, the exploratory phase will probably prove the most difficult. However, it will also be the most important one, since it will help ministers and officials to gain an impression of both the magnitude of fiscal imbalances in China (both now and in the future) and the gaps in the information base used to assess the imbalances. This will permit them to make informed decisions on subsequent policy actions, including, most importantly, whether equalization grants are needed, and the degree of sophistication and coverage.

Borrowing and Capital Spending

To the extent that there remains an overall deficit on public sector operations, reflecting a need to finance infrastructure and other capital projects through borrowing, attention will also have to be given to the appropriate mechanisms for controlling borrowing by lower levels of government. The main issue is whether regional and local governments should be given, under supervision, power to borrow on own account, for example, from higher levels of government, and the use of particular approved instruments. The alternative is that all borrowing authority should continue to be vested in the central government. Analysis of this issue will also require the compilation of a comprehensive picture of the existing and likely future capital expenditure profile and its financing.

In order to build a complete picture of all regional requirements, it would be useful to build a separate picture of the overall borrowing to finance capital investment in China by constructing an overall capital appropriation account. This would trace the amount and structure of capital investment and, to the extent possible, its financing. This task involves the collection of data on the following variables:

  • Total capital spending in China

    • By State Enterprises

      • Centrally Owned

      • Locally Owned

    • By Governments

      • Central Governments

      • Regional Governments

    • By Other Entities

      • Cooperatives

      • Joint Ventures

      • State Financial Institutions

      • Foreign Companies and Banks

    • Other Capital Spending

  • Financing of Capital Expenditure

    • By State Enterprises

      • Centrally Owned

        • Internal Reserves (including amortization reserves)

          • From Budget

          • From Overseas Borrowing

          • From Banking System

          • From Other Sources

  • By the Budget Sector

    • Internal Reserves (including surpluses from recurrent operations)

      • From State Enterprises

      • From Overseas Borrowing

      • From Banking System

      • From Other Sources

  • By Other Entities

    • Internal Reserves (including amortization reserves)

      • From State Enterprises

      • From Budget

      • From Overseas Borrowing

      • From Banking System

      • From Other Sources

The issue of control of borrowing by lower levels of government is crucial in maintaining macroeconomic stability. This issue is not addressed here,11 but the information described above will be important in establishing a framework for monitoring and control of borrowing.

Phasing-ln Equalization Arrangements

A full equalization of regional fiscal capacities, given the apparently large regional differences that already exist in fiscal capacities in China, may be difficult to achieve in the near term. Moreover, it may be inappropriate to seek to move rapidly in the direction of a historically determined standard, given the large shifts now occurring in the structure of the economy. Thus, an agreed “indicative” standard, rather than a historically based standard, may need to be used during the period of rapid structural change.

Which Government Should Pay the Grant?

The question is left open as to who should pay the equalization grant. In Canada and Australia, the “equalizing grant” is paid by the central government from the shares of total taxes available to it, made possible by a vertical balance favoring the central government. But in Germany, where the vertical imbalances are smaller, Lander with above-average revenue capacity make equalization transfers to those with below-average revenue capacity.

Possible Sequencing for China

A process of establishing a system for horizontal grants in China may involve action on a number of fronts. First, the vertical balance against proposed revenue-sharing arrangements and tax assignments, on the one hand, and existing expenditure assignments, on the other would need to be quantified. This will require an expansion and modifications of the simplified models in Chapter 16.

Second, these quantifications could be used to clarify options for the reform of intragovernmental fiscal relations. Depending on the size of the calculated vertical imbalance and the desired degree of equalization, these options may range from a marginal reform of the existing system of grants, to arrangements for horizontal equalization based on both relative revenue capacities and relative expenditure needs. Consideration must also be given to whether regional and local governments should be given power to borrow directly from capital markets and, if so, what controls and supervision mechanisms will need to be established.

Third, the process of collection and, if necessary, creation of data required as input in the equalization exercise would need to be initiated.

International Monetary Fund.

Local governments in China are taken to refer to all subcentral levels of administration.

Usually, it is the central government that has a structural surplus, with structural deficits at lower levels of government. However, some countries, such as Germany, display little or no vertical imbalances.

In many countries, particular attention is given to regional spillovers of expenditure programs. The spillovers occur because the benefits of a locally provided good or service “spill” beyond the local jurisdiction, to benefit those not contributing to the costs (e.g., beneficiaries from control of air or water pollution and locally educated students who relocate) and because of migration from other regions to the locality (due to benefits of parks, cultural, recreational and transport facilities, regional universities, and, most important, regional health and welfare services). Regional governments usually consider only their own benefits and, because of such spillovers, underprovide public services, hence, yielding a case for supplementary central government grants.

The use of overlapping tax bases is currently being reviewed by the new Canadian administration. In general, an overlapping tax base, with the coexistence of central and state level VATs, as in Brazil, would pose considerable problems with administration and compliance.

See also Chapter 2.

Table 2 does not include provincial and local access to resources through extrabudgetary funds. The true situation is thus even more favorable to the provincial and local governments than appears in Table 2.

See the World Bank study China: Budgetary Policy and Intergovernmental Fiscal Relations, Vol. II (Washington: World Bank, 1992), Tables A-4.2, p.232, and A-6.2, p.236.

For 1994, all taxes are assigned either to the center or to local governments, except the VAT, which is shared with 75 percent of the increment going to the center.

For further discussion of these issues see Chapter 2 of the IMF’s A Manual on Government Finance Statistics (Washington: IMF, 1986).

If capital spending is to be included in the equalization exercise, the comparison base will usually be the stock of facilities available in each region rather than the flow of spending in any one year.

See Chapters 4 and 5 for further discussion.

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