This Selected Issues paper examines conditions in Colombian labor markets, which present a big challenge to the country. At end-2004, the unemployment rate amounted to 12 percent, and about one-third of the labor force was considered underemployed. The paper reviews labor market developments leading up to the reforms. It examines structural issues in the labor markets, reviews the labor market reforms, and analyzes the impact of reforms versus stronger growth. The paper also analyzes various aspects of Colombia’s system of intergovernmental transfers.

Abstract

This Selected Issues paper examines conditions in Colombian labor markets, which present a big challenge to the country. At end-2004, the unemployment rate amounted to 12 percent, and about one-third of the labor force was considered underemployed. The paper reviews labor market developments leading up to the reforms. It examines structural issues in the labor markets, reviews the labor market reforms, and analyzes the impact of reforms versus stronger growth. The paper also analyzes various aspects of Colombia’s system of intergovernmental transfers.

II. The Intergovernmental Transfer System in Colombia 1

A. Introduction

1. Colombia has reached an advanced stage of decentralization with large-scale transfers from the center to the regions. The 1991 constitution established a revenue sharing transfer system from the central administration to the subnational governments, earmarked by sectors, in order to finance service provision in the health and education sectors at the local level. A constitutional reform in 2001 led to slower growth of intergovernmental transfers during the period 2002–08. In 2004, transfers to the subnational level reached 5.1 percent of GDP, and 36 percent of expenditure was carried out at the decentralized level.

2. While the automatic revenue-sharing system has contributed to fiscal problems at the subnational level through the 1990s, it is likely to create serious fiscal difficulties for the central administration going forward. After fiscal legislation has managed to control subnational spending and borrowing, local governments have run surpluses in recent years, while the central administration continues to run a deficit. A reform in 2001 decoupled intergovernmental transfers from central administration revenue for a transition period, and has provided some temporary fiscal space for the central administration. However, the central administration deficit is forecast to widen in the near future, reflecting severe rigidities of the central expenditure system. In response, the authorities are embarking on a study that would assess the revenue sharing system, with a view to ensuring medium-term fiscal sustainability at all levels of government.

3. The purpose of this paper is to analyze various aspects of Colombia’s system of intergovernmental transfers. Section B reviews the revenue-sharing system, including the 2001 reform and the transition rules, and the experience to date. It also simulates possible alternatives to the system for possible future reform. Section C highlights the characteristics of the distribution of transfers at the local level, including incentives, and the efficiency of subnational spending. Section D summarizes the experience of other countries, namely Spain, Brazil, and India, with intergovernmental transfers. The last section concludes.

B. The Level of Intergovernmental Transfers and their Fiscal Implications

4. Colombia’s decentralization process began in the early 1980s and was reinforced by the 1991 constitution. Today, the country is a decentralized republic consisting of a central administration, 32 departments, 1,084 municipalities, 4 special districts and indigenous territories that are politically independent. Political and administrative institutions replicate the structure of the central administration, and governors, members of departmental parliaments, mayors, and members of municipal councils are elected directly.

5. The constitution stipulated large-scale revenue transfers from the center to the region, in order to finance subnational expenditure in the social sectors. These provisions (Box 1.) reflected the principle that local governments could carry out expenditure in the health and education sector more effectively. Transfers were to smooth out vertical differences and provide a stable income flow to subnational governments, as well as address horizontal differences at the subnational level.

The Intergovernmental Transfer System Before 2001

The 1991 constitution, in combination with Law 60 (1993), stipulated that transfers to territorial governments must increase to 46.5 percent of the central administrations’ revenue in 2002. Out of the 46.5 percent, 24.5 percent would go to departments and 22 percent to municipalities. The constitution requires that revenue should only be devolved to lower levels of government after a specific expenditure responsibility has been assigned; however, this requirement has not been observed in practice. As established by the automatic tax–sharing system, departments received an increasing percentage of current revenue from the central administration, from 22 percent in 1993 to 26 percent in 2001. Transfers to municipalities increased from 15 percent of central administration revenues to 29 percent in 2001.

Law 60 of 1993 complemented the 1991 constitution in the area of transfers. It demands that the total amount of the transfers to departments be determined as a minimum share of the central administration’s total current revenues, ranging from 23 percent in 1994 to 24.5 percent in 1996. Law 60 also stipulates that for the period 1994–98, every municipality would receive an annual basic transfer that is equal, in constant prices, to the transfer received in 1992.

Before the 2001 reform, the two main instruments for central administration revenue sharing were the Situado Fiscal and the Participación Municipal. The Situado Fiscal provided automatic transfers to departments, earmarked for current expenditure in health and education. The Participación Municipal was channeled into current and investment expenditure on basic services, including education, health, and water supply at the municipal level. Apart from these two mechanisms, resources were distributed to the subnational level through a system of cofinancing funds, as well as through the National Royalties Fund (Fondo Nacional de Regalías). As the latter were not subject to automatic increase based on central administration current revenue and follow specific distribution rules, the discussion presented in this paper will relate mainly to the Situado Fiscal and Participación Municipal.

6. However, expenditure responsibilities were not specified clearly, and the revenue-sharing mechanism contributed to transfer dependence at the local level. As will be discussed in this section, the system resulted in subnational fiscal indiscipline and aggravated fiscal problems at the central level, which are likely to increase going forward. Regions had no incentive to control their deficits, as transfers kept growing, creating the perception that costs for additional spending would be borne by the central administration.

The revenue-sharing system before 2001

7. During the 1990s, automatically and sharply rising transfers, combined with a lack of clear rules and incentives to control deficits and debt levels at the subnational level, created an unsustainable subnational debt burden. As required by the constitution (see Box 1.), transfers from the central administration increased significantly during the period 1993–99 (Tables 1. and 2.). At the same time, the stock of debt of subnational governments grew by 40 percent in 1993, and on average by 23 percent each year until end–1999 (Figure 1.). Weak fiscal rules, nonbinding expenditure ceilings, and automatically rising revenue transfers to local governments had created a free rider problem at the subnational level.2 In addition, bank lending to local governments through the early 1990s rose substantially, with banks using the transfers from the central administration as implicit collateral for their loans. Eventually, several departments collapsed financially, and the central administration bailed them out.

Table 1.

Colombia: Trends of Local Government Fiscal Operations

(In percent of GDP)

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Sources: Colombian authorities; and staff estimates.
Table 2.

Colombia: Operations of the Central Administration

(In percent of GDP)

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Sources: Colombian authorities; and Fund staff estimates.

Excludes proceeds of financial transaction tax in 1999 from revenue and expenditure.

Includes change in the budget carryover. A negative number corrects for current cash payments of expenditures incurred in previous periods.

Figure 1.
Figure 1.

Subnational Public Debt

(Annual percentage changes)

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A002

Sources: Ministry of Finance; and staff estimates.

8. Moreover, large scale transfers to the subnational governments discouraged local tax collection, in particular at the departmental level (Figure 2.). One of the reasons for establishing high and automatic transfers from the center to the local governments was to counteract limited tax collection capacity at the local level. Departments collect excise taxes, a motor vehicle tax, and a registration tax, while municipalities levy a real estate tax, an industry tax, and a gasoline tax. However, the increasing dependency on the transfer system was particularly pronounced at the departmental level, where the share of outlays financed by own tax collection fell from 57 percent in 1993 to 22 percent in 2001 (Table 3.). At the municipal level, this share fell from 37 percent in 1993 to 27 percent in 2001 (Figure 3.).

Figure 2.
Figure 2.

Transfers from the Central Government and Subnational Total Expenditure

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A002

Source: Ministry of Finance.
Figure 3.
Figure 3.

Subnational Tax Revenue

(In percent of combined public sector tax revenue)

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A002

Source: Ministry of Finance.
Table 3.

Colombia: Subnational Spending in Relation to Combined Public Sector

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Sources: Colombian authorities; and Fund staff estimates.

9. The automatic tax-sharing system also weakened the link between revenue and expenditure at the subnational level, given that the sequencing between the assignment of expenditure responsibilities and revenue transfers was poor. The 1991 constitution lacked clarity regarding the assignment of expenditure responsibilities across the different layers of government, which led to duplication of spending between the central and the decentralized governments, especially in the health and education sectors. While the automatic transfers enhanced the revenue side of the decentralization process, expenditure responsibilities and expenditure control lagged behind and were not properly developed across levels of government. In addition, the relative high level of transfers from the central administrations to the territorial governments, reaching 5.3 percent of GDP in 2001, would have been more typical for fully fledged federal systems, where expenditure responsibilities of the territorial governments are much more extensive. 3 This disparity between vague expenditure responsibilities, and automatic and high transfers from the central administration gave rise to a lack of subnational fiscal discipline.

10. In addition, high and growing transfers from the central administration to the lower levels of government in Colombia did not smooth out vertical and horizontal differences. At the department level, the vertical balance, measured as the ratio between the transfers received by the subnational government and its total expenditures, increased from 56 percent in 1994 to 65 percent in 2001. At the municipal level, the vertical balance stayed roughly constant, fluctuating around 33 percent for the period 1994–2001. Horizontal differences, understood as the ratio of own tax revenues to total revenues, also continued to exist (Figure 4.). While in some departments receipts from the transfer system amount to almost 90 percent of total revenue, others are much less dependent on transfers from the center, drawing as little as 10–15 percent of their revenues from transfers. At the municipal level, the dependency of income on revenue transfers from the central administration showed an equally broad range—from below 20 percent to almost 100 percent. Neither departments nor municipalities converged in terms of fiscal performance; while some were running continued deficits, other achieved solid surpluses through 2001.

Figure 4.
Figure 4.

Colombia: Decentralization Indicators by Department, 2000

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A002

Source: Ministry of Finance.1/ Exclude transfers from co-financing schemes and royalties.

11. The revenue sharing system also created serious difficulties for fiscal management at the central administration level. Between 1996 and 2001, transfers to departments increased by 112 percent and to municipalities by 115 percent. These large-scale transfers had the following consequences:

  • The rigid formula for automatic revenue transfers to local governments diminished the incentive to collect more revenue at the central administration level.

  • Transfers to subnational government based on revenues were pro–cyclical, hampering the central administration’s ability to conduct a counter–cyclical policy even if deemed appropriate. In addition, the rigid formula for increasing transfers limited the scope for expenditure discretion at the central level.

The effects of these consequences were compounded by the absence of a tight budget constraint, including at the subnational level, and the absence of expenditure coordination across levels of government in an automatic revenue sharing system increased the expenditures of the overall public sector.

The reform of the system in 2001

12. Given the difficulties that the tax–revenue sharing system and lack of fiscal discipline had created, Colombia modified the arrangement in 2001. The changes aimed to limit the automatic transfers to local governments and to improve macroeconomic and fiscal coordination across different levels of government by a series of laws (Box 2.). In 2001, a constitutional reform was passed that changed the automatic tax–sharing system as follows:

Fiscal Rules for Subnational Governments

In 1997, Colombia started to enact a series of laws to ensure sound macroeconomic management at all levels of government, in particular to improve coordination between, as well as monitoring of, different layers of government. Law 358 (1997) was designed to curb excessive debt levels of subnational governments, by linking their ability to contract debt to liquidity and solvency indicators. A local entity that does not adhere to these indicators would have to establish a fiscal adjustment plan, to be monitored by the ministry of finance of the central administration. However, subnational debt still grew by 15 percent a year on average during the years 1998–2000, and the performance plans did not always bring about stronger fiscal discipline at the local level. These plans turned out to be a device to address short–term liquidity problems rather than solving the underlying fiscal imbalances, caused by high unconditional transfers and a lack of expenditure ceilings.

In 2000, Law 617 was passed in response to the latter developments, and established a set of fiscal rules for subnational governments. It classified department into five categories, and municipalities into six, based on several indicators related to population and fiscal performance. The law limits the operating expenses of subnational entities to a certain percentage of their freely disposable revenue, i.e., excluding earmarked transfers. Subnational governments that do not comply with these ceilings must establish a corrective adjustment program, to be monitored by the ministry of finance.

In 2003, another important law to improve fiscal coordination among different levels of government was passed. Law 819 requires both the central administration and local governments to present each year a consistent 10–year macroeconomic framework. While the liquidity and solvency indicators of Law 617 remain binding, the law established one additional rule, namely that the primary surplus has to be at least equal to debt service. It further stipulates that fiscal management at all levels of government, including expenditure authorizations and revenue collection, must be in adherence with the medium–term macroeconomic framework. Whenever a government plans to decrease its revenue collection or increase its sending beyond the explicit targets, it has to seek the analysis and approval of the ministry of finance. Both the central and decentralized budgets must also be in full compliance with the medium–term macroeconomic frameworks.

  • It consolidated several individual transfers, namely the Situado Fiscal, the Participación Municipal, the Fondo Educativo de Compensaciónand other transfers that were channeled into teacher wages in both departments and municipalities, into one single transfer called Sistema General de Participaciónes (SGP).

  • The SGP is based on an amount of Col$10.9 trillion for the year 2001. For a transition period (2002–08), this amount is to grow 2 percentage points in real terms for the period 2002–05, and 2.5 percentage points in real terms for the period 2006–08. From 2009 onwards, the rate of growth of the SGP will be the average percentage rate of growth of current government revenue of the preceding four years. At a minimum, however, the SGP must amount to at least the percentage of central administration current revenue that was transferred in 2001, which was around 42 percent of revenue, after the transition period ends.

  • During the transition period, the following additional rule applies: whenever real GDP growth is higher than 4 percent, the growth of transfers would be raised by the excess of real GDP growth above 4 percent. This overall level of adjusted transfers, however, would be discounted by any extra costs that were caused by the transfer amounts in years in which real GDP growth was below 2 percent (during 2002–06), or 2.5 percent (2006–08).

  • This new design of intergovernmental transfers led to SGP growth of 9.6 percent in 2002, 8.9 percent in 2003, and 8.3 percent in 2004.

Evaluation of the transition system and simulations of alternatives

13. As a result of these efforts, fiscal discipline among subnational entities increased between 2000–04. Spending grew less rapidly than during the period 1997–99, subnational deficits decreased, and the stock of territorial debt grew by only 5 percent on average throughout 2000–03. While local governments ran deficits through the 1990s, they began to achieve small surpluses in 2001, and reached a surplus of 1.3 percent of GDP in 2004.

14. The 2001 reform of the transfer system was also instrumental in establishing fiscal discipline at the local government level. Moving from an automatic revenue sharing system to a system in which transfers grow by a defined rate in addition to the inflation rate helped to address some of the incentive problems. Moreover, the system ensured a more stable and predictable flow of resources. Since transfers must be channeled through local budgets, the greater predictability has helped improve fiscal management. A relatively steady growth in the level of transfers has led to lower spending at the local level, as windfall gains are less likely.

15. For the central administration, the reform of the transfer system managed to address some of the problems of the previous arrangement, but other expenditure rigidities led to continued deficits. Expenditure of the central administration, however, is constrained by severe rigidities, of which transfers to local governments are only one element. Mandatory transfers to the public pension system, which depleted its reserves in 2004, have started to increase sharply. In addition, a relatively high public debt—53 percent of GDP at end–2004—has caused interest payments to rise. Multiannual expenditure for important investment projects, a special feature of the Colombian budgetary system, reduces the room for expenditure discretion further. As a consequence, the fiscal deficit at the central administration level has fluctuated around 5½ percent of GDP through recent years.

16. Going forward, the central administration’s outlays mandated by expenditure rigidities are projected to increase. Even after the recent pension reforms, and net pension costs for the central administration are projected to rise significantly in relation to GDP between 2003 and 2010. The implementation of the revised budget code, which seeks to reduce revenue earmarking and scale back multiannual commitment, will take some time.

17. A return to the revenue sharing system of intergovernmental transfers is likely to create substantial difficulties for fiscal management at the central administration level. As pointed out above, current legislation foresees that, beginning in 2009, the transfers system will go back to a moving average share of central administration revenues. A simulation of a scenario in which transfers were linked to a moving average of central administration current revenue of the last four years,4 starting in 2007 and other things being equal, reveals that the deficit would rise from 6.3 percent of GDP in 2006 to 8 percent in 2007. By 2010, the deficit would reach almost 9 percent of GDP, if no fiscal adjustment measures were taken (Table 4. and Annex I). The level of transfers would reach 7.1 percent of GDP in 2010, up from 5.2 percent of GDP in 2006.

Table 4.

Colombia: Estimates of Effect of Different Intergovernmental Transfer Scenarios on Central Administration Finances 1/

(In percent of GDP)

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Sources: Colombian authorities; and staff calculations.

Simulation starts in 2007.

This scenario is based on the current system in which transfers grow by the rate of inflation plus 2.5 percent. Transfer growth is determined by the average growth of current revenue through the preceding four years. In

addition, transfers have to reach at least 42 percent of current revenue.

Transfers grow by the projected rate of inflation.

18. A better alternative might be to link growth of transfers to the rate of inflation, which would improve the fiscal outlook. Under this scenario, transfers would decline from 5.2 percent of GDP in 2006 to 4.5 percent of GDP by 2010. The 2010 deficit would thus be lower by 2.6 percentage points of GDP than in the scenario with the return to the previous, revenue-sharing system (see Table 4). This would clearly imply that the subnational governments will need to raise their own revenues or trim spending, given the constraint on their ability to borrow.

Macroeconomic coordination

19. Macroeconomic coordination and accountability across different layers are crucial for an effective decentralization process involving large-scale redistribution of resources. The literature has underlined the importance of macroeconomic coordination across different levels of government, preferably under a tight budget constraint for the overall public sector, and the need for accountability in a context of large-scale transfers between central and subnational governments. 5

20. As in many other Latin American countries, the need to have fully consistent fiscal policy frameworks was not recognized in the early stages of decentralization in Colombia. The institutional development lagged behind the relatively aggressive and large-scale distribution of resources. Moreover, there was relatively little or no accountability of lower levels of government, and the information flow back to the center was erratic. While Colombia has made important progress to address these shortcomings, a certain fragmentation of different levels of governments continues.

21. In particular, there is no designated institutional structure that coordinates and integrates the fiscal planning of different levels of government. Overall fiscal coordination still needs to be strengthened across levels of government, including the coordination of budgets. No formal coordination of the different budgets—the one of the central administration and the ones of local governments—takes place to ensure consistency with spending targets for the overall public sector. In addition, a shortcoming of Law 819 is that it does not differentiate in terms of administrative capacity among subnational governments.

22. Furthermore, the information system from, and accountability of subnational governments is still inadequate. While subnational governments report some fiscal data to a number of institutions, there is no systematic monitoring and integration of complete fiscal data, including expenditure, for the subnational sector. The lack of monthly fiscal reporting requirement even for bigger municipalities and departments weakens the accountability of subnational entities. Sectoral expenditure data are also lacking, and the last census was conducted in 1993, even though the level of transfers to subnational entities for certain categories is determined by specific population indicators.

C. The Distribution of Intergovernmental Transfers

23. The purpose of this section is to evaluate the distribution side of Colombia’s intergovernmental transfer system. Excessive earmarking for distributing resources to lower levels of government prevails (Box 3.). In addition, the system could improve on promoting the right incentives across the different layers of government. Finally, this section examines how well Colombia fares regarding efficiency of spending, in particular in the social sectors.

Earmarking of Transfers to Subnational Governments

Transfers to subnational governments are characterized by extensive earmarking, based on Law 715 of 2001. Of the resources transferred to the subnational level, 4 percent is earmarked for specific purposes, 1 and 96 percent is distributed between education and health, and the category “general purpose.” In education, expenditure must take place in the subcategories current expenditure, subsidies, and “quality.” The funds for the health sector must be spent on demand subsidies, services to unaffiliated segments of the population, and health insurance.

The distribution to subnational governments within these categories is regulated by a complex system of various criteria. The guiding principle in the distribution of transfers in the education sector is the number of pupils enrolled. In addition, a residual sum may be distributed on the basis of poverty indicators. While the number of enrolled pupils determines the level of resources a subnational entity receives in the education subcategories current expenditure and subsidies, the amount in “quality” is derived by adjusting the number of students by an “Unsatisfied Basic Needs” Index (NBI). In the health sector, the amount distributed to individual subnational governments for demand subsidies is based on the subsidies in the preceding year. The amount to be distributed for poor people unaffiliated with any health plans is determined by an estimation of poor people in the respective territorial entity. The amount subnational governments receive for the health plan is based on their total population (40 percent), equity considerations in the form of the number of poor in a subnational entity (50 percent), as well as estimated health risks, and administrative efficiency (10 percent), measured by health indicators achieved.

The distribution of the “general purpose” part of the transfers is based on a mix of equity and efficiency indicators. Out of the general purpose portion of the transfers, 40 percent are distributed on the grounds of relative poverty, as measured mainly by the NBI index. Another 40 percent relates to the proportion between urban and rural population. Fiscal efficiency, defined as the average growth of tax revenue per capita during the three preceding years, is the basis on which 10 percent is distributed. Another 10 percent is disbursed on the grounds of administrative efficiency to municipalities that manage to maintain or increase their investment spending per capita, financed by non–earmarked current revenue, for two years in a row.

Some earmarking is maintained for spending within the “general purpose” category. Smaller municipalities can spend up to 28 percent of the resources they receive for “general purposes” on investment, debt payments or other current administrative costs. The other 72 percent, and 100 percent for the bigger municipalities, must be spent in what is labeled “mandatory investment.”

1 Out of these 4 percent, 0.5 percent are earmarked for the indigenous population, 0.08 percent for municipalities around the Rio Magdalena, 0.5 percent for school food programs, and 2.9 percent for the local pension fund (FONPET).

The distribution system

24. More room for expenditure discretion may need to be given to the local level. Significant earmarking of the use of transfers has prevented local governments from taking on decentralized responsibilities in the form of prioritizing expenditure at the local level based on local needs, thereby hampering the decentralization process. While some earmarking might be retained to improve social indicators, more room should be given to general purpose transfers to increase ownership at the local level. In addition, the distribution system is very complex and uses a variety of indicators.

The role of incentives

25. As discussed extensively in the literature, a crucial pillar of a successful decentralization framework is the provision of the “right” incentives across the different levels of government. 6 In the context of large-scale transfers from the central administration to local governments, the importance of incentives to stimulate local tax collection has been stressed in order to avoid a free rider problem at the subnational level. Excessive earmarking of transfers, automatic formula transfers, a lack of independent evaluation of results, and weak institutional frameworks have been identified in the literature as the “wrong” incentives for a decentralization process.

26. While some progress has been made in Colombia, the current redistribution system needs to give stronger incentives to local governments to increase their fiscal sustainability. The 2001 reform of the automatic revenue sharing transfer system has helped to curb the free rider problem at the local level, and has also introduced some elements to reward fiscal and administrative efficiency. However, these incentives are poorly designed and have too little weight. Rewarding tax revenue per capita through the last two preceding years is a questionable measurement of fiscal efficiency, as cyclical factors or new activities might bias tax revenues. Equally, defining fiscal efficiency as investment expenditure financed by own revenue might create the wrong incentives and lead to investment expenditure that would have not taken place otherwise. Finally, overall earmarking of revenues remains heavy.

27. A better device to instill fiscal efficiency at the local level might be to reward local tax collection in relation to local tax capacity. As has been argued above, the large scale transfers to local government tend to discourage local tax collection, in particular at the departmental level. A better device to raise local tax collection and strengthen fiscal sustainability than the current indicators of fiscal and administrative efficiency might be to measure the local tax effort in terms of fiscal capacity. This capacity can be estimated by using the average effective local tax rate as a proxy for a benchmark level of revenue and thus local revenue capacity. Fiscal capacity is estimated to vary a lot across local governments in Colombia, particularly among municipalities.

28. The current transfers system could be reformed to smooth out the differences in local fiscal capacity. Local entities with a tax base below the average would thus be compensated by higher transfers from the center, and tax collection in line with tax capacity would be rewarded. Local government that collect taxes below their capacity, however, would receive lower transfers. This approach would be more equipped to pursue both equity and efficiency goals among decentralized entities than the current distribution system, which does not differentiate between local revenue collection and local revenue capacity.

Efficiency of spending

29. Despite a long period of high transfers to local governments to be spent in the social sectors, the quality of social services continues to lag behind. One of the core objectives of the whole decentralization process and the design of the transfer system in Colombia was to address local needs, in particular in the social sectors. As indicated above, large-scale transfers to the local level were earmarked extensively for social expenditure. Yet, social indicators did not improve at the same pace as intergovernmental transfers, especially before the 2001 reform, which tried to align transfers better with actual local needs and costs by reforming the distribution side of transfers. A study by the Colombian National Planning Department (DNP) showed that while some progress had been achieved in the education sector in terms of school coverage through the 1990s, the quality of both education and health services was still relatively low, in particular at the municipal level. 7

30. While some progress has been achieved after 2001, studies point to continued inefficiency of local spending, especially in the social sectors. Helped by the 2001 reform, health service and school coverage improved between 2002 and 2004, as did the supply of drinking water. However, additional studies by the DNP 8 point to remaining deficiencies in the quality of education and health sectors at the local level, as well as duplication of spending on the social sectors. Further clarification of expenditure responsibilities, continued fiscal adjustment through better coordination across levels of government, a better use of the fiscal capacity of local entities, measures to improve the efficiency of subnational spending, and better accountability and monitoring of local governments are thus crucial areas for future reform.

D. Cross–Country Comparison

31. The purpose of this section is to compare Colombia’s experience with intergovernmental transfers with the experience in Spain, Brazil, and India. The latter countries were chosen because they share some common features with the system in Colombia:

  • All countries are highly decentralized, with relatively large autonomy of subnational governments. In Spain, 45.3 percent of all expenditure was carried out at the subnational level, while in Brazil 35.8 percent was spent at the local level, and 56.7 percent in India (Table 5.).

  • In all three countries, decentralization involved large intergovernmental transfers, and all have some form of revenue-sharing arrangement in place. In turn, subnational governments in these countries were relatively dependent on large-scale transfers from the center. The share of transfers in subnational revenue amounted to 42.4 percent in India, very close to Colombia’s share of 42.2 percent.

  • In all countries, the high degree of decentralization and significant intergovernmental transfers posed challenges for the conduct of fiscal policy. In particular, establishing fiscal discipline at the local level proved difficult, and all counties strove to set the right incentives among the different levels of government while controlling subnational borrowing.

Table 5.

Comparison of Decentralization in Selected Countries

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2003 data.

2003 data.

2003 data for share of subnational spending. Data for revenues exclude transfers from other levels of government but include revenues from tax-sharing arrangements. They refer to 2001.

Data relate to average for 1990-1997. Data for subnational revenue exclude grants from the central government.

32. In Spain, transfers from the central governments to subnational governments are designed to cover the gap between mandatory expenditures and revenues accruing at the local level. The formula for the amount of transfers is based on the costs of expenditure responsibilities minus revenues of local entities in a base year, growing by the rate of central government’s tax revenue increase relative to the base year. 9 If the region’s sources of financing were larger than its expenditure responsibilities, it will contribute to the central government’s expenses. Since the formula is independent of the actual costs in the years after the base year, local governments have an incentive to trim their costs.

33. Spain has been more successful than other countries—including Colombia—in clearly specifying expenditure responsibilities across levels of government. It also has a relatively well functioning institutional framework in place, including a Fiscal and Financial Policy Council (FFPC) regulating the financial relations between national and subnational governments. While the FFPC has formally only consultative power, it coordinates fiscal policy in practice. In particular, in practice fiscal targets for the overall public sector are discussed within the FFPC, even though regions are de jure autonomous in their fiscal policy. As a result, regions were required to run a balanced budget in recent years. Weaknesses in the Spanish intergovernmental system include relatively weak enforcement mechanisms for adjustment at the local level, and the lack of timely subnational fiscal information.

34. After three debt crises at the state level in the past decade, Brazil has made significant progress in improving fiscal performance at the subnational level. As in Colombia and Spain, revenues of the central government are shared with local governments. However, only a certain number of federal government taxes are subject to revenue sharing, which has led to some distortion, with the federal government relying more on the taxes which are not shared with the regions. Also, some tax revenue is generated and redistributed at the local level itself. Despite these circumstances, the Brazilian states10 raise a large share of their revenue through their own taxation, which includes a value-added tax, and the dependence on transfers varies a lot among subnational entities. The coefficients for the horizontal distribution are to a large extent subject to political bargaining, so that there is little incentive for subnational governments to improve their performance. In addition, in some states, a moral hazard problem arose, as the central government did not credibly commit to a no-bail-out stance through the mid–1990s.

35. In response, the debt rescheduling agreements signed in 1996 and the Fiscal Responsibility Law (FRL) of 2000 successfully re-established fiscal subnational discipline. The FRL included a no-bail-out clause, and through recent years the center has taken strong stance against bail-outs. In 2004, subnational governments ran a primary surplus of about 1 percent of GDP. The law also established expenditure ceilings and set comprehensive reporting and transparence requirements for subnational governments, so that Brazil is now ahead of many other countries as regards access to subnational fiscal information and local accountability. However, there is a discussion in Brazil how sanctions would be applied in case of a subnational breach of the debt limits set by the FRL.

36. In India, state governments account for close to 60 percent of public sector expenditure, but only for about 40 percent of revenue collection. The vertical gap is closed by a complex combination of shared taxes, transfers, and borrowing. Several bodies are involved in determining the overall level of resources that are transferred to the local level, but there is no one institution setting a limit to the overall deficit, which creates problems similar to those arising from the Colombian set up. A constitutional body called the Finance Commission (FC) specifies the magnitude of shared taxes, several different bodies determine grant transfers, and the central government sets the market borrowing limit and provides direct loans to the subnational level. Control of state borrowing in the form of bank loans, however, is limited.

37. In more detail, every five years, the FC determines what share of central taxes are to be distributed to the states, and how these resources are to be allocated across states. In addition, the ministry of finance transfers resources in the framework of the annual budget to the local level to finance developmental needs. A body called the Planning Commission distributes these resources across states in the form of both loans and grants. Moreover, the central government also transfers specific tied grants to local government to finance particular projects.

38. As in Colombia in the 1990s, this intergovernmental transfer system has discouraged local tax collection and efforts to control expenditure, and the absence of a ceiling on subnational domestic borrowing has undermined fiscal discipline. In response, the FC has made attempts to take into account local tax capacity when distributing transfers among subnational governments, which however proved difficult to measure. Coordination among the different Commissions and institutions involved in India’s transfer system also caused problems. To date, some regional governments are highly dependent on transfers from the center and have little incentive to control their deficits.11 Their ensuing receiving 11 Purfield (2004) shows empirically that Indian states with greater access to central administration transfers tend to have higher deficits. loans from the center to cover their deficits creates a moral hazard problem. Thus, reform efforts should aim to pass appropriate fiscal legislation to establish local discipline and give some incentives to subnational governments to improve their performance.

E. Conclusions and Policy Options

39. The intergovernmental transfer system in Colombia continues to pose challenges for the conduct of fiscal policy. While a reform of the system and adequate legislation to promote fiscal responsibility have helped to establish fiscal discipline at the subnational level, further reform might be warranted to ensure fiscal sustainability of the overall public sector going forward.

40. Remaining challenges in improving the system include in particular:

  • After 2009, the transfer system should remain decoupled from the central administration’s revenues. A possible alternative might be to link the rate of transfer growth to the rate of inflation, which would curb pressures on the central administration deficit. In addition, this measure could help limit the combined public sector deficit, if subnational governments raised their own revenues or trimmed spending, in response to slower growth in transfers from the central administration.

  • Macroeconomic coordination mechanisms between different levels of government need to be strengthened, including at the formal level. An institution similar to the Fiscal and Financial Policy Council (FFPC) regulating the financial relations between national and subnational governments in Spain might be warranted, so that budgets and fiscal targets can be coordinated more systematically.

  • Reporting and monitoring of subnational governments should be improved. In order to promote transparency and accountability of local governments, a comprehensive set of fiscal data should be released at the local level regularly. Brazil can serve as a model in this respect.

  • The distribution side of intergovernmental transfers should be simplified, with a view to reducing earmarking to provide more room for local expenditure discretion.

  • The incentive structure of the system should strive to reward local tax collection, possibly by measuring subnational tax collection in relation to tax capacity.

References

  • Acosta, O.L., and Bird, R. M., 2003. “The Dilemma of Decentralization in Colombia,” Fedesarrollo, Bogotá.

  • Acosta, O.L., 2002. “Finanzas Territoriales y Estructura Fiscal Colombiana,” Fedesarrollo, Bogotá.

  • Echavarria, J.J., Renteria, C., and Steiner, R., 2002. “Decentralization and Bailouts in Colombia,” Working Paper, Fedesarrollo, Bogotá.

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  • Montenegro, S., 2003. “El Sistema General de Participaciones frente al Déficit Fiscal Nacional,” Departamento Nacional de Planeación, Bogotá.

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  • Porras, O.A., 2002. “Decentralización Municipal in Colombia: Balance de una Decada,” Departamento Nacional de Planeación, Bogotá.

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  • Rodden, J., Eskeland, G.S., and Litvack, J., 2003. “Fiscal Decentralization and the Challenge of Budget Constraints,” MIT Press, Cambridge, Massachusetts.

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  • Purfield, C., 2004. “The Decentralization Dilemma in India,” International Monetary Fund Working Paper.

  • Ter-Minassian, T., 1997. “Fiscal Federalism in Theory and Practice,” International Monetary Fund, Washington D.C.

  • Sanchez, F. 2001. “Evaluación de la decentralización municipal en Colombia,” Departamento Nacional de Planeación, Bogotá.

  • Wiesner, E., 2002. “Transferencias, Incentivos y la Endogenidad del Gasto Territorial,” Departamento Nacional de Planeación, Bogotá.

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  • Wiesner, E., 2003. “Fiscal Federalism in Latin America,” Inter-American Development Bank, Washington D.C.

  • Winkler, D., 1994. “The Design and Administration of Intergovernmental Transfers,” World Bank Discussion Paper, Washington D.C.

ANNEX I: Simulation of Different Scenarios for the Level of Intergovernmental Transfers

This annex provides more details on the simulation of different arrangements for the determination of the level of transfers. Three different scenarios were considered:

  1. A baseline scenario in which transfers grow according to the current system in place, i.e., 2.5 percent in real terms per year. In addition, pension outlays are projected to pick up substantially, based on estimates provided by the Colombian authorities. All other expenditure and revenue is projected to grow in line with GDP.

  2. A scenario as foreseen by law for the period after the current, transitional system described in (i) has ended: transfers grow in line with the moving average of central administration current revenue during the four preceding years of year t. In addition, transfers may not be lower than 42 percent of current government revenue, the amount transferred from the center to the regions in 2001.

  3. A scenario in which transfer growth is determined by the projected average inflation rate for year t.

In addition, the following assumptions were made for all scenarios:

  • The different scenarios will start in 2007.

  • Current revenue will grow in line with nominal GDP.

  • No measures to contain other expenditure, including rising pension costs, are assumed.

  • The nominal base for transfer growth are transfers under the Sistema General de Participaciones, projected at Col$ 15,504,275 million in 2006.

Table 4 presents the results. By 2010, the overall fiscal deficit would be 2.6 percent of GDP higher in the scenario in which transfers are based on revenue sharing, compared with the scenario in which they grow in line with inflation. By contrast, the deficit would be half a percentage point lower in 2010, compared with the baseline scenario, if transfers would grow in line with inflation. Accordingly, the difference in the fiscal deficit between the revenue sharing system and the baseline scenario would amount to 2.1 percent of GDP in 2010.

1

Prepared by Isabell Adenauer.

2

The 1991 constitution specified some measures to control debt levels at the subnational level, introducing the rule that both internal and external debt of the central administration and the decentralized governments could not exceed their payment capacity. These regulations, however, proved insufficient to control local debt levels.

4

In addition, the simulation exercise takes into account the 2001 reform stipulation that after the transition period of defined transfer growth ends and the system will be based on revenue-sharing again, transfers need to reach the minimum amount of the share of current revenue transferred in 2001, which is about 42 percent of current revenue (see Annex I for more details).

5

See Rodden (2003), Wiesner (2002 and 2003), and Winkler (1994).

6

See in particular Wiesner (2003, p. 45), and Rodden (2003, p. 14).

9

The transfer regulation also provides for transitory financing floors, and some compensation for demographic shocks in regions, and for solidarity financing to poorer regions. Moreover, for historical reasons, the Basque country and Navarre have separate financing systems.

10

In addition, municipalities raise a sales tax on services.

11

Purfield (2004) shows empirically that Indian states with greater access to central administration transfers tend to have higher deficits.

Colombia: Selected Issues
Author: International Monetary Fund
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    Subnational Public Debt

    (Annual percentage changes)

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    Transfers from the Central Government and Subnational Total Expenditure

    (In percent of GDP)

  • View in gallery

    Subnational Tax Revenue

    (In percent of combined public sector tax revenue)

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    Colombia: Decentralization Indicators by Department, 2000