Abstract
This Selected Issues paper and Statistical Appendix analyzes the key challenges facing Nigeria. The paper discusses issues and prospects in the oil and gas sector, provides basic information on the sector, and highlights the importance of strengthened governance. It describes the fiscal policy rules, which presents options for Nigeria based on the experience of other countries. The paper highlights that implementing a fiscal policy rule is identified as one possible way for Nigeria to stabilize public expenditures in the face of volatile oil prices.
IV. Issues in Intergovernmental Finance in Nigeria40
A. Introduction
104. This section does the following two things. First, it highlights the key issues in the current fiscal federal system that will need to be addressed in the short and medium term in order to improve overall fiscal management in Nigeria. Some options for strengthening fiscal management in the context of a federal system are explored. In discussing fiscal federal issues, the paper complements the other section on fiscal rules. Second, the section draws on some recent examples of reforms to federal systems that might be relevant to Nigeria’s system of intergovernmental finance.
Overview of current institutional arrangements in Nigeria
105. The federal system in Nigeria is based on three layers of government: the federal government, and the states’ and local government. Currently, there are 36 states in Nigeria, plus the federal territory of Abuja, the capital. In addition, there are 774 local governments. While the 1999 Constitution recognizes local governments, most of their governance (such as structure, functions, and finance) is given over to the states. Nonetheless, direct allocations are made to local governments through the federation account—the repository of the major tax revenues (see below).
Expenditure assignments
106. The formal assignment of responsibilities among the different layers of government is similar to that found in large federal systems. The federal government is responsible for maintaining defense, foreign affairs, law and public order, railways, posts, communications, roads of national interest and air and sea travel. The states are responsible for providing education and health services and public works, although, in a few cases, these services are provided by the federal government. Local governments are responsible for providing local infrastructure services, such as water and sanitation. Local governments also participate in the provision of primary health care and education services. In most cases, however, local governments act as agents of the states.
Revenue assignments
107. States and local governments have three sources of revenues: (i) own revenues; (ii) revenues shared with the federal government; and (iii) transfers from the federation account. The assignment of revenue bases is broadly consistent with acceptable principles in intergovernmental finance, that is, mobile bases belong to the central authorities, while revenues assigned to subnational governments usually have links to the services these governments provide. The one exception is the personal income tax, which, although having a mobile base, is assigned to the states. In addition to the personal income tax, states receive stamp duties, road taxes, and various fees. In most cases, however, the states simply administer these taxes, since the bases and rates are determined nationally. Local governments are assigned property taxes and various other fees, such as those for sewage and refuse collections. The proceeds from the value-added tax (VAT) are shared among the three tiers of government. The federal government receives 15 percent, the states, 47 percent, and the local governments, 38 percent. However, 20 percent of the amounts allocated to state and local governments are distributed according to the derivation principle, that is, according to the actual collection made in each individual jurisdiction. Another 50 percent is distributed according to the population, and the remaining 30 percent in equal amounts for all government units.
Intergovernmental transfers
108. Intergovernmental transfers are made from the federation account. Proceeds in this account accrue from oil revenues, the company income tax, and customs and excise duties. Until April 2002, certain “first charges” were deducted from oil revenues before they were shared with subnational governments. These first charges included external debt service, “cash calls” (the government’s share in the production costs of oil) of the Nigeria National Petroleum Corporation (NNPC), expenditures for certain NNPC priority projects, expenditure of the National Judiciary Council, and the allocation of a share of oil revenue to oil-producing states based on the derivation principle. The allocations based on the derivation principle were set at 13 percent of oil revenues. In April 2002, the Supreme Court ruled, among other things, that the deduction of first charges before the sharing of oil revenues was unconstitutional. Since then, the federal government has modified its oil revenue sharing accordingly but has sought to share the external debt-service burden with states based on their share in the external debt (estimated at 24 percent of the total).
109. The basic shares of revenues from the federation account are 48.5 percent to the federal government, 24 percent to states, 20 percent to local governments, 1 percent to the federal capital of Abuja and 2.5 percent to the Ecological and Stabilization Reserve Funds. The remaining 4 percent is then shared among the three tiers of government in a second round. 41 The distribution to individual states and local governments are based on ten factors. The first is an “equality factor,” which is essentially a lump-sum payment and accounts for 47.5 percent of the total transfers. Transfers based on population are accorded a weight of 30 percent, geographical area, 10 percent, and revenue effort, 2.5 percent. The remaining amounts are distributed based on “social development” factors, namely, the direct and inverse number of pupils enrolled in primary schools, the number of hospital beds, and an index of clean water and the quantity of rainfall.
Subnational borrowing
110. States are not prohibited from borrowing either domestically or externally. However, there is practically no borrowing from the central bank. States, however, do borrow from commercial banks, although recent regulations on provisioning against these loans have made it more difficult for banks to extend credit to states. The new regulations call for banks to provision against their profit-and loss account 50 percent of the credit advanced to states or local governments. This provisioning, however, does not apply to the banks’ holdings of bonds that may be issued by states. Four states have issued bonds this year totaling N 12.5 billion. In addition, Lagos recently offered N 15 billion to investors, primarily to finance its debts of approximately the same size. While these bond issues have yet to create macroeconomic problems, a proliferation of state bonds could lead to an explosion in domestic debt and calls on the federal government to bail out states in the event of a default on bond payments. In this regard, policies (e.g., prudential regulations) may have to be developed on banks’ holdings of state bonds.
111. All external borrowing by states have to be guaranteed by the federal government. Such borrowing is limited at 30 percent of individual state’s share in the federation account, and this is held as collateral against default. In most cases, the federal government borrows externally directly and onlends to the states. As indicated above, the states’ share in Nigeria’s external debt is currently about 24 percent.
Why worry about fiscal federalism issues in Nigeria?
112. There are several reasons why the nature of intergovernmental fiscal relations in Nigeria matters. First, Nigeria has a high dependency on oil revenues, which is volatile. These revenues are distributed among the three tiers of government according to the principles described above and account for over 80 percent of total consolidated revenues. Second, the size of subnational spending in Nigeria is large. Over the last five years, this spending has averaged about 9 percent of GDP—or 48 percent of total consolidated government spending. Furthermore, a large part of subnational spending is devoted to wages (about 40-50 percent in 2001)—an arrangement that can be difficult to reverse during periods of declining oil prices. Third, states in Nigeria enjoy significant autonomy by law and traditionally have not been required to coordinate their fiscal policies with those of the federal government. Furthermore, states are not obliged to report on the execution of their budgets, and consequently little information is available in Nigeria on these budgets.
113. Nigeria, therefore, faces the challenge of managing fiscal policy in the context of highly volatile oil export prices, a task which is further complicated by the existence of a federal system. The past has not been encouraging. Following the oil booms of the 1970s, expenditures rose faster than revenues. The consolidated budget deficit has remained above 4 percent for most years since 1975 and was substantially higher in a number of years, particularly in the early 1990s. The absence of a predictable and sound medium-term fiscal policy at all levels of government has led to boom-and-bust cycles.
B. Fiscal Federalism in a Macroeconomic Context in Nigeria
114. Trends toward devolution of fiscal responsibility in countries typically reflect an evolution toward more democratic and participatory forms of government. Devolution can ensure closer correspondence of the quantity, quality, and composition of goods to local preferences.
115. The reason for this development is that, by being close to the consumers of government services, local decision makers can more effectively receive information from consumers. Distance, however, reduces the amount of information available to make good decisions. By being removed from the local community, distance also reduces the incentives for decision makers to care about the preferences of local consumers. This argument would suggest that the size of a country matters in determining whether a federal system would provide benefits to local consumers. Thus, decentralization of spending responsibilities can lead to efficiency and welfare gains.
116. Decentralization may also become necessary for political reasons. In Nigeria, for example, the frequent increases in the number of states have served as an instrument to mitigate regional and ethnic rivalries. At independence in 1960, Nigeria had 4 regions, which were subsequently transformed into 36 states. As oil revenues have become more important, demands have increased to distribute these revenues to the regions of origin. Starting in the 1940s and continuing after independence in 1960, several commissions and constitutional changes sought to establish revenue-sharing formulas—sometimes with unclear assignments of expenditure responsibilities (see Box IV-1 below).42
117. For a federal system to be preferable to a unitary system, the gains from the former have to be strong enough to offset the advantages economies of scale in the production of public goods and in the generation of tax revenues may give to keeping power in the hands of a central government. In a federal system, therefore, the centralized provision of public goods should be limited to those goods whose benefits extend nationwide or whose provision is subject to substantial economies of scale—such as defense and certain infrastructures.
Issues of equity and fiscal management
118. Federal systems can, however, present two major challenges. First, decentralization can entail costs in terms of distributional equity—normally an important goal of public finance and, second, decentralization can make macroeconomic management more difficult. Substantial disparities in the regional distribution of endowments, tax-raising capacity, or differential costs in meeting assigned expenditure responsibilities can lead to inequities in the provision of public goods and services. These so-called horizontal imbalances can be only mitigated through an effective intergovernmental transfer system. Also—at least in principle—the federal government can influence the decentralized delivery of goods and services by setting overarching standards or mandates and the use of certain transfers, in order to ensure the level and standards of goods and services provided by subnational governments.
The Evolution of Federation Account Revenue Sharing in Nigeria
Intergovernmental transfers are made from the federation account, which consist of oil revenues, the company income tax, and customs and excise duties. Transfers are meant to address both vertical and horizontal imbalances. Over the years, the principles of revenue sharing have reflected political changes; at times, favoring greater centralization of revenues, while at other times they have provided more resources for states, in particular, based on the derivation principle. Changes to revenue sharing have typically followed the reports of commissions or presidential decrees. The main highlights governing revenue sharing over the years are as follows.
Pre-independence (1946-59). While Nigeria was still following a unitary system, in 1946, the Phillipson Commission determined revenue allocation among the three regions using the criteria of derivation and “even development.” Between 1951 and 1959, the Hicks-Phillipson and Chicks Commissions modified these criteria to include need, fiscal autonomy and national interest.
Postindependence (1959-68). This period was characterized by three main revenue allocation commissions: Raisman (1958), Binns (1964) and Dinns (1968). The allocation criteria were based on the continuity of existing levels of service, responsibilities of each regional government, population (added by decree in 1967), balanced development, and derivation. Regarding derivation, the Raisman Commission recommended that 50 percent of revenues should go to the region of origin.
Military/oil boom period (1968-80). Changes to the allocation formula were made mainly by decrees. The country was further reorganized into 12 states. In general, derivation suffered a setback as it was seen as accentuating regional imbalances. In 1970, under a decree, 50 percent of oil revenue was allocated to the Distributive Pool Account, 45 percent to states based on derivation, and 5 percent to the federal government. In 1971, offshore oil revenues were allocated to the federal government, and in 1975 (again under decree) onshore revenues to the states of origin were further reduced to 20 percent.
1980-99. In 1980, the Okigbo Commission revised the revenue-sharing formula as follows: 55 percent to the federal government, 30 percent to states, 8 percent to local governments and 7 percent to special funds. Horizontal allocations among states were determined with population and a minimum standard for national integration each receiving a weight of 40 percent; a social development factor, 15 percent; and an internal revenue effort, 5 percent. The Revenue Act of 1982 modified the sharing formula slightly, giving states and local governments larger shares at the expense of the special funds.
1999 Constitution. The allocations based on the derivation principle was set at 13 percent of oil revenues. The basic shares were as follows: 48.5 percent to the federal government, 24 percent to states, 20 percent to local governments, and 7.5 percent to special funds. The constitution also provided for grants-in-aid to minimize disparities in social services among states. Transfers to states were to be based on ten factors.
April 2002 Supreme Court ruling. The deduction of “first charges” (e.g., external debt service, “cash calls” to cover the government’s share in the production costs of oil, and expenditures on NNPC priority projects) before the sharing of oil revenues was ruled unconstitutional. Offshore oil proceeds were ruled to belong to the federal government. Since then, oil revenue for sharing is net of the production costs of oil, and debt service is no longer treated as a first charge. The states have been called upon to meet their share of external debt service (estimated at 24 percent of the total). The federation account has been distributed as follows: 54.68 percent to the federal government; 24.72 to states; 20.6 percent to local governments. The Federal Capital Territory and the Ecological Fund would be funded directly by the federal government.
October 2002 National Assembly legislative changes. The natural derivation grant had been calculated at 60 percent of total oil production (the assumed onshore proportion of production). In October, the National Assembly enacted legislation that would allow the derivation grant to be calculated on the basis of 100 percent of oil production.
119. Ahmad and Singh (2002) have calculated horizontal imbalances (that is, fiscal deficits before transfers) in per capita terms in Nigeria for 1998. Their findings show that the largest imbalance is more than four times the size of the smallest. As indicated above, these imbalances can result from differences in revenue mobilization capacity. For example, Lagos’ internally generated revenue and revenue from the derivation of the VAT in per capita terms amounted to 27 times that of Bauchi in 1998. Ahmad and Singh (2002) conclude that the present transfer system does not do an effective job of redistribution. Using income per capita and the number of hospital beds per capita as indicators of need, they find little correlation between transfers from the federation account and these indicators. They also find that the current mechanism does not provide for any distinct pattern of redistribution among regions. Differences in transfers per capita are much greater within states in the three large regions than among eastern, northern and western states.
120. The inability of the present intergovernmental transfer system to address inequities poses a significant challenge to Nigeria as it develops a poverty reduction strategy. Some studies (for example, Thomas and Canagarajah, 2002) show large variations in the incidence and depth of poverty across states in Nigeria. Changes in poverty over time have also varied by state and by region. During 1985-86 and 1992-93, for example, Thomas and Canagarajah (2002) found that poverty declined in all areas, except the north. Furthermore, although the improvement was most marked in the south, important exceptions were Sokoto, Kano, and Rivers States. While the use of the budget by itself does not provide the solution to poverty, an effective intergovernmental fiscal system can play a significant role in addressing poverty and other inequities. 43
121. The devolution of expenditures with a large impact on aggregate demand can complicate macroeconomic management. This is the case even if states and local governments are constrained by their revenue-raising capacity or borrowing powers. For example, shifts in the composition of subnational expenditures toward items that have a relatively large impact on aggregate demand, such as transfers to individuals with a high propensity to consume, can run counter to the stabilization objectives of the federal government. More important, in Nigeria, the current fiscal federal structure makes it difficult to manage fiscal policy at the consolidated government level.
122. While revenue-sharing arrangements with coefficients set in law or in the Constitution—as is the case in Nigeria—provide the subnational governments with predictable revenue flows, they cause considerable rigidity in the formulation of fiscal policy. Fiscal tightening, for example by the federal government, can be easily undermined by subnational government spending. Fixed revenue shares can also have procyclical effects, with higher revenues increasing the capacity to spend in times of boom and lower revenues causing a collapse of spending during economic downturns.
C. Stabilizing Intergovernmental Finance in Nigeria
Policy coordination at the national level
123. Stabilizing intergovernmental finances is a challenge that many countries have faced in recent years, Among developing countries, Argentina, Indonesia, and Russia have had to introduce reforms to their federal systems in order to improve macroeconomic management and redistribution policies. In some countries, the reforms have been extensive. In Russia, for example, the thrust of the reforms has been to recentralize revenues while relying on transfer mechanisms to meet the spending needs of subnational governments.
124. In Russia, these reforms have involved increasing the centralization of revenues (including shifting VAT to the center and abolishing a number of funds receiving earmarked revenue), with the intent of allocating expenditures to subnational governments in a more equitable fashion and exercising greater central control over the execution of subnational budgets. On the expenditure side, policy changes (including the implementation of transfers linked to fiscal capacity and expenditure needs) have been complemented by expenditure management reforms.
125. While such radical reforms may not all be politically feasible at this time in Nigeria, given the existing constitutional arrangements, there is at a minimum, scope for greater macroeconomic coordination, and the strengthening of budgetary processes and control. Expenditure management reforms (at all levels of government) were particularly effective in Russia in enhancing macroeconomic management. Nigeria could also learn from the Russian attempts to address equity issues through expenditure policy reforms and through a reform of the transfer formula. Of more relevance to Nigeria is the need to set expenditure norms and standards for subnational governments to follow.
126. Greater macroeconomic coordination and a strengthening of budgetary processes would, in the main, not necessarily require changes in the existing Constitution or the tax-sharing rules. Large federal systems pursue coordination through institutional forums to discuss macroeconomic policies. This is done, for example, in Australia, through the Premiers’ Conference and the Loan Council, and in Germany through the Financial Planning Council. In cases such as these, the main lines of budgetary policy would be discussed each year, usually within the context of a medium-term framework, in advance of the preparation of national and subnational budgets. Agreement would be reached on the main macroeconomic assumptions and the key budgetary aggregates for the federal and subnational budgets. The same forum would monitor the implementation of agreed plans during the year and approve any significant modifications in light of current developments.
127. Effective coordination of fiscal polices among the three tiers of government will, however, require a strengthening of the entire public expenditure management process in Nigeria. This includes planning and budget preparation, budget implementation, cash management, debt management, reporting, and auditing. In particular, for coordination to be meaningful, all tiers of government will need to adopt modern, comprehensive, standardized, and transparent budget classification systems and accounting rules.
128. Adoption of a fiscal responsibility act along the lines of other countries such as Argentina’s and Brazil’s, can also strengthen macroeconomic coordination. In the case of countries that have adopted such acts, limits are set on borrowing at all levels in terms of debt-service ratios and debt-revenue ratios together with other kinds of restrictions. In Brazil, for example, the debt service ratio has to be less than or equal to 15 percent of total revenues or current surplus, whichever is less, while the debt-revenue ratio has to be less than or equal to 27 percent of total revenue. Additional restrictions require the debts to be long-term credits for investment purposes only. Furthermore, restrictions are placed on external borrowing.
129. In general, international experience suggests that countries follow four basic approaches to borrowing by subnational governments: (i) reliance on market discipline (e.g., Canada); (ii) a cooperative approach among all levels of government (Australia and Germany); (iii) rules-based approach (e.g., United States and Spain); and (iv) administrative control-based approach, typical of unitary systems (e.g., United Kingdom and Japan). The main considerations involved in adopting any of these approaches would be how to preserve macroeconomic stability, manage the monetary impact of the borrowing, and ensure the ability to repay. Furthermore, the capacity of local governments to manage their debt and institute effective public expenditure management systems that are transparent and accountable would be critical.
130. Given Nigeria’s level of development, it would be advisable to follow a conservative, rules-based approach, which would include the following: (i) barring subnational governments from borrowing from the central bank; (ii) prohibiting external borrowing by states, except through the federal government, as at present; (iii) restricting borrowing to new investments that have a well-defined minimum social and economic return; (iv) establishing prudent debt-level limits and debt-service ratios; and (iv) coordinating borrowing among all tiers of government.
131. Nigeria has recently taken initiatives in the direction of harmonizing fiscal policies among the three tiers of government and of strengthening financial discipline at subnational levels, by introducing a draft Fiscal Responsibility Bill in the National Assembly. These initiatives reflect the authorities awareness that policy coordination across various levels of government should be at the core of macroeconomic management in a country like Nigeria. Among other things, this draft bill proposes that the annual federal budget be prepared in the context of a three-year medium-term “rolling plan,” that the budgetary planning process of all three tiers of government be derived from this underlying rolling plan, that sanctions for the nonremittance of revenues be collected at the subnational level, and that expenditure be based on conservative revenue estimates, the setting of debt ceilings on each tier of government and the restriction of borrowing to capital projects. The bill also proposes the setting up of a Fiscal Monitoring Council to monitor and ensure application of the provisions of the bill. This initiative takes Nigeria in the right direction, and, should the bill be approved by the National Assembly, it could lay the basis for a more effective intergovernmental fiscal system.
More far-reaching reforms to the tax-sharing system
132. Given the volatility of oil prices and the difficulty that this poses for macroeconomic management, a key issue for Nigeria is the appropriateness of the present oil revenue-sharing rule. As indicated above, the present rule results in procyclical fiscal policies and complicates the adoption of a fiscal stance at the subnational levels that supports the federal government’s.
133. To address this problem, elements of flexibility could be included in the sharing arrangements, which, in turn, could complement fiscal rules that are developed at the federal level (see the section on fiscal policy rules). For example, transfers could be related to a moving average of the federation account revenue over a few years. While a moving-average type of transfer rule would not fully protect subnational governments from adjusting during periods of negative shocks, it would nonetheless give them time to make the necessary changes in their expenditure policies. This approach, therefore, allows for an intermediate path to be taken to stabilize a permanent shock—or, for that matter, a shock whose permanence is not known. Recent federal agreements in Argentina and the constitutional amendment in Colombia contemplate an eventual stabilization on the basis of a moving average, (see Gonzalez Losenblatt, and Webb (2002)).
134. Another option would be to require subnational governments to set up stabilization funds to even out fluctuations in the revenue flows. In the United States, most states have “rainy day” funds, which are drawn down during cyclical downturns and reconstituted during periods of boom (see Stotsky and Sunley (1997)). These funds could complement similar fiscal rules at the federal level. To ensure consistency with the practice of the federal government, the rule for saving could be predicated on the same medium-term assumptions on the trend price of oil as used by the federal government.
Addressing states’ expenditure needs and redistribution issues
135. A radical departure from the present transfer system, which relies on the sharing of volatile oil revenues would be one that assured states that the provision of at least a minimum set of essential public services would be financed. This approach would require a new transfer system based on the costing of a minimum set of essential functions and estimates of overall expenditure needs and own-revenue capacities. This approach could complement a rules- based fiscal policy aimed at attaining fiscal balance when oil prices approach their medium-term average. In other words, the federal government would guarantee that the minimum expenditure needs would be met when oil prices experienced a downturn, while excess revenues would be saved when oil prices were above their medium-term average. The estimation of expenditure needs could be based on the familiar indicators—some of which are used in the current transfer formula. These could include population, population density, income per capita, and certain social indicators in the education and health sectors.
136. To address redistribution issues, the transfer framework would include general purpose grants and special purpose transfers. General purpose transfers would aim to equalize state and local governments’ fiscal capacities, in order to provide public services at similar levels of own-revenue efforts. Special purpose transfers would aim to meet nationally determined objectives and to correct for spillovers.
References
Ahmad, Etisham, and Raju Singh, 2002, “Political Economy of Oil Revenue-Sharing in a Developing country: Illustrations from Nigeria” (forthcoming; IMF Working Paper (Washington: International Monetary Fund).
Ashwe, Chiichii, 1986, Fiscal Federalism in Nigeria (Canberra, Australia: Australian National University).
Gonzalez, G. Y., David Rosenblatt, and Steven B. Webb, 2002, “Stabilizing Intergovernmental Transfers in Latin America: A Complement to National/Subnational Fiscal Rules?” paper presented at Conference on Rules-Based Fiscal Policy in Emerging Market Economies, Oaxaca, Mexico, February 14-16 2002.
Ikein, Augustine, and Comfort Briggs-Anigboh, 1998, Oil and Fiscal Federalism in Nigeria: The Political Economy of Resource Allocation in a Developing Country (Aldershot, England: Ashgate Ltd.). Hampshire.
Stotsky, Janet, and Emil Sunley, 1997, “United States,” in, Fiscal Federalism in Theory and Practice, ed. By Teresa Ter-Minassian (International Monetary Fund)
Thomas, Saji, and Sudharshan Canagarajah, 2002, “Poverty in a Wealthy Economy: The Case of Nigeria,” IMF Working Paper 02/114 (Washington: International Monetary Fund).
Prepared by Calvin McDonald.
Since the Supreme Court ruling, the federal government has sought to increase its share of the federation account in order to compensate for the lost revenues occasioned by the ruling (see box).
For a discussion of the outcome of the various commissions and constitutional changes, see Ashwe, Chiichii (1986) and Ikein and Briggs-Anigboh (1998).
A proper assessment of the links between the budget and poverty requires, as a minimum, information on the composition of spending by function, both at the federal and subnational levels. Functional categories of spending (e.g. on health and education) are non-existent at the federal and state levels. Limited and incomplete information is available on the functional categories of capital spending by local governments based on surveys carried out by the Central Bank of Nigeria.