2 The IMF’s Advice on Designing and Managing Fiscal Decentralization

Annalisa Fedelino
Published Date:
October 2010
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Anecessary, albeit not sufficient, condition for fiscal discipline is a broad plan to match spending responsibilities with overall resources at each level of government. Therefore, appropriate sequencing of the decentralization process requires that the devolution of spending responsibilities to subnational governments be closely coordinated with the corresponding assignment of own-revenue sources and transfers from the center. Several reasons support this condition. First, the required level of subnational resources has to be defined in relation to the aggregate estimate of subnational expenditure needs. Second, an appropriate mix of taxes and transfers can best be determined once expenditure responsibilities are defined. Finally, unless revenue assignments and transfers are adequately clarified, effectively imposing a hard budget constraint on subnational governments is difficult.

However, political, and sometimes economic, pressures frequently prevent such an orderly process. Devolution of resources has often proceeded unmatched by a corresponding reassignment of spending responsibilities, as was the experience of Colombia in the 1990s, Indonesia in 2000, and Nigeria in the recent oil-boom years. The same situation may have been happening in the Democratic Republic of the Congo and Kosovo in 2009, as these countries moved toward decentralization. During the initial phase in such cases, administrative weaknesses may limit subnational governments’ capacity to spend the devolved resources (as happened initially in Indonesia); over time, the increased revenue availability tends to promote additional (and frequently inefficient) spending. As a result, emerging deficits at the central government level may not be off set by surpluses at the subnational level, leading to deteriorating budget and debt positions of the general government as a whole (or requiring additional increases in the overall tax burden). In other cases (for example, the transition economies of the former Soviet Union in the early 1990s), fiscal stress at the central government level led the government to push spending responsibilities down to the subnational level, without passing on the corresponding resources. In these circumstances, subnationals had to resort to unsustainable borrowing (or accumulation of arrears), and the quality of devolved services (e.g., health and education) deteriorated sharply.

Designing, implementing, and enforcing policies that ensure a hard budget constraint are, however, challenging tasks. Unless a hard budget constraint can be effectively enforced at the subnational level, no plan to match spending responsibilities with resources can ensure adequate maintenance of fiscal discipline. In the absence of such a constraint, subnational governments may overspend, or slacken their revenue efforts, or both, eventually resulting in fiscal pressures for the general government.

For these reasons, designing fiscal decentralization reforms requires a consistent and well-coordinated package of measures. Countries have typically displayed a tendency to change some specific aspects of their systems of intergovernmental fiscal relations in isolation (e.g., modifying expenditure mandates, introducing new revenue-sharing schemes, or changing the transfer system). If not assessed and designed as part of a comprehensive framework, these isolated changes may eventually create inconsistencies and imbalances across government levels, undermining the effectiveness of fiscal policy.

Institutional and political arrangements at the subnational level—although not immediately related to the IMF mandate—have also been taken into account in IMF advice on fiscal decentralization. In countries where there are too many subnational entities (or they are too small to be viable), issues of spending and tax assignments cannot be properly addressed in the absence of some form of territorial reorganization, whereby subnational governments are streamlined and their roles refocused. This situation has been noted in Liberia and the former Yugoslav Republic of Macedonia (FYR Macedonia), for example. Similarly, merit may be found in increasing local participation in economic decision making outside of formal channels, for example, by seeking increased consultation with local communities. Although not a substitute for devolution of actual fiscal powers, these and similar steps might mitigate the political imperative driving fiscal decentralization, allowing more time to prepare properly for its design and implementation. Finally, sound and viable political mechanisms must be in place to identify and express local preferences—this is the channel through which fiscal decentralization can deliver its promise of better services. In this respect, political mechanisms such as local elections should be in place to help local preferences to be revealed and accountability to subnational constituents to be established. As the background information in Chapter 6 notes, introducing the local election of mayors contributed to the success of fiscal decentralization in Colombia.

Defining Spending Responsibilities

Earlier normative theories of fiscal decentralization provide guidance on the assignment of expenditure responsibilities across government levels. As indicated in Chapter 1, efficiency considerations should drive the assignment of spending responsibilities to subnational governments; according to the so-called decentralization theorem, “each public service should be provided by the jurisdiction having control over the minimum geographic area that would internalize the benefits and costs of such provision” (Oates, 1972, p. 55). At the same time, national public goods (benefiting all citizens and involving externalities, such as defense, foreign affairs, and macroeconomic stabilization) should be centrally provided.

In practice, however, most public outputs do not lend themselves neatly to a categorization into national (centralized) versus local (decentralized) assignments; and concurrent and joint assignments are common. Beyond a few functions that can be predominantly and exclusively assigned either to the center (as in the examples above) or to lower tiers of governments (such as local garbage collection and street cleaning) on the basis of considerations of “internalized benefits,” most spending assignments are jointly undertaken by different government levels. More generally, spending assignments reflect “political jurisdictions,” not “economic clubs” based on normative benefit considerations (Dafflon, 2006): in practice, identifying “minimum geographic areas” within which the costs and benefits of public service provision can be internalized is generally not feasible.

Most spending assignments and functions tend to overlap. The assignment of spending responsibilities covers three main decisions: which level of government should formulate a spending program; which level should finance it; and, finally, which level should implement the related spending.1 Accordingly, it is not uncommon to find that different levels of government are responsible for different aspects of a given spending function, thus creating concurrent assignments. For example, a given service may be considered a national priority, so the center retains some legislative and regulatory control in the definition of related policies and standards, and provides some or all financing, while lower levels of government are directly involved in the provision of such service. Typical examples of concurrent assignment are health care, education, social welfare, environment, infrastructure, and water and sanitation. The case studies in Part II of this occasional paper confirm this pattern, regardless of the degree of spending decentralization (as measured by subnational spending shares, Figure 2.1). Therefore, there are reasons for functions to overlap, and fiscal decentralization reforms should aim to clarify responsibilities and identify appropriate resources for their financing, rather than seek a complete remapping of spending assignments based on optimal allocation of functions—this would be neither a feasible nor a useful task.2

Figure 2.1.Subnational Spending in Case-Study Countries

Source: Case studies in Part II of this occasional paper.

Note: Data for the Democratic Republic of the Congo and Liberia are not available.

Concurrent responsibilities may nonetheless present fulfillment problems, when clarity in their definition and execution is lacking. Lack of clarity may be related to a number of factors. First, existing constitutional and legal provisions on the role and authority of the different government levels may be unclear or inadequate. Second, there may be duplication of tasks and weak coordination between the different tiers in implementing their responsibilities, possibly resulting in excessive spending and waste. Third, lower levels of government may display insufficient involvement and ownership, and when providing politically sensitive social programs, may opt for suboptimally low levels of services, relying on the center to become the natural “financier of last resort.”

Lack of clarity in spending assignments is, therefore, a root cause of soft budget constraint problems. One immediate implication of unclear spending assignments is that accountability is weakened: if voters do not know which level of government to hold responsible for possible shortcomings in service provision, politicians can play a blame game and avoid taking responsibility and corrective action. The difficult situation of health care in Italy is a case in point: while the center sets standards and largely provides financing, the regions are mainly responsible for administering service provision. Repeated episodes of “ex post” bailouts have occurred, as regional financing needs for health have exceeded the center’s allocations (Bordignon, 2006).3

Difficulties with overlapping expenditure assignments are apparent in many countries. In Colombia, the 1991 constitution envisaged that education and health care would be provided at the local or municipal level, and provided for earmarked transfers for this purpose. However, the responsibility for hiring and f ring teachers and health care workers remained with the center—attempts to move this function to municipalities were thwarted by powerful unions. In Bolivia, municipalities are responsible for building infrastructure for education and health care, and for the operation and maintenance of that infrastructure; departments hire the teachers; and the central government pays the salaries of the teachers. In addition, municipalities certify hours worked. In these circumstances, information on total spending on education or the actual number of teachers or health care personnel is not available. At the same time, different government levels may operate in their areas of competency without proper consideration for, and coordination with, other levels’ operations (for example, school facilities may be built without taking into account staffing availability; or teachers may be hired without considering the availability of school facilities). Similar cases of divided responsibilities arise in Africa (see Gersh-berg and Winkler, 2004). In Nigeria, under the new constitution adopted in 1999, primary education was assigned to the lowest tier—districts. However, most districts lacked the capacity to manage this function, and the financing from transfers was not effectively used for this purpose, with resulting shortfalls in the payment of teachers’ wages. An effective “recentralization” of this function then took place, with the states hiring and managing teachers, and financing occurring through a special-purpose or earmarked grant from the center.

The need to clarify roles and responsibilities of government levels has been emphasized in IMF staff advice. Without proper definition of which government level is responsible for what, the appropriate balance between spending mandates and resources to fund them cannot be addressed. Thus, staff have often called for rationalizing the legal framework and, where possible, eliminating overlaps that could lead to waste and duplication (Table 2.1 summarizes the main policy recommendations on spending assignments in the case-study countries). At the same time, assignments should reflect the subnational governments’ implementation capacity. When capacity is limited or varying, asymmetric options might allow a more-rapid take-up of responsibilities, for example, in advanced regions and the main urban centers, while capacity continues to be built elsewhere. This approach was recommended in FYR Macedonia, a very centralized country where significant devolution of spending was planned. Specific phasing was devised to help safeguard fiscal sustain-ability, ensure continued service quality, and avoid straining limited capacity at the municipal level.4 Finally, in China (one of the most decentralized countries, Figure 2.1), decentralization of pension provision to, in some cases, the lowest government tiers has put an excessive burden on jurisdictions and undermined risk sharing. Therefore, staff have recommended pooling of pension provisions, if not at the central level, at least at the provincial level.

Table 2.1.Main Recommendations on Spending Assignments in Case-Study Countries
CountriesMain issuesIMF advice
Clarification and definition of expenditure assignments
BoliviaSpending responsibilities overlap in many sectors, including health and education; are not in line with revenue assignments; and do not reflect differences in subnational capacities.Clarify and review spending responsibilities.
ColombiaUnclear legal framework with overlapping jurisdictions.Clarify legal framework and eliminate overlap.
Congo, Dem.

Rep. of
Constitution does not clearly define “shared expenditure responsibilities.” Institutional capacity on the provincial level is very weak, particularly in the reunified eastern provinces.Aim for a clear delineation of expenditure responsibilities. Transfer expenditure responsibilities gradually, in line with progress in strengthening provincial capacities, including PFM. Full and immediate transfer to largely unprepared provincial authorities implies high risks for the quality of spending, including large-scale misappropriation of funds.
IndonesiaSpending responsibilities overlapped in many sectors, including health and education; were not in line with revenue assignments; and did not reflect differences in subnational capacities.Clarify and review spending responsibilities. Be careful to consider all levels of service delivery and limit cost shifting.
KosovoIn 2007, it was noted that status resolution would bring increased spending responsibilities to municipalities and introduce asymmetric arrangements for Serb-majority jurisdictions. In 2010, discussion focused on strengthening incentives for municipalities to spend better.Clarify spending responsibilities—often defined in legislation but blurred in practice. Assign increased responsibilities in line with proven capacity to execute functions and based on well-defined accountability mechanisms. In 2010, advice is to eventually remove staff ceilings in the context of a well-designed civil service reform. Cost out functions before the grant system is revised, so that funds can be properly allocated in line with spending mandates.
LiberiaLiberia follows a deconcentrated model, with counties operating as agents of central line ministries. Limited spending autonomy is taking place through the County Development Fund (CDF), with some merits and shortcomings.Because counties have limited capacity, precede a move to fiscal decentralization with structural reforms and legislative initiatives. Meanwhile, pursue increased deconcentration to promote a stronger role of government in the provision of needed services at the local level. Improve procedures for CDF operations.
MexicoExpenditure responsibilities were not clearly defined, with health and education being two main areas of overlapping responsibilities. Subnational spending was dominated by personnel expenses, while spending on goods and services (including investment) was limited.Clarify functional spending responsibilities for lower levels of government, while allowing full control over the choice of economic inputs (wages and salaries, operations and maintenance, and so on).
NigeriaClarity is lacking in certain areas (both through omission and shared responsibility), as is coordination of intergovernmental expenditure policy. There is a proliferation of deductions-at-source practices by higher levels of government to undertake some spending responsibilities assigned to lower government levels.Pass national legislation to detail the distribution of functions relating to individual public services, such as education and health. Establish streamlined special-purpose transfers to achieve national objectives in fundamental areas. Ensure that the availability of financial resources for a level of government be broadly commensurate with the devolution of expenditure responsibilities.
Asymmetric options for spending devolution

This has been a very centralized country; while fiscal decentralization reforms are driven by political considerations, assigning spending mandates to municipalities will require careful sequencing and avoidance of duplication of spending.Expenditure assignments should be transferred gradually, starting from some basic administrative tasks at no or small financial cost, and progressively expanding to decision-making powers. The devolution of spending should proceed at different paces in different sectors, and across different municipalities (asymmetric options).
Centralization of devolved spending
ChinaLocal governments have replaced the state-owned enterprise sector as the main provider of social services (health and education) and social security (pensions). These burgeoning spending mandates were not clearly defined or financed.Clarify and review spending responsibilities. Centralize social security (pensions) to allow better pooling of risks and ensure proper financing.
Source: Case studies in Part II of this occasional paper.Note: PFM = Public financial management.
Source: Case studies in Part II of this occasional paper.Note: PFM = Public financial management.

Decentralization of spending responsibilities could start in areas where success is more likely to be rapid, and where accountability can be easily established. This would give rise to asymmetric sectoral decentralization. In FYR Macedonia, for example, it was recommended that specific strategies and the time frame needed for decentralization vary by sector. It was noted that fiscal decentralization in the education sector might be easier to achieve than in the health sector, and should therefore proceed at a sector-specific pace. General guidance was provided on specific stages, starting with the transfer of physical assets (e.g., buildings) to the municipalities along with the responsibility for maintaining them, moving on to responsibilities for personnel decisions (e.g., recruiting teachers), and in the final stage, for paying a significant share of current expenditures (e.g., at least part of the wage bill). Decisions on which sectors could be the best candidates for decentralization should be informed by the advice of specialists, for example, from the World Bank (as recommended in FYR Macedonia, as well as in Kosovo).

Another important issue is the impact of spending decentralization on the quality of service delivery. In principle, the assignment of expenditure responsibilities among government levels could be a valuable tool for improving performance of the overall public sector, by generating efficiency gains in the management of existing resources and strengthening accountability—one of the foremost rationales for decentralized provision of some public services. In practice, however, evidence of a positive relationship between decentralized spending and improvements in service delivery is hard to come by, not least because measures of outcomes of subnational spending—needed to gauge performance—are often lacking. Conclusive evidence of the positive impact of decentralization on the quality of public services remains limited.5 Service efficiency hinges on strong accountability links between the players in the delivery chain—service providers, customers and citizens, and policymakers. Decentralization can either strengthen or weaken these links, depending on the way in which it affects the incentives of the various players, thus yielding, on average, mixed results for service outcomes. For example, in cases where “partial decentralization” is implemented—with citizens not able to hold local governments accountable for budgetary allocations and their outcomes—the successful provision of decentralized public services cannot take place and the promised gains of decentralization—better quality services—do not materialize.6

By their nature, issues of expenditure assignment are inextricably linked to sectoral policies. This intertwining has been the experience in a number of countries where staff have provided advice on fiscal decentralization, and where specific recommendations required dedicated expertise of specific sectors. Therefore, in a number of cases, staff’s technical assistance has benefited from World Bank input, most notably on health and education (Kosovo, FYR Macedonia, Nigeria), but also on social assistance (China).

Ensuring Sound Public Financial Management

A clear and transparent public financial management (PFM) framework, at the subnational level as well as the central government level, is a crucial ingredient of successful fiscal decentralization (Ahmad, Albino-War, and Singh, 2006). It facilitates consistent decision making to ensure macro-economic stability and accountability for effective use of public resources. Sound PFM arrangements need to be supplemented by legal provisions and institutional mechanisms governing the responsibilities and financing of different levels of government to generate the incentives to manage resources efficiently. In countries in which subnational PFM systems do not meet minimum adequacy standards—for example, where budget formulation is incomplete, and information and reporting of government operations is limited, inaccurate, and not timely—staff have emphasized that strengthening PFM arrangements should be a prerequisite for increasing decentralization (this was the position taken in Bolivia, the Democratic Republic of the Congo, Indonesia, Kenya, Kosovo, Liberia, and Nigeria).

Several elements of good PFM and governance are critical at the subnational level. Among these elements are a realistic budget envelope prepared in a timely manner; an adequate budget classification system, preferably compatible with international standards (e.g., the Government Finance Statistics 2001—especially for economic and functional classifications), and an accounting framework consistent with such classification;7 effective audit and control mechanisms, with a high probability of detection of, and penalties for, misuse of public funds; and firmly enforced requirements for timely and accurate reporting.

The budget framework should encompass all government levels. To facilitate consistent decision making across the whole general government, the budgets of all jurisdictions must be based on common macroeconomic assumptions, use a harmonized budget classification, and be formulated and executed according to well-coordinated schedules. Problems arise when operations at all government levels, and their financial interactions, are not fully captured in the budget. For example, in Nigeria, a portion of the transfers to state and local governments is netted out against subnational mandatory spending (including for teachers’ salaries), a practice that significantly reduces the coverage of the budget and weakens transparency and accountability. In Liberia, where the budget document does not include information on operations at the county level, staff advised to start including in the budget an annex showing consolidated projected spending by county, because transparency and more-informed decisions would also lead to a rationalization of such spending, thus paving the way for effective further devolution of functions to counties in the future. In some cases, the budget calendar does not allow coordination among government levels—a problem exacerbated in countries where the fiscal years differ across government levels,8 or where the central budget is adopted late and subnationals do not receive information on their allocations until late in the fiscal year, a problem experienced in China.

In cases where the center cannot impose or enforce a common framework, consensus can be forged to introduce it. This strategy is being used in Nigeria, where the government is seeking to institutionalize a framework for the sharing and spending of oil revenue, as well as mechanisms to coordinate policy priorities and spending levels between the federal government and the states. Similarly, the states have been encouraged to approve fiscal responsibility legislation that parallels that of the federal government, which enshrines a fiscal framework based on an oil price—based rule. The 2007 Nigerian Fiscal Responsibility Act also sets out transparency requirements, sanctions, compliance provisions, and guidelines for budgetary practices. In Brazil, the passage of a national Fiscal Responsibility Law, binding for all levels of government, was facilitated by a comprehensive and effective consensus-building effort by the federal government with subnational governments, as well as the federal congress and public opinion at large.

Timely monitoring and transparent reporting of fiscal operations at all government levels, to include guidance for subnationals on the content and format of reporting, are important for effective macroeconomic management. A common framework for accounting and reporting—consistent with the budget classification—is critical to establishing transparency and accountability. Among various issues in this area, the importance of an adequate information management system cannot be overemphasized. Although systems can differ across government tiers, especially in larger, federal countries, the systems need to interface to allow comprehensive reporting. Effective auditing and control systems, together with firmly enforced sanctions for non-compliance, constitute additional conditions for good governance.

Staff advice on strengthening subnational PFM systems has focused on different issues in different countries, depending on the specific needs and circumstances of the requesting country (Table 2.2). It has focused especially on those elements of PFM systems that are most critical from a macroeconomic standpoint. In a number of countries, staff advice has emphasized strengthening the framework legislation for PFM, which provides the basis for sound budget formulation, execution, accounting, and reporting. For example, staff provided input for the Financial Management Legislation in Iraq (2004) and, more recently, for planned reforms to framework legislation for financial management for all government levels in Bolivia and Peru.

Table 2.2.Main Recommendations on Public Financial Management in Case-Study Countries
CountriesMain issuesIMF advice
BoliviaWeak budget process does not impose hard budget constraint. Economic classification, link with chart of accounts remain inadequate. The poor budgetary procedures and the related information system (SIGMA) preclude up-to-date reporting of subnational finances.Adopt a new organic budget framework law. Assess options for the information system (the existing system is inadequate, and it may prove more costly to fix than to design a new one or get one off the shelf).
ChinaBudget formulation, execution, and reporting showed weaknesses at the subnational level, making it difficult to monitor subnational operations.Adopt a modern budget classification (and revise the chart of accounts consistent with it) across levels of governments, to improve the transparency of government operations. Design and implement nested subnational information systems and treasury single accounts.
ColombiaLack of effective macroeconomic coordination across levels of government hindered policy formulation and implementation, along with lack of consolidated fiscal accounts.Consolidate the data coming from various sources that collect local fiscal data. Introduce a fiscal coordination council.
Congo, Dem.

Rep. of
Institutional capacity of subnational governments in budget preparation and execution, as well as treasury management, is weak. Harmonized accounting and computer systems are nonexistent.Strengthen local governments’ PFM capacity and harmonize accounting standards.
IndonesiaBudget classification structure used by regions was not aligned with the central government; there was no regional government reporting mechanism; data on subnational governments were provided with a two-year delay, with no information available on local spending during the year.MoF to provide guidance to the regions on classification. Develop budget planning allowing for smoothing large variances in regional transfers. Establish regional reporting framework, with monthly reports on expenditures provided to the MoF. Introduce penalties for subnational governments failing to report budget documents to the MoF, via reducing central government transfers.
KosovoDespite significant improvements in budget preparation, execution, and reporting at the municipal level, there was still a need to consolidate progress in PFM, in particular regarding the public investment process.Continue to pursue PFM reforms and build capacity, and execute municipal budgets through the central treasury system. Introduce a more stringent certification scheme for municipalities. Strengthen the public investment process, including project selection, planning, and execution. Allocate funds for municipal projects directly (albeit gradually) to municipalities, rather than line ministries, within a well-specified medium-term framework.
LiberiaThe centralized system has hampered the development of PFM capacity at the county level. All financial transactions take place in the capital. Weak or nonexistent capacity poses a risk to the successful devolution of funds and functions.Adopt a sequenced approach, starting with increased transparency and coverage of county-level operations in the budget. Establish county treasuries to provide treasury services and ensure better use of cash resources and provide regular reporting of county financial transactions. Prepare the legal framework and the institutional framework for decentralization, including through the establishment of a small unit at the MoF.
Macedonia, FYRAll stages of the municipal budget process (including budget preparation, execution, reporting, and audit) were in need of improvement. Absent a significant PFM reform at the municipal level, fiscal decentralization would be bound to fail.Strengthen PFM system by establishing comprehensive and timely reporting mechanisms on budget execution, as well as by strengthening human capacity in these areas (including via training of municipal financial officers). Introduce penalties for noncompliance.
MexicoStandardized and timely information on fiscal performance of states and municipalities was lacking. Only a few states have modern information systems (GFMIS) that integrate budget and accounting. This prevented federal government from producing information on general government fiscal operations, and did not allow states and municipalities to compare with others.Establish a common budget classification and accounting framework consistent with international standards, at all levels of government. Determine reporting standards and introduce sanctions for noncompliance. Ensure GFMIS fully integrate budget modules and accounting, and interfaces are designed for the effective flows of information. Federal government, with assistance of Bank of Mexico, should also begin below-the-line tracking of subnational operations.
NigeriaThere was no common macroeconomic framework for all levels of government; no reporting of information on subnational fiscal developments; no harmonized system of budget classification and accounting for all levels of government; and there was no well-defined treasury system at the subnational level.Ensure that the budgets of all three levels of government are consistent with the same basic underlying macroeconomic assumptions. Make public the transfers from the Federation Account, as well as subnational budgets and their outturn. Establish comprehensive coverage of fiscal accounts. Prepare a uniform set of guidelines for budget preparation and accounting to be followed by all tiers of government. Establish a consolidated single account for the states at the central bank.
Source: Case studies in Part II of this occasional paper.Note: GFMIS = Government Financial Management Information System; MoF = Ministry of Finance.
Source: Case studies in Part II of this occasional paper.Note: GFMIS = Government Financial Management Information System; MoF = Ministry of Finance.

Staff advice has also emphasized the importance of treasury single accounts (TSAs).9 TSAs are used in modern administrations to consolidate the government’s cash, minimize borrowing requirements, facilitate asset and debt management, and also establish a better record of who spends what and when. TSAs also make it less likely that government funds, which might otherwise be held in thousands of bank accounts with little oversight, are misused. The establishment of a TSA, even if shared with the central government on an agency basis—one of the options recommended in Mexico—need not impair the autonomy of subnational governments. On the contrary, it could serve as a vehicle for increased transparency and, hence, better decision making. In Kosovo, municipal operations are covered by the central TSA, which provides the main source for reporting on municipal finances and cash flows. Whether subnationals should have their own TSAs or use a centralized TSA depends on institutional arrangements and political preferences, as long as ledger accounts (used in a TSA in lieu of bank accounts) are used to track spending by enabling the identification of the resource use.

In cases where the “above-the-line” information is either inaccurate or not available, staff have advised to monitor “below-the-line” subnational operations. In Mexico, staff recommended tracking subnational fiscal operations from bank transactions, with assistance from the Bank of Mexico. Because this would not identify the possible buildup of arrears or contingent liabilities, establishing and maintaining subnational debt and risk registries was also recommended in some countries (Bolivia, China, and Mexico).

On occasion, staff have also provided advice on organizational issues. Decentralization typically places responsibilities on the Ministry of Finance (MoF) to guide and monitor fiscal relations with subnational governments. Although the degree of MoF oversight over intergovernmental relations varies across countries, the basic set of MoF responsibilities includes preparing and disseminating financial management instructions for subnationals; providing guidance to subnationals for budget preparation; collecting, consolidating, and publishing subnational budgets and budget execution data; and monitoring adherence to financial rules and the PFM legal framework. Given that these tasks require full-time, dedicated staff with computerized support, ideally, a special unit should be established within the MoF, with clear reporting responsibilities both within the MoF and with other government ministries. The size of this unit would depend on the complexity of the devolved government system and the role assigned to the MoF.10

Preparations for the creation of a dedicated unit—or the assignment of dedicated staff—should begin early in the fiscal decentralization process. Planning should begin at an early stage, particularly for identification of job descriptions, skills, and training. In Liberia, staff advised authorities to start planning a dedicated unit once the main law establishing local governments had been adopted. In Nigeria, staff recommended the creation of a Fiscal Analysis Unit to be in charge of providing a common macroeconomic framework for fiscal policy formulation and of monitoring fiscal developments at all government levels.

Designing Intergovernmental Revenue Arrangements

One of the basic tenets of fiscal decentralization is that funds should follow functions; thus, resources assigned to different levels of government should be linked to the scope of the functions devolved to those levels. This matching principle has two main implications: (1) subnational governments’ spending responsibilities should be adequately financed through a combination of own-source revenue, shared taxes, transfers, and to the extent allowed, borrowing; and (2) revenue assignments should be contingent on a transparent and clear definition and delegation of the functions the revenues are intended to fund. These prerequisites are often neglected in practice, because sometimes political pressures emerge to devolve taxes to (or share them with) subnational governments, without due consideration for the use of such funds. For example, this is a risk arising in the Democratic Republic of the Congo, where the planned decentralization strategy would assign some 40 percent of overall revenue to provinces although the provinces would only be responsible for about 20 percent of overall spending (see Chapter 7); it could also be a risk in Liberia if pressures to share large resource revenue flows are acceded to before counties are ready to take up new spending responsibilities. As explained above, in these cases the central government’s fiscal space is significantly eroded, and the ability of the center to undertake stabilization and redistributive policies is hampered.

Defining the right financing mix requires a delicate balancing act. Allowing access to own-revenue (for which subnational governments have discretion over tax rates and bases) at the margin through local taxation is essential to promoting fiscal discipline and accountability, because access to own taxes can help curb perceptions of soft budget constraints. If considerable expenditure responsibilities are devolved, access to significant tax handles at the margin may be needed at the subnational level to ensure that local spending decisions are linked to financing by those who benefit from these expenditures. However, excessive tax autonomy may create inefficiencies and widen disparities across jurisdictions, thereby undermining the stabilization role of the central government. Thus, the right degree of taxing autonomy is a matter of judgment, and reflects historical, political, and other country-specific factors.

Normative theories of fiscal federalism emphasize a number of principles for optimal tax assignments. In this literature, the assignment of taxes derives directly from the optimal assignment of government functions (as described in Table 1.1). Taxes with large and elastic bases, such as income taxes, should be assigned to the central government as the best instruments for both macroeconomic stabilization and income redistribution. For allocation functions, benefit taxation should be used by various government tiers. Accordingly, the provision of local services (such as public utilities and local transportation) should be subject to user charges and fees; services with local benefit zones (parks, roads) should be financed with local taxes; while goods and services with significant externalities should be financed with regionwide taxes or transfers. To prevent revenue losses or tax erosion resulting from tax competition, local tax bases should be relatively immobile; bases should also be evenly distributed across jurisdictions, to avoid horizontal fiscal imbalances; and their yield should be relatively stable, to allow subnational governments to rely on steady and predictable revenue streams. These principles rest on the assumption that governments behave as benevolent welfare maximizers. When this tenet is challenged—as in the public choice approach (Brennan and Buchanan, 1980)—the opposite conclusion derives, that is, that subnational taxes should be imposed on mobile factors to promote competition among “rapacious” governments; less availability of taxes would help limit the size of governments (the “starve the beast” argument). As explained earlier, however, the main limitation of these normative theories is that they do not explain tax assignments in the real world.

More-recent positive theories underline the political interactions among government levels—and the incentives faced by politicians—as key factors in the distribution of taxing powers. However, while these theories help explain some of the observed intergovernmental tax systems, “no clear indication concerning the optimal tax assignment to different levels of government emerges from them” (Ambrosanio and Bordignon, 2006, p. 314).

In practice, revenue assignments are guided by a number of considerations. In addition to ensuring funding adequacy and promoting accountability, administrative feasibility is an important factor in defining revenue assignments. As discussed below, some tax handles that are appropriate for countries with sophisticated administrations at the subnational level may not be advisable for ones with weaker administrations at the same level. This issue is recognized by both normative and positive theories of revenue assignments. On this basis, most major tax handles—such as the valueadded tax (VAT) and income taxes—tend to be assigned to the central government, given that the administration of these taxes within a multilayered government presents particular challenges.11 Import duties also are typically assigned to the center. These assignments tend to create vertical imbalances in favor of the center because the center collects more revenue than needed to carry out its spending responsibilities. This opens up the possibility to redistribute resources according to various equalization criteria (see “Other Intergovernmental Transfers” later in this chapter).

In addition, revenue assignments rarely take the form of full and exclusive assignments of taxes to one government level. Rather, various options are possible (and countries have indeed adopted different models). Just as establishing a one-function—one-government-level link is not possible, and an overlapping “continuum” of functions is assigned to various government levels instead (see the “Defining Spending Responsibilities” section of this chapter), so the sources of government funding also form a continuum of different yet overlapping alternatives.

Options for intergovernmental revenue arrangements vary according to the degree of subnational revenue autonomy these options allow. Three main types of arrangement exist. First, own-revenue assignments allow some degree of discretion to subnational governments, with a distinction between own-source revenue (under which subnational governments enjoy full legal control over both the definition of taxable bases and the rate structure of the revenue source) and surcharges or piggybacking on central taxes (under which subnational governments have limited or no control over the specification of the tax base, but a typically bounded degree of control over tax rates).12 Second, revenue-sharing arrangements allocate to subnational governments shares of taxes whose bases and rates are defined (and typically administered) by the central government; in this case, subnational governments have no control over these revenue sources. (In some cases, though, the subnational may collect and administer these taxes, as in Germany.) Finally, intergovernmental grants transfer budgetary resources to subnational governments. Although the distinction between revenue-sharing and grants is a fine one, grants are typically characterized by a higher level of central discretion than is revenue-sharing, to the point that subnational governments may not even be able to predict their grant amounts with any degree of confidence. Table 2.3 presents a taxonomy of subnational revenue assignments, further discussed in the remainder of this section.

Table 2.3.A Taxonomy of Subnational Revenue Arrangements
Revenue sourceElements controlled by subnationals
Tax baseTax rateAdministration
Own-revenue assignments
Own-source revenueYesYesYes/Possibly
Surcharges on national taxesNoYesPossibly
Other intergovernmental transfersNoNoNo
Source: Authors.
Source: Authors.

Subnational Own-Revenue Assignments

Assigning own-revenue to subnationals is believed to provide incentives to promote improved economic performance. Subnational governments that can keep a share of the revenue raised in their jurisdictions have an interest in promoting business- and market-friendly policies for their positive impacts on local tax bases and revenues. In contrast, when a large portion of locally raised revenue is siphoned of to the center or other jurisdictions, local politicians have little incentive to increase revenue intakes, thus placing lower priority on stimulating economic activity through good policies.13

Property and land taxes are typical subnational own-source taxes, for a number of reasons. The bases of these taxes are immobile, so taxpayers cannot easily shift location to avoid taxation; the taxes reflect the benefit principle because local services (e.g., roads, transportation, parks) confer benefits on properties and increase property values; the taxes allow subnational governments to determine the desired level of services and raise revenues to pay for that level (because the property tax base is relatively inelastic, maintenance of the tax yield may require discretionary policy changes of tax rates or valuations), which makes the tax highly visible and establishes a clear accountability link by enhancing the responsiveness of local politicians to local demands. However, determining the value of property tax bases is often difficult, thus complicating their administration, especially in countries where market valuation is hindered by limited real estate market activity or by limited information on market transactions. Hence, determining the tax base is often a matter of judgment. International experience suggests that the yield from property taxes is usually limited.14 Still, there is a general perception that property taxes remain largely underexploited (OECD, 2004).

Benefit taxes, including user charges, are another important revenue-raising tool for subnational operations at the margin.15 Yet in most cases, the revenue potential remains limited relative to financing needs of subnational governments, mainly because of distributional or political considerations; and these taxes can become nuisance taxes if allowed to proliferate excessively. Similarly, excises of various kinds are sometimes used at the subnational level, and may be relevant at either the intermediate (regional) or local tiers of government. From an efficiency standpoint, excises should be levied on a destination basis (where the taxed good is consumed), but this may give rise to smuggling and cross-border shopping if subnational jurisdictions apply significantly different rates.

More-mobile tax bases are increasingly being recommended in the literature for assignment to subnational governments. Additional competition—within and across regions—may help promote spending discipline. However, these options remain subject to administrative feasibility and constraints. Given its strong long-term revenue potential, interest continues in the possibility of implementing the VAT as a subnational tax, which requires addressing the inherent difficulties noted above.16 Experiences with subnational VATs in practice, however, have been mixed (Perry, 2009). For example, VAT could become a central-local tax, administered by either level of government on a jointly determined base, but with each government level choosing its own rate (the so-called dual VAT). More-sophisticated options exist, although they have not yet passed the empirical test and remain theoretical.17 Experiences with subnational VATs have been mixed. While these taxes represent important revenue handles, the lack of harmonization has increased compliance costs to taxpayers operating in different jurisdictions, and has also resulted in tax wars across states (as has happened with the state-level VAT in Brazil). The Canadian dual VAT appears more successful. Experience to date with the state VATs in India is too short to make definitive judgments.

In a few countries, local business taxes have been replaced by a subtraction-type origin-based VAT. This tax is levied on a measure of value added, calculated for each taxable entity as the difference (hence the name “subtraction-type”) between revenue and purchases. This has proved to be a powerful and easy-to-administer revenue tool for subnational governments (the Italian regional business tax, IRAP, and the German local trade tax, Gewerbesteuer, provide good examples). This tax has a number of theoretical advantages, including the avoidance of cascading that might be present with traditional business taxes, and the fact that the tax base is essentially a measure of an entity’s value added.18 To be effective, this tax should be levied at a single rate. However, although relatively simple to administer, it is not suitable where lower tax-administration levels have limited capacity; in these cases, an alternative may be to have it administered by the central tax administration.

The assignment of specific taxes reflects historical, political, and institutional factors, as well as countries’ levels of capacity and development. Table 2.4 highlights the main advantages and disadvantages of various tax assignments.

Table 2.4.Assignment of Taxes to Subnational Governments
Personal income tax• Buoyant revenues

• Visible (increases accountability)

• Cost-effective if piggybacked on national taxation
• May create or aggravate horizontal imbalances.

• In areas where average incomes are below threshold, insufficient yield; also, as most people would not pay, the price-signal effect of the tax is weakened.

• If levied at different rates among jurisdictions, it may create distortions if people are mobile.
Corporate income taxSometimes seen as a sort of benefit tax• Mobile tax bases and complex administration make it suitable for collection by the center (except taxation of small businesses).
User fees and charges• Low-mobility tax base

• No obvious horizontal or vertical imbalance problems

• Visible

• Linked to benefits
• Generally low yield

• Low cost-efficiency
Property tax• Immobile tax base

• Visible

• Stable yield

• Indirectly linked to benefits
• Difficult administration (especially in setting up well-functioning cadastres), often resulting in low yield.
Sales and excise tax• No horizontal or vertical imbalance problems

• Visible

• Easy to administer
• May create cross-border shopping if levied at different rates among subnational jurisdictions.
Value-added tax• If properly designed and administered, it could be a good subnational tax, although experience has been mixed (see text).• Complex tax administration

• If applied on destination principle, border controls between local jurisdictions required; if applied on origin principle, tax exporting and transfer pricing may arise.
Resource taxNone apparent• Significant horizontal imbalances

• Difficult to administer

• Excessively volatile
Source: Feyzioğlu and Norregaard, 2008.
Source: Feyzioğlu and Norregaard, 2008.

Surcharges, or piggybacking, on central taxes may provide additional subnational revenue, building on the central tax administration—indeed, a key source of subnational revenue in many countries. These arrangements confer a more limited degree of autonomy to subnational jurisdictions because the subnationals simply impose a surcharge on tax bases defined by the central government. Still, there may be incentives on both sides—local authorities may have an advantage in identifying potential taxpayers, to the mutual benefit of both the center and the subnational governments. Surcharges are most typically levied on personal income taxes, but piggybacking on sales taxes and excises also occurs.

Surcharge tax rates are frequently subject to both upper and lower limits set by the central government. Although surcharges are easy to administer, a possible drawback is that they may create (or deepen) horizontal disparities, because revenue tends to be geographically concentrated in richer and more-developed jurisdictions. This situation would require an appropriate equalization transfer system (see “Other Intergovernmental Transfers” later in this chapter).

In their advice, IMF staff have attempted to balance normative principles with administrative capacity considerations and political economy constraints (Table 2.5). In most countries, the legal framework for local taxation is unclear; policy weaknesses are often compounded by shortcomings in revenue administrations, making yields from local own-source revenue inadequate to ensure spending accountability and proper funding of subnational operations. In these cases, advice has focused on clarifying and simplifying the legal framework, eliminating nuisance taxes, and improving the design and administration of a few good tax handles, most notably property taxes (for example, in the Democratic Republic of the Congo, Indonesia, Kosovo, Liberia, FYR Macedonia, and Nigeria). In countries with relatively advanced tax administration, new taxes were recommended, along the lines of a local VAT-type tax, either directly assigned to subnational governments (Colombia) or assigned to the national government with piggybacking arrangements for subnational governments (Mexico). In other cases (Bolivia and China, among others), surcharges on national income taxes were suggested to bolster subnational taxation.

Table 2.5.Main Recommendations on Own-Revenue Assignments in Case-Study Countries
CountriesMain issuesIMF advice
Clarify legal framework for subnational taxation; streamline system of own-source revenue; strengthen property taxes
Congo, Dem.

Rep. of
Tax assignments are not clearly defined, and yields (especially for the property taxes) are insufficient to cover provinces’ spending needs.Establish well-defined tax assignments for subnational governments. Strengthen the design and collection of property taxes; review all subnational taxes with a view to streamlining and eliminating nuisance fees and taxes.
IndonesiaLimited own-source revenues. The taxes that could be levied by regions had low yields.Include the land and building tax in the list of local taxes, with local governments allowed to set the assessment rate.
KosovoMunicipal own-source revenues are limited. Property tax collections are low because of weaknesses in administration.Strengthen property taxes through establishing a national fiscal cadastre and applying common and harmonized valuation procedures. Exploit fee-for-service instruments (such as municipal parking lots), which could support municipal own-source revenue. These recommendations were reiterated in 2010, along with a gradual increase in the property tax rates, a review of municipal fees and charges, and a regularization of construction permits. It was also noted that allowing more spending autonomy at the margin would provide the strongest incentive to boost own-source revenue collections.
LiberiaThe legal framework for taxation at county and city levels is unclear; some local taxes exist, but these are unlikely to fund increasing spending mandates.Clarify the legal framework for local taxation. Strengthen the design and administration of property taxes, potentially a good revenue handle for subnational governments.
Macedonia, FYRMunicipal revenues were capped (those in excess of the cap were reallocated using not fully transparent criteria); volatile; and municipal revenue bases were insufficient to provide for increasing spending responsibilities.Increase municipal tax collections by giving municipalities bounded control over rates; remove caps on their revenue; and allow them to keep all property taxes. As expenditure mandates are broadened, monitor that revenue bases of municipalities are adequate, not only in the aggregate but also across municipalities.
NigeriaNon-oil taxes of state and local governments (SLGs) have very low yield and productivity. SLGs do not control the rates of most of the taxes they levy, thus having very limited own-source revenue.Provide subnational governments with additional sources of revenue, with some control over rates, including excises and business taxes, surcharges on utility bills, and improved property taxes. Repeal nuisance taxes at the local level. Transform oil revenue derivation rule into a royalty share and an explicit environmental excise.
Strengthen own-source revenue through piggybacking on national taxes
BoliviaBoth municipalities and regions have limited autonomy regarding the tax base and the tax rates, which are mostly set by the central government, thus encouraging dependence on transfers and central government decisions. This undermines subnational incentives to raise revenue through better tax administration and through increasing revenue.Assign subnational government significant own-sources of revenues (i.e., enabling them to set rates for local taxes and impose, on the margin, surcharges on national taxes) in line with redefined spending responsibilities. Appropriate sequencing is needed in giving subnational governments access to new own-revenue sources and the transfer of additional responsibilities. Only subnational governments that accept new responsibilities and perform them adequately should be given continued access to new tax resources.
ChinaLocal governments had only limited power to set rates for a few local taxes. Revenue-generating capacity varied widely across provinces, contributing to the creation of significant disparities in service provision.Give more control over tax rates to local governments. This would also help compensate the richer provinces losing from a more equalization-based system of transfers. To this end, for instance, allow provinces to levy surcharges on personal income tax; grant the power to levy domestic excises; and increase freedom in setting property tax rates.
Introduce a new VAT-like tax
ColombiaAlthough the distribution of revenue bases across levels of government was broadly adequate (departments collected excise taxes and municipalities collected property taxes, a tax on turnover, and a surcharge on gasoline), the structure was complex.Increase local own-source revenue via tax and tax administration measures. Convert the local turnover tax into a simplified (subtraction-based) local VAT.1 Simplify departmental excises’ procedures and administration; collect them as production (and not consumption) taxes and redistribute part of the proceeds among departments.
MexicoStates had limited own-source revenues, and relied primarily on transfers.Piggyback the IDTU (a new federal tax to be levied on business, akin to an income-type, origin-based VAT administered with the subtraction method).1 Alternatives would be to piggyback on the income tax and to revamp the property tax. These measures would create greater accountability through a major tax handle for states. Piggybacking could be introduced quickly and be administered by the federal government tax collection agency.
Source: Case studies in Part II of this occasional paper.

See the main text for a description of this tax.

Source: Case studies in Part II of this occasional paper.

See the main text for a description of this tax.

Availability of own-source revenue is a necessary, but not sufficient, condition for accountability and fiscal discipline at the subnational level. Even if subnational governments can mobilize own-source revenue, they will not necessarily have an incentive to do so. In fact, although the availability of own-source revenue helps mitigate the common pool problem, it does not automatically eliminate the soft budget constraint problem (as illustrated by the Italian experience with regional health spending mentioned in the “Defining Spending Responsibilities” section earlier in this chapter). Elimination of the soft budget constraint depends critically on the interactions of other elements of intergovernmental fiscal relations, specifically, the clarity of expenditure responsibilities and the scope and design of the transfer system and borrowing options.


Revenue-sharing, often used to close vertical fiscal imbalances, can be based on either individual taxes or total tax collection. Although revenue-sharing offers some of the advantages of surcharges, such as administrative simplicity, it does not constitute own-source revenue, in the sense that the subnational jurisdiction does not have control at the margin over the rate structure; and revenue-sharing generally does not provide equalization, as discussed further in this section. In aggregate terms, revenue-sharing may provide greater resources than own-source revenues, but, as indicated above, must be accompanied by own-source revenues to promote accountability at the subnational level. Given that revenue-sharing makes the revenue of one government tier dependent on the choices of another (on tax bases and rates), it is often considered akin to transfers rather than a method of revenue assignment.19

Similar to transfers, revenue-sharing involves two main policy choices: how to define the revenue pool to share, and how to allocate that share among subnational governments. If some taxes are shared and others are not, a built-in bias occurs for central governments to maximize collections of those taxes that are not (or are less) shared. Taxes should also be shared at the same rates (a certain percentage of all taxes) to avoid distortions; extraordinary revenue, for example, from the sales of assets, should not be shared. In addition, to reduce procyclicality of shared revenues, a moving average of revenue collected over the cycle could be used (or a fraction of a moving average of nominal GDP over the cycle, as recommended by staff in Argentina). As for the distribution of shared revenue, revenues are often shared on an origin basis (where revenues are collected; also called the “derivation principle”). Other criteria are also applied, for example, equal per capita allocations.

Natural resource revenues are not suitable for sharing arrangements because they are very volatile and tend to be geographically concentrated. Two main problems arise: revenue-sharing on an origin basis would create significant horizontal disparities, and subnational governments are typically not well equipped to deal with the inherent volatility of these revenues (Box 2.1). For these reasons, the IMF has recommended against sharing of resource revenues (for example, in the Democratic Republic of the Congo, Liberia, and Nigeria). Rather, advice has focused on introducing production-related excises (together with equalization transfers) in lieu of natural resource revenue-sharing, as in Bolivia, Indonesia, and Nigeria. Excises might be fully or partly assigned to lower levels of government as part of compensation for damage to the environment and other costs, together with a transfer system that ensures that basic subnational spending can be adequately funded.

Despite its administrative simplicity, revenue-sharing presents a number of drawbacks. The first major difficulty with sharing of revenues is the rigidity that it imposes on macroeconomic management. For example, if 50 percent of revenues are shared with subnational administrations, any required revenue adjustment would need to be substantially larger for the central government, because subnational governments may spend part or all of their shares.20 Second, revenue-sharing distorts incentives: if additional taxes have to be shared, governments do not gain much by raising additional revenue (this is believed to be the case in Germany, where the marginal transfer rate—the proportion of revenue at the margin to be transferred away—is significant, thus weakening incentives to raise revenue). Finally, because revenue-sharing on an origin basis exacerbates horizontal inequalities, it needs to be accompanied by compensatory redistributive transfers.

IMF staff advice on this issue has focused on three main elements: First, revenue-sharing should be considered as part of the overall financing framework for subnational governments; because revenue-sharing is conceptually akin to transfers, in some cases advice has focused on the design of transfer arrangements (for example, in Colombia and Kosovo). Second, sharing of revenues that tend to be geographically concentrated (such as natural resource revenue) should be avoided; for example, in FYR Macedonia, staff advised sharing VAT rather than income taxes, given that VAT were more evenly distributed across municipalities. Finally, revenue-sharing should be accompanied by a proper equalization transfer system. Table 2.6 includes more detail on staff policy recommendations on revenue-sharing.

Table 2.6.Main Recommendations on Revenue-Sharing in Case-Study Countries
CountriesMain issuesIMF advice
BoliviaDistribution of hydrocarbon revenues generates vertical and horizontal imbalances and transfer volatility, and has resulted in low incentives to exploit tax bases at the subnational level.Hydrocarbon taxation should accrue to the central government level only.
ChinaRevenue-sharing (based on taxes whose bases were stronger in richer provinces) had elements of regressivity because it favored richer provinces.Reform transfer system to make it consistent with delivering a minimum standard of public services and based on a rules-based equalization system.
Congo, Dem. Rep. ofConstitution grants provinces 40 percent of government revenue collected in their territory, but does not define the tax bases.Full and immediate implementation of the 40 percent rule would create a major vertical imbalance (health and primary education, assigned to local governments, account for less than 20 percent of total expenditures). Revenue-sharing mechanisms should be gradual and in line with the devolution of expenditure responsibilities.
IndonesiaOil and gas revenues are included as part of revenue-sharing, thus creating imbalances and increased volatility of transfers. In addition, a floor was imposed on transfers.Avoid sharing oil and gas revenues on an origin basis.
LiberiaIn 2009, there was no revenue-sharing mechanism in place, but pressures are likely to arise to assign and share natural resource revenue on an origin basis.Refrain from sharing natural resource revenues because this would complicate financial management at the county level and would open horizontal gaps. In the initial stages of decentralization, limited spending assignments will likely not require funding through revenue-sharing.
Macedonia, FYRNo revenue-sharing in place at the time the IMF provided technical assistance.As larger spending assignments are transferred to municipalities, revenue-sharing could be used to close vertical imbalances. Sharing VAT should be preferred to sharing PIT: (1) VAT-sharing is administratively simpler; (2) VAT revenues are more stable; and (3) redistribution may be easier because local incidence matters less.
MexicoComplex and nonredistributive system based on revenue-sharing and earmarked transfers.Reform revenue-sharing and fold it into a new transfer system designed to reflect spending needs and revenue capacity.
NigeriaAll federally collected receipts are pooled and shared based on two formulas: one for the VAT and one for all other revenues, including oil revenue. Sharing of oil revenue is highly procyclical; increases the sensitivity of subnational finances to volatile oil revenue; and creates marked horizontal imbalances at the state level. States are mandated to share 10 percent of all their receipts with local governments.Repeal oil revenue-sharing and convert into a royalty share and an explicit environmental excise. Repeal the 10 percent sharing of internally generated revenue of states with their local governments, which has been erratically applied, and fold into properly designed revenue assignments (including piggybacking on PIT).
Source: Case studies in Part II of this occasional paper.Note: PIT = Personal income tax. Colombia and Kosovo are not included (advice was provided more specifically on transfer design).
Source: Case studies in Part II of this occasional paper.Note: PIT = Personal income tax. Colombia and Kosovo are not included (advice was provided more specifically on transfer design).

Other Intergovernmental Transfers

A transfer system’s design has a significant impact on incentives to manage subnational operations efficiently. As highlighted in Chapter 1, sole reliance on grants, or transfers designed to automatically meet subnational deficits (gap-filling transfers), is likely to sap efficiency and reduce accountability, and should be avoided. The design of transfers has been a major focus in overall assessments of intergovernmental fiscal relations, as well as a subject for which IMF advice has been sought by member countries.

Box 2.1.Sharing of Natural Resource Revenue

Even though the availability of large natural resource revenues typically exacerbates demands for decentralization (with producing jurisdictions claiming control of such revenue), sharing of such revenue should be avoided. Assignment of natural resource revenues to subnational entities has many disadvantages, especially in small countries.

  • Attribution of volatile resource revenues to local governments can complicate fiscal management and macroeconomic policy at the central level: during price booms, large resource revenues tend to induce unsustainable expenditure levels, while during price downturns, basic expenditures assigned to subnational governments might come under pressure.This was acutely felt in Nigeria, where the states (which receive a fixed share of the oil revenue) built in unsustainable levels of spending during the oil boom in the late 1990s.
  • Geology or geography differences should not determine the distribution of revenues from national resources; when shared on the basis of origin, significant horizontal imbalances arise.
  • Resource revenues bring with them little local accountability; this problem exists at the national level, but is probably exacerbated in local government.
  • The size of resource revenues, relative to the size of the jurisdiction, may bring risks not only of absorptive capacity, but also of corruption.

The central government is often in a better position to smooth fluctuations in natural resource revenues, provided that these resources are transparently managed. Although political economy considerations often suggest some sharing of natural resource revenues, in practice, agreeing on a percentage is hard (resource-rich subnationals would always be better of by keeping 100 percent of all resource revenue)—a problem that is often exacerbated if there are ethnic or religious differences involved, as in Nigeria and Aceh in Indonesia.

Transfers typically satisfy a number of purposes. They correct vertical imbalances between the spending responsibilities and tax revenues devolved to the local level. Because most taxes tend to be assigned to the national level, but expenditure responsibilities are more easily decentralized, the difference needs to be covered. In this case, general-purpose (or unconditional) transfers are provided by the center to subnational governments for general funding purposes. Equalization transfers are also used to correct horizontal imbalances among subnational governments created by differences in local tax bases. In other cases, transfers may be used to correct externalities among governments, or to promote specific types of expenditure at the local level, for example, on certain services particularly sensitive from the national point of view. In this case, block grants are used to provide funding for specific sectors, and special-purpose (or earmarked) grants mandate the type of spending within a designated sector (also called conditional transfers because they can only be used for particular goods or services).

A transfer system should not be designed in isolation but should complement the choices made about the spending responsibilities and revenue assignments to subnational governments—a point typically stressed in IMF advice to member countries. In practice, most countries use combinations of special-purpose and unconditional transfers, with a view to balancing the preferences of the central government (or in some cases, of donors) with the priorities and resources of subnational governments.

Transfers may require some degree of coparticipation (matching) from subnational governments. A matching requirement, however, may only divert resources from other important or basic spending, particularly in the presence of weak own-source revenue. Moreover, matching requirements may prevent poorer regions from accessing the transfers, and could exacerbate horizontal inequalities. Staff have often recommended that special-purpose grants be provided on the basis of costed programs, where possible, and that these be implemented in countries where the central government can monitor that the grants have been used for the specified purposes, a criterion that is difficult to satisfy in the context of weak PFM systems at the subnational level, given that transferred funds are fungible. Another key issue is whether these grants should be taken into consideration in setting equalization grants, along with other unconditional grants.21

Transfers also differ in the degree of central government discretion. Mandatory transfers (entitlements) are rules-based obligations for the government providing the transfer. The transfer amounts and conditions are legally defined. Alternatively, transfers can be discretionary, so that their amounts and the conditions for their disbursement are decided on a one-time basis. Discretionary transfers are usually temporary, for example, for specific infrastructure projects or emergency assistance.

Simple mechanisms to allocate transfers across jurisdictions tend to be based on spending needs, revenue capacities, or both. Providing transfers on an equal per capita basis is the simplest way to achieve some degree of equalization. This formulation, however, does not take into account the differential needs of different groups of the population or of different regions, and more complex formulations use various poverty indices and geographic criteria to reflect cost differentials in service provision. At the same time, sole reliance on needs-based criteria does not account for differences in revenue capacities; conversely, exclusive equalization of revenue capacities implicitly assumes that cost differentials are not significant. Thus, countries use a combination of expenditure needs and revenue capacities to design equalization transfers. Australia and Denmark have advanced transfer systems, and recent reforms in Sweden and Switzerland take these two countries in the same direction. The trade-off occurs with the availability of data and the difficulty of administering such transfers.

Staff advice on transfers has focused on design issues. In many countries, recommendations focused on simplifying transfer design and improving transfer formulas by transparently including both spending needs and revenue-capacity criteria (Bolivia, Indonesia, Kosovo, Mexico, and Nigeria). To make transfers incentive-compatible, staff have discouraged the use of equalizing criteria relative to historical or actual spending and revenue (such criteria could discourage revenue collection, or promote excessive spending, as in Kosovo). Staff have also often advised that special-purpose transfers be simplified, given their administrative costs (China, Colombia, Indonesia, and Nigeria). Finally, because winners and losers are likely to emerge when transfers are redesigned—and losers will create political resistance—staff have sometimes advised in favor of hold-harmless provisions, under which the subnationals standing to lose out from the reform are guaranteed, in the first year of implementation, the same transfer amounts (usually in nominal terms) as in the year preceding the reform, with the full impact generally phased in over a period of time. Hold-harmless provisions were recommended by staff in a few cases, including in Mexico and Kosovo. Table 2.7 summarizes staff advice on transfer design in the case-study countries.

Table 2.7.Main Recommendations on Transfer Design in Case-Study Countries
CountriesMain issuesIMF advice
BoliviaTransfers suffer from excessive earmarking, without due consideration for equity.Reduce earmarking and reform transfer system to make it more equitable by taking into account spending needs and fiscal capacity.
ChinaThe transfer system was complex and not fully transparent.Reform transfer system to make it consistent with delivering a minimum standard of public services. Expand the use of well-designed, rules-based equalization system. Clarify and simplify special-purpose transfers.
ColombiaTransfers were excessively earmarked at the time the IMF provided technical assistance. Transfer amounts were decided as a fixed amount, not linked to revenue (but this was expected to change in 2008).Maintain current framework of defined transfer growth because transfers as a share of revenue would (1) create rigidity for the central government; (2) induce procyclicality in fiscal policy (as excess shared-revenues are spent by subnationals); and (3) create volatility at the subnational level. Reduce gradually earmarking of transfers.
Congo, Dem. Rep. ofA planned equalization fund is unable to mitigate horizontal imbalances generated by revenue-sharing because it is limited to investment financing.Establish a transfer system based on an equalization formula with transparent and objective criteria (e.g., number of inhabitants and surface).
IndonesiaOil and gas revenues were included as part of revenue-sharing, thus creating imbalances and increased volatility of transfers. In addition, a floor was imposed on transfers.Remove floor on transfers (which can create rigidities and complicate macroeconomic management) while keeping the hold-harmless rule for the general purpose fund.
KosovoIn 2007, formulas for earmarked transfers in health and education were not adequate to cover municipalities’ spending mandates in these areas, while unconditional transfers were not providing any spending autonomy to municipalities, given their limited size. In 2010, a new transfer system was in place according to 2008 legislation, and was due for review.Maintain close-ended transfer amounts, but increase size of unconditional transfers, based on equalization criteria, and link block grants for health and education more closely to spending needs. Over time, move gradually to general transfers, based on revenue capacity and spending needs. Include a hold-harmless provision to ensure that each municipality is at least provided with the same nominal level of transfer as in the year preceding the reform. In 2010, hold changes of the transfers until new census data are available and municipal functions have been better costed. Refrain from adding ad hoc grants at the margin. Strengthen the role of the Grants Commission and make its operations more transparent.
LiberiaTransfers are virtually nonexistent, with the exception of the County Development Fund, which assigns a certain nominal amount to counties for capital projects.With decentralization, a transfer system will need to fund counties’ operations. A simple formula should be adopted, based on transparent criteria.
Macedonia, FYRTransfers allocated using a nontransparent system.Create Municipal Equalization Fund and adopt a formula-driven allocation rule for equalization across municipalities. As expenditure mandates expand, broaden revenue-sharing or transfer system (or both).
MexicoComplex and nonredistributive system based on revenue-sharing and earmarked transfers.Freeze in nominal terms the existing transfers (hold-harmless provision, to make the reform politically viable) and phase in an equalizing system based on spending needs and revenue capacities. Clarify and simplify special-purpose transfers.
NigeriaLow correlation between transfers and states’ relative needs. The derivation formula benefits mostly middle- and high-income states. No definition of minimum public services in return to the transfers.Establish special-purpose transfers in lieu of direct investment by the federal government. Over time, include a new general transfer system based on estimates of spending needs and own-revenue capacities; introduce a floor for transfers to ensure the continued provision of essential services, to be financed by savings from periods of high oil prices. Limit specific-purpose grants to high-priority national objectives.
Source: Case studies in Part II of this occasional paper.
Source: Case studies in Part II of this occasional paper.

Managing Revenue

The choice between central and subnational tax administration is not easy, and tends to vary depending on country circumstances. Although IMF technical assistance on this issue has been limited, advice was provided when changes in the financing mechanisms of subnationals required a rethinking of existing tax administration arrangements. For example, in Colombia, advice focused on centralizing tax administration while necessary capacity at the subnational level was being built. In FYR Macedonia, much of the revenue-administration structure was still organized around the 34 pre-1997 municipalities, but these municipalities lacked capacity and incentives to strengthen tax compliance because collection of municipal taxes was assigned to the central government; thus, staff advised to build capacity and align tax administration structures to a streamlined territorial organization of municipalities. In contrast, the Chinese revenue-sharing arrangements of 1994 were designed (in line with staff advice) to give the central government additional tax handles, and to establish a state administration of taxation for the center, separate from the local administrations (see Ahmad, Qiang, and Tanzi, 1995; and Ahmad and others, 2002).

Revenue-sharing and surcharging may help circumvent the challenges associated with the administration of major taxes at the subnational level. If certain taxes can be collected with minimal additional effort, such as surcharges on income taxes, and if subnational information may be helpful to the center, resistance is unlikely to arise from the central tax administration to collecting such taxes on behalf of other administrations. The issue of collecting a VAT on behalf of subnational administrations might be more difficult for national administrations. Subnational governments are often concerned that the central tax administration might not have the incentive to devote sufficient resources to collecting subnational taxes, although this might be partially mitigated by well-structured service contracts with the central tax administration.

Subnational tax administrations can be designed and operated on the basic principles of modern tax administration. The large municipalities in Colombia have made considerable improvements in own-revenue collection, and some Brazilian states have shown that it is possible to effectively administer subnational VATs, albeit origin-based ones. However, subnational tax administration is unlikely to be feasible in many developing countries. Setting up information systems and processes to support local tax collection, such as establishing a cadastre as the basis for assessing and collecting property taxes, may be costly.22 At the same time, complex rules for tax revenue assignment among national and subnational levels of governments may stand in the way of tax modernization efforts. This situation has occurred in Sudan, where a dual network of tax offices (i.e., the national and states offices) collects taxes on businesses, hampering the integration of VAT and income tax operations. In the Democratic Republic of the Congo, staff recommended that if collection of local taxes were to be assigned to the central tax administration (Direction Générale des Impôts, DGI), the DGI should be granted a larger share of such taxes as compensation for its services; conversely, if administration of local taxes were to be assigned to subnational tax administrations, their responsibilities should be limited to managing only local taxes, within a framework clearly defined by law.

Identifying Mechanisms to Control Borrowing

An essential element of fiscal discipline is the avoidance of excessive borrowing by subnational governments. Excessive borrowing results in adverse externalities for other subnational governments, as well as for the central government. These externalities may happen through a number of channels—by preempting a disproportionate share of available financing, and thereby putting upward pressure on interest rates; by pushing up risk premiums on government bonds more generally; or through the cost of bailouts. The likelihood of such externalities constitutes the fundamental rationale for limitations on subnational borrowing.

Borrowing controls can be grouped into four broad, not mutually exclusive, categories: (1) reliance on market discipline, (2) cooperation between central and subnational governments, (3) rules-based controls, and (4) administrative controls.23 These categories are ranked according to the degree of central control over subnational borrowing, from maximum autonomy (depending on markets) to maximum control (administrative measures, including outright bans on subnational borrowing). Table 2.8 summarizes the main advantages and preconditions for these approaches, and provides examples of their application in different regions and countries.

Table 2.8.Approaches to Controlling Subnational Borrowing
Market disciplineCooperative approachRules-based controlsAdministrative controls
Advantages• Emphasis on self-control

• Monitoring by credit rating agencies
• Promotes dialogue

• Enhances responsibility of subnational policymakers
• Transparent

• Avoids bargaining
• Potential central government (CG) control

• Better terms and conditions

• Useful for foreign borrowing
Preconditions• Comprehensive, timely, and reliable information

• Developed financial markets

• No access to privileged financing

• No previous history of bailouts
• Constitutional underpinnings

• Culture of fiscal discipline

• Existence of institutions for cooperative decision-making or strong bargaining position of central government
• Sound and credible rules (e.g., well-defined, transparent, and flexible)

• Clear coverage and full information
• Ability of CG to effectively monitor and implement controls

Argentina’s bilateral pacts




Stability Pacts in

EU countries







United Kingdom
Source: Based on Ter-Minassian and Craig, 1997.Note: Because most countries use a combination of approaches, the examples primarily illustrate the relative reliance by the country in question on that approach.
Source: Based on Ter-Minassian and Craig, 1997.Note: Because most countries use a combination of approaches, the examples primarily illustrate the relative reliance by the country in question on that approach.

Sole reliance on market discipline in governing subnational borrowing requires a number of preconditions seldom met in practice, but has worked in countries with high standards of transparency and governance at all government tiers (such as Australia, Canada, and Sweden), and with no significant history of bailouts. In most emerging markets and developing economies, as well as in some industrial countries, one or more of the preconditions for effective market discipline to control subnational borrowing are lacking. In particular, information on subnational finances is frequently not accurate and comprehensive or is subject to long delays; subnational governments often have access to privileged channels of financing (including through banks or enterprises they own); and many have significant histories of bailouts (through gap-filling transfers, or debt restructuring). At the same time, when investors perceive an implicit guarantee by the center, market signals do not work effectively; in Germany, states with significant debt levels have nonetheless enjoyed very high credit ratings. Many attribute this to the bailouts of Bremen and Saarland in the 1990s, mandated by the constitutional court (Rodden, 2006; and Stehn and Fedelino, 2009).24

A cooperative approach entails the setting of borrowing limits for individual subnational jurisdictions through negotiations with the center. A variant of this approach involves bilateral negotiations between the central government and individual subnational entities, or groups of them. Examples include Australia’s experience with its Loan Council; European Union countries (including through the so-called Domestic Stability Pacts); Brazil’s debt agreements with states and municipalities; and Argentina’s bilateral pacts between the nation and the provinces. The record of effectiveness of cooperative approaches is mixed. Preconditions for the success of a cooperative approach include the absence of severe fiscal stress; relative economic homogeneity of the subnationals (and, relatedly, absence of strong distributive conflicts); a tradition of cooperation in intergovernmental relations or a relatively strong bargaining position on the part of the central government (as in Brazil’s debt-restructuring agreements); a stable institutional framework for the negotiations; and availability of reliable and timely information to assess compliance with agreed-on borrowing limits.

Fiscal rules provide a third approach to controlling subnational borrowing. These rules may take the form of quantitative ceilings on borrowing, debt, or debt service of subnational governments (often specified in relation to these governments’ revenues, as in Brazil and Colombia); or of procedural rules relating to subnationals’ budget processes. The rules may be embodied in national legislation (e.g., Brazil and Spain) or in subnational constitutions or laws (e.g., some states of the United States and some Canadian provinces). The effectiveness of such rules depends on their specificity, comprehensiveness of coverage, and most important, the degree of political commitment to their observance and enforcement.25 The design of the rules also matters, particularly clear specification of appropriate escape clauses (that is, legal provisions that would waive the application of the fiscal rule under well-specified circumstances, such as national disasters or similar) and of credible sanctions for noncompliance. Reliance on a revenue base for subnationals that is relatively stable over the business cycle is also useful for minimizing the risk of procyclicality of quantitative ceilings on borrowing or debt for subnational governments. The availability of timely information to assess compliance is crucial to these rules’ effectiveness.

Finally, a number of countries (both industrial and developing) continue to rely to some extent on administrative and direct controls on subnational borrowing. Given the constitutional status of subnational governments in federations, administrative controls tend to be used more in unitary states, especially with regard to local governments. Controls vary in comprehensiveness and degree of detail; increasingly, they have tended to focus on overall levels of borrowing (flow) or debt (stock), rather than on authorization of individual borrowing operations. In some cases, control is limited to external borrowing, while in others limits are set on banks’ exposures to subnational governments. Administrative controls, especially those involving central authorization of individual instances of subnational borrowing, carry a significant risk of moral hazard, because the central government may be seen by lenders as implicitly backing the service of those loans. The effectiveness of administrative controls as instruments to promote subnational fiscal discipline depends crucially on the depoliticization of the central government’s decisions, and on the availability of information needed to shape these decisions and check their enforcement (including information on off-budget activities of the subnational government, and on arrears incurred).

On balance, no single approach to subnational borrowing frameworks is preferable in all circumstances. Rules-based approaches, underpinned by adequate enforcement mechanisms, may well have an edge in countries with inadequate bases for exclusive reliance on market discipline, and with relatively weak records of the use of discretion by the central government in its interactions with subnational governments (or in countries where some of these governments have strong political influence on the center). Rules may be usefully complemented by increasing reliance on market discipline, as the preconditions for effective working of market discipline are being put in place through improvements in the transparency of subnational government operations, elimination of privileged financing channels for these governments, and establishment of track records of no bailouts. Finally, subnational borrowing frameworks should also include mechanisms for addressing insolvency to help manage expectations about possible defaults and allow efficient resolution of distressed debt (Liu and Waibel, 2008).

IMF staff have taken an eclectic approach in advising on the control of subnational borrowing. Advice has been shaped according to the specific circumstances of the country in question, including any legal or constitutional limitations on the central government’s powers with regard to subnational governments, and the presence or absence of preconditions for the effective working of market discipline. In some countries (for example, the Democratic Republic of the Congo, Kosovo, and FYR Macedonia), advice has focused on building effective preconditions for borrowing arrangements at the subnational levels; allowing subnationals to borrow prematurely may severely undermine macro-economic management and eventually lead to debt-sustainability problems. In other cases, for example, in China, the possibility of asymmetric arrangements, under which more-advanced provinces could seek credit ratings and start limited borrowing, was suggested. In countries where subnational borrowing was established (as in Bolivia, Indonesia, Mexico, and Nigeria) staff advice focused on setting up guidelines (in some cases, rules) for subnational borrowing, strengthening borrowing-reporting frameworks, and creating professional capacity for debt management. Table 2.9 summarizes staff advice on this topic.

Table 2.9.Main Recommendations on Subnational Borrowing Arrangements in Case-Study Countries
CountriesMain issuesIMF advice
Administrative controls on borrowing
Congo, Dem.

Rep. of
Draft decentralization law requires the Ministry of Interior to authorize all subnational borrowing operations, but does not specify the criteria to control subnational borrowing.Control mechanisms for subnational government debt should be defined (e.g., through direct controls or central government authorization of individual borrowing operations). Tight control over borrowing is necessary to avoid the risk of unsustainable spending at the provincial level and prevent conflicts with the fiscal stance determined at the national level.
KosovoIn 2007, municipalities were not allowed to borrow, but pressures to release current ban were increasing; given that municipalities’ spending responsibilities were expanding, there would be a need to provide them with adequate financing mechanisms, possibly including borrowing. In 2010, a draft Public Debt Law would allow municipalities to borrow, subject to well-specified preconditions (obtaining two consecutive unqualified opinions from the Auditor General).Develop municipal debt management capacity, even if the immediate impact of municipal borrowing is likely to be small. Put in place procedures and processes to monitor municipal borrowing. Design a mechanism setting borrowing limits by municipality, to ensure that municipal borrowing does not exceed aggregate limits.
Macedonia, FYRMunicipalities were not allowed to borrow, but increasing spending mandates would need additional financing.In the initial stage of decentralization, the ban on municipal borrowing should continue. A Municipal Investment Fund could be created, from which municipalities would borrow to fund investment in a limited way.
Rules-based controls
IndonesiaWeak subnational borrowing framework prior to decentralization: local governments can borrow directly from banks and there is no reporting framework.Impose borrowing limits and strengthen borrowing reporting framework.
MexicoAbsence of standardized debt limits and fragmentation in subnational debt information. Proliferation of new instruments, such as securitization of revenues and PPPs.Establish prudential limits on borrowing, linked to fiscal rules. Ensure total coverage of the subnational debt registry at the MoF. Develop a sound legal framework for PPPs. Greater oversight on credit rating assessments.
NigeriaLack of clear debt limits and reporting requirements by subnational governments.Restrict domestic borrowing by local governments only to those with a balanced budget in the current and the previous year, and limit it to a certain percentage of local government’s revenue. Maintain the practice of not allowing external borrowing by the local governments. Create professional capacity for debt management in the states’ MoFs. Establish a system for all levels to provide the Debt Management Office with information on all debt aspects.
Eclectic approaches
BoliviaWeak subnational borrowing framework and repeated tendency to bail out subnational governments. Lack of political will to implement sanctions and weaknesses in the framework provided incentives for excessive borrowing and soft budget constraint.Strengthen subnational borrowing framework and transparency. Create a fiscal risk register to take stock of subnational liabilities and facilitate their management.
ChinaAlthough subnational borrowing was not allowed, there was evidence that local governments were using indirect ways to incur indebtedness, with a possible related buildup of fiscal risks.Adopt an asymmetric framework whereby certain subnational governments would be allowed to borrow, provided certain preconditions are in place. Create incentives for local governments to strengthen their fiscal policy management, while allowing recourse to additional (and needed) resources to carry out their mandates. Establish a subnational fiscal risk registry, to be kept at the central treasury.
Source: Case studies in Part II.Note: Colombia and Liberia are excluded, as technical assistance did not cover the issue of borrowing arrangements.
Source: Case studies in Part II.Note: Colombia and Liberia are excluded, as technical assistance did not cover the issue of borrowing arrangements.

Finally, staff have also emphasized the possible fiscal risk arising from indirect borrowing mechanisms. In many countries, subnational governments have entered (or have expressed an interest in entering) public-private partnerships (PPPs), generally based on the use of the subnational land or other assets.26 PPPs typically involve complex financial and legal arrangements, and may pose significant risks, especially for inexperienced governments. Experience from various countries demonstrates that successful development of PPPs requires strong institutional and operational frameworks and a clear and transparent legal framework. PPPs also have to be subject to stringent investment planning and project evaluation, which must be closely coordinated with other public investment projects. Finally, clear standards are needed for disclosure of PPP arrangements in government budgets and accounts, and for transparent financial reporting about these projects. On this basis, IMF advice has cautioned against possible PPP arrangements (for example, in Kosovo and FYR Macedonia) until an appropriate legal framework is in place and, equally important, an appropriate level of expertise has been developed within the government sector to ensure that all levels of risk are well understood and appraised.

However, controls on subnational borrowing are only one of the elements of a sound system of intergovernmental fiscal relations. Borrowing arrangements cannot be viewed in isolation. Subnationals usually demand more borrowing autonomy because their financing means are not adequate—either their spending responsibilities are not sufficiently funded or they do not face a hard budget constraint, possibly resulting in inefficient spending and a prodeficit bias. These underlying motivations call for a closer and more comprehensive assessment of other aspects of fiscal decentralization, as repeatedly stressed in this volume.


See Ahmad, Hewitt, and Ruggiero (1997). Implementation of public spending, in turn, covers two dimensions: (1) providing or administering a service; and (2) actually producing a good or delivering a service. For example, municipalities may provide garbage collection services, but the actual service may be delivered by a private operator contracted by the local government (Feruglio, Martinez-Vasquez, and Timofeev, 2008).


In practice decentralization often does not involve a clean transfer of new responsibilities, but an adding of new layers of responsibility for local governments.


These issues were also covered in IMF (2000).


Even when not explicitly recognized, asymmetric arrangements tend to prevail, for example, in capital cities or major urban centers (such as Bogotá in Colombia, Skopje in FYR Macedonia, and Shanghai in China). The use of contracts among levels of government to address assignments is an interesting area of research (e.g., see Spahn, 2006).


Ahmad and Brosio (2009) review the literature on these issues, and provide a series of case studies.


Under partial decentralization, local governments have no discretion to choose among competing uses for resources subject to a budget constraint, and citizens are not aware and cannot evaluate government’s decisions (for example, when the central government provides earmarked grants for capital expenditures). Devarajan, Khemani, and Shah (2009) explore these issues in more detail.


For more information on the GFS 2001, see


This used to be a problem in Tanzania, where the central government followed a July–June fiscal year, and the subnational governments adhered to the calendar year. As of 2008, the subnational fiscal year is aligned to that of the central government.


A standard TSA is a bank account or a set of linked bank accounts through which the government, including its entities and spending units, transacts all receipts and payments, and consolidates its cash balances.


For example, South Africa has more than 80 staff members in the Intergovernmental Fiscal Relations (IGFR) Directorate of the National Treasury, whereas Tanzania and Rwanda have only a few staff located within their respective budget departments. In South Africa, the IGFR Directorate is responsible for planning at the local government level, as well as budgeting and financial reporting.


The absence of border controls makes it difficult to administer a subnational VAT that is destination-based.


Subnational governments may still see their effective room for maneuver constrained by economic factors, such as a high degree of mobility of the relevant tax base (e.g., income from capital).


This argument has been used to explain China’s remarkable growth performance compared with that of the Russian Federation in the 1990s: in China, subnational governments had a secure share of local revenue, whereas in the Russian Federation the revenue share was low (Roland, 2000; and Jin, Qian, and Weingast, 2005). However, Treisman (2006b) notes that the changes in the decentralization system in China in 1994, which led to a recentralization of revenue (see also Chapter 5 in this occasional paper), do not seem to have affected market-friendly policies at the provincial level; and the growth surge in the Russian Federation since 1999 happened despite continued tax sharing and weak local incentives. These contrasting results underline that the design of tax assignments is only one aspect of fiscal decentralization, which should be looked at in its entirety, as repeatedly stressed in this paper.


The share of property taxes in subnational revenue varies considerably, from as low as 5 percent in Turkey and 7 percent in Norway, to 90 percent in New Zealand and 100 percent in Australia, Ireland, and the United Kingdom. As a share of GDP, property taxes account on average for about 1 percent in unitary countries and 2 percent in federal countries.


These taxes have long been supported in the literature (Musgrave, 1959).


See Bird and Gendron (1998), and Keen (2000). McLure (2009) deals with these issues in the U.S. context.


These include the CVAT (compensating VAT) and VIVAT (vertically integrated VAT). The VIVAT makes a distinction between sales to registered traders and sales to households and unregistered traders; the former are subject to a uniform (national) rate, while different (local) rates apply to the latter. In the CVAT, sales to local purchasers (registered and unregistered traders, and households) are subject to a local VAT, but sales to purchasers in other jurisdictions are zero rated for central VAT and subject instead to a compensating VAT. For more detail, see Bird and Gendron (1998), and Keen (2000).


Capital inputs can be either fully subtracted or, as in Italy, a course can be followed where only depreciation is taken out of the taxable base (thus making the tax an income-type, production-based VAT).


The distinction between revenue sharing and transfers also depends on the degree of discretion of the level of government “in charge”: when parameters of revenue-sharing are defined at the constitutional level (as with VAT-sharing in Germany), revenue-sharing can protect subnational governments from the political vagaries of the central government (more so than transfers, if those transfers are determined on a discretionary basis).


In Indonesia, the mandated revenue shares led to a substantial increase in funds for local governments that were saved initially, given local spending-capacity constraints; however, saving is unlikely to be the preferred use of these funds over time (see the case study in Chapter 8 of this occasional paper).


For example, the IMF has recommended in China that financing to minimize the effects of natural disasters should be a central government responsibility, and that the grants should be treated as special-purpose transfers and not included in the equalization framework.


The World Bank is actively engaged in providing loans and assistance in this area (e.g., in Bolivia and Peru). Given limited resources, the IMF has not typically provided technical assistance to specific subnational tax administrations, with two exceptions in the 1990s (to the provinces of Cordoba and Buenos Aires in Argentina).


See Ter-Minassian and Craig (1997) for a detailed discussion of these approaches.


The Constitutional Court’s rejection of a bailout request by Berlin in October 2006 may contribute to changing states’ and investors’ perceptions of soft budget constraints and implicit federal guarantees.


See, for example, Kopits and Symansky (1998) and Ter-Minassian (2005). Some of these issues are also covered in Box 1.2.


For example, a developer may agree to finance a public road in return for a long-term lease on land along the road that can be used for commercial purposes. T ere may also be additional payments, guarantees, and counter guarantees involved in such transactions.

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