3 Lessons Learned and Challenges Ahead

Annalisa Fedelino
Published Date:
October 2010
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The design of intergovernmental fiscal arrangements is one of the more complex areas of public finance—it spans a number of policy and institution-building issues requiring careful coordination and sequencing, and is shaped by economic, historical, political, and social factors. IMF advice in this area, while focusing on macrorelevant aspects in line with the institution’s core mandate and expertise, has tried to recognize these complexities and adjust to them, particularly because there is no single “right” model for the design or reform of intergovernmental fiscal relations. IMF advice has sought to take into account (1) macroeconomic constraints; (2) the need to strike a balance between efficiency and distributional considerations; and (3) the need to reflect relevant institutional factors, such as constitutional and other legal constraints, and the capacity of subnational governments to spend well and raise own-revenues. As relevant circumstances have changed over time and across countries, IMF advice on fiscal decentralization has evolved.

Despite differences, general lessons can still be drawn from the range of experiences of countries to which the IMF has provided advice on fiscal decentralization. These lessons can be summarized as follows:

  • The sequencing of decentralization matters: resources should be made available to subnational governments simultaneously with the assignment to them of spending responsibilities. The importance of sequencing decentralization appropriately is borne out by the difficulties experienced by countries such as Colombia and Nigeria, where the devolution of resources initially outpaced that of spending responsibilities, and conversely by countries (like some transition economies of the former Soviet Union in the 1990s) where spending mandates were pushed down to the subnational level without adequate provision of resources to the affected governments, leading to accumulation of debt or arrears, or to a significant deterioration of the quality of the decentralized public services. As part of the sequencing, issues of territorial organization and political arrangements are also relevant, although not central to the IMF mandate (as noted in the case studies of Liberia and FYR Macedonia in Part II).
  • At the same time, the pace of decentralization should be linked, to the greatest extent possible, to the capacity of subnational governments to effectively carry out the functions assigned to them. Two corollaries derive: First, increased devolution of expenditure functions should be conditioned on compliance by the subnational governments with a minimum set of public financial management (PFM) requirements, in particular an orderly, transparent, and reasonably participatory budget process. Second, because capacity varies among levels of government, there is scope for asymmetric arrangements (differentiated speed, based on clearly specified criteria) in the decentralization of public functions to individual jurisdictions, or groups thereof. Colombia has successfully shown that asymmetric decentralization is not only feasible, but desirable as a means to motivate subnational politicians to implement “good” policies. Asymmetric arrangements would also suit capital cities (or larger or more-advanced jurisdictions) that are, in many countries, better prepared than other subnationals to take on additional responsibilities, as recommended in Kosovo, Liberia, and FYR Macedonia (and in China, as a way to start relaxing borrowing arrangements for some provinces).
  • Although spending responsibilities in some sectors (such as education and health) will inevitably overlap across levels of government, adequate clarity of the role of each level of government in the provision of the services must be ensured to avoid duplication, waste, and loss of accountability. The experiences of countries such as Bolivia, the Democratic Republic of the Congo, Mexico, and Nigeria, as outlined in the case studies in Part II, are illustrative of the costs of such lack of clarity.
  • In some cases, complementary policy reforms, such as in the civil service and regulatory frameworks, are needed. For example, unless there is adequate scope for geographic or functional mobility of civil servants (including providers of health and education services), increased devolution of public services may result in a deterioration of the quality of the services in certain jurisdictions (e.g., in rural communities) or in increases in overall public employment, or both. Similarly, devolution of subsidized public services (e.g., utilities) to local governments is unlikely to lead to a reduction of subsidies, or may result in deterioration of the services, unless local authorities are allowed to adjust their prices as needed. In fact, allowing some regulatory autonomy and supporting increased participation by subnational jurisdictions in public policy matters may go a long way toward addressing decentralization pressures while allowing more time to make the institutional and legal changes required to implement fiscal decentralization successfully (see next point).
  • Realizing the potential efficiency gains of decentralization in the provision of public goods and services often requires significant investments in capacity building and improvement of PFM systems at the subnational level, specifically aiming at improving transparency of the budget process in all its phases. Although technical assistance by multilateral and bilateral development partners, dissemination of good practices, and peer pressure can play useful (sometimes indispensable) roles in this respect, experience indicates that a strong commitment to such reforms by the central as well as the subnational governments is essential to ensuring their lasting success, as shown by experiences in Colombia and Brazil. Unfortunately, such commitment has not always been present, undermining or reversing progress in this area. There is also a risk of spreading too thinly the limited resources of countries where capacity at the central level is being built or rebuilt and skills are in short supply, as in postconflict countries (Democratic Republic of the Congo and Liberia). In these countries, the aim of decentralization should not distract from the fundamental need to continue on the path of PFM reforms at the central level.
  • To facilitate the effective implementation of hard budget constraints on subnational governments, subnationals must be provided beforehand with an overall resource envelope that will allow them to carry out their assigned spending responsibilities at an average level of efficiency. A persistent significant mismatch between spending needs and resources of subnational governments is likely to lead over time to inadequate provision of the devolved public services, or to fiscal indiscipline (typically resulting in resorting inappropriately to borrowing, or accumulation of arrears). However, it is not generally easy to assess the spending needs of subnational governments, given the frequent absence of reliable information on the cost-effectiveness of spending programs at all levels of government. Sample studies comparing the cost-effectiveness of selected key spending programs in similar jurisdictions (for example, recent studies in the United States comparing the performance of hospitals in selected states and cities) can help shed light on this area.
  • Control over a portion of subnational resources is key to promoting accountability of subnational governments to their constituents, as well as fiscal responsibility. The assignment of own-revenue sources to subnational governments must take into account economic considerations (such as the degree of mobility of the tax base), as well as institutional ones, particularly the capacity of subnational tax administrations. When tax administrations are relatively weak, subnational taxes might best be administered by the central government on an agency basis. Potential candidates for own-revenue sources at the regional government level are surcharges on central or federal taxes (notably the personal income tax); retail sales taxes; and, in relatively advanced countries, some form of regional value-added tax (such as the Italian regional business tax). However, as demonstrated by the experience with the Brazilian state-level value-added tax, a degree of coordination of subnational taxes, especially the definition of the tax base, is important to avoiding predatory tax competition, and to reducing compliance costs for taxpayers who transact across regional jurisdictions. For local governments, movable (e.g., motor vehicles) or immovable properties provide appropriate, albeit not always adequately exploited, tax handles. IMF advice has typically, but not exclusively, focused on strengthening the design and administration of property taxes, as shown by the case studies in Part II.
  • Subnational own resources typically fall well short of spending responsibilities, leading to the need for intergovernmental transfers to offset the resulting vertical imbalances. Revenue-sharing is generally used to correct such imbalances, but can expose the budgets of subnational governments to significant cyclical fluctuations, which they are generally less well able to shoulder than the central government. To address this problem, the least-cyclically sensitive taxes as own-revenue handles and smoothing mechanisms (such as moving averages of central revenues as the basis for revenue-sharing) have been suggested. Although these mechanisms would attenuate the impact of cyclical fluctuations, they are unlikely to eliminate it. It is therefore desirable for subnational governments to build up cushions (such as the “rainy day funds” used by some U.S. states) during boom periods, to be drawn down during cyclical downturns.
  • Intergovernmental transfers are also used to moderate horizontal imbalances within each level of government. Horizontal redistribution is best accomplished through a system of equalization transfers, designed to take into account to the extent possible—given data availability—relative taxing capacities and spending needs of subnational governments. Special-purpose, earmarked transfers should be used sparingly because they impart rigidity to subnational spending (as shown in Bolivia, Colombia, Mexico, Nigeria, and Indonesia at an earlier stage), and whether they are being used for the specified purpose is difficult to monitor effectively.
  • Limits to subnational borrowing are needed, in most cases, to ensure adequate fiscal discipline. Effective reliance on market discipline alone requires a number of preconditions (notably, a significant history of no bailouts) that are met in relatively few countries (exceptions being Canada and the United States). At the same time, market discipline can usefully complement other control mechanisms. The choice among alternative control methods (administrative, rules-based, or cooperative) depends on country circumstances, and in some cases, a blend of different methods is most effective. In countries with less-developed credit and bond markets or where availability of reliable information on government operations is not adequate to ensure proper monitoring, borrowing should be made contingent upon well-identified preconditions (possibly including certification that subnationals meet a minimum set of PFM requirements), as recommended in China, Kosovo, and FYR Macedonia.
  • To enforce any form of control, availability of relevant information is crucial, including on floating debt and contingent liabilities (especially guarantees and public-private partnerships). Countries should seek to establish subnational debt registries (as recommended in Bolivia and Mexico) or fiscal risk registries (as recommended in China) by consolidating various sources of information, especially on “below-the-line” financing flows to subnationals. Progressively developing the capacity of subnational governments to manage their own debt is also important. Debt limits can be complemented by strengthened prudential regulations on financial intermediaries lending to the subnationals. Sound mechanisms for the resolution of subnational debt crises, when they occur, should also be in place.

As the case studies presented in Part II indicate, the effectiveness of IMF advice in the fiscal decentralization area has varied significantly across countries and over time. A fundamental factor has been the degree of political support for reforms that inevitably entail difficult trade-offs and create winners and losers. The degree of political commitment to such reforms at times has been enhanced by external factors, such as an economic crisis. Even then, however, piecemeal reforms (for example, a tightening of borrowing controls on subnational governments) have proved easier to implement than comprehensive reforms that would have helped achieve more efficient and lasting outcomes.

Looking ahead, as decentralization continues to advance even in countries that are currently relatively centralized, the IMF will need to remain engaged in the provision of advice on the more macroeconomically relevant aspects of the process. The IMF should also further strengthen its cooperation with other institutions (such as the World Bank, other multilateral institutions, and some bilateral donors) that are active in this area and that have resources to support capacity-building at the subnational level, given that improvements in capacity are often the linchpin to the success of fiscal decentralization.

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