Abstract
This Selected Issues paper for Peru explains growth and reform in the country post-1990. As half of the population in Peru still lives below the poverty line, further research should consider how the link between average income improvements and poverty reduction can be strengthened. Although the ongoing decentralization effort in Peru has been based on considerations of fiscal sustainability, more work needs to be done to ensure that the conditions for a successful decentralization are in place. The experience of Peru teaches that sound macroeconomic policies are a precondition for de-dollarization.
II. Toward a Sound Fiscal Decentralization In Peru1
A. Introduction
1. Like other countries in Latin America, Peru has embarked on a fiscal decentralization process in recent years. The current Peruvian decentralization attempt started in 2002, with a constitutional amendment that mandated political and fiscal decentralization. Other countries in Latin America, such as Bolivia and Ecuador, have also experienced pressures to decentralize, while others, like Chile, remain fairly centralized. In Peru, the process was promoted by the general view that decentralization would help improve governance and public service delivery through enhanced accountability at subnational levels. Decentralization was also aimed at ensuring broader access to basic public services and, ultimately, at reducing high poverty rates and regional income disparities.
2. Despite its potential benefits, decentralization is a difficult and challenging process. International experience shows that the merits of decentralization largely depend on its design, as well as its implementation. Appropriate revenue assignments are critical to ensuring an effective provision of public services by subnational governments—for example, local taxes are generally preferable to central government transfers in order to generate incentives for subnational accountability (Ahmad and Brosio, 2006). In countries where important natural resources are located in specific regions, decentralization may increase regional disparities in the absence of equalization mechanisms (Ahmad and Brosio, 2006). The assignment of expenditure responsibilities is also critical. For instance, ill-defined functions combined with a rapid devolution of revenues may result in fiscal imbalances, as was the case in Indonesia (Ahmad and Tanzi, 2002).
3. The success of decentralization also depends in part on the quality of institutions. If local institutions related to tax administration, expenditure management systems, and budgetary processes are weak, their ability to collect effectively and manage public resources is limited. In turn, this tends to jeopardize the effective delivery of social services and to lead to waste in public resources. In fact, there is no convincing evidence that decentralization brings significant improvements in the delivery of services, particularly to disadvantaged groups (Ahmad and Tanzi, 2002).
4. Decentralization could pose risks to macroeconomic stability. If the central government has limited capacity to monitor indebtedness operations by subnational governments, decentralization could result in a rapid increase in subnational debt. At various points in time, these problems became evident in countries such as Brazil, Argentina, or Russia (Tanzi, 2002, Ahmad and Tanzi, 2002). Also, in a decentralized fiscal structure it is more difficult to coordinate the actions of national and subnational jurisdictions to achieve certain well-specified macroeconomic objectives.
5. This paper seeks to assess the extent to which the conditions for a sound decentralization process are present in Peru. Peru remains fairly centralized and, despite a legal framework for decentralization yet to be completed, the authorities have reaffirmed their intention to press ahead rapidly with decentralization.2 This chapter presents the legal framework and its status of implementation, and assesses the extent to which the institutional conditions for efficient spending and adequate reporting by lower levels of government are in place. It finds out that the legal framework is well advanced but that further steps should be taken before pressing ahead with decentralization, including through a clearer definition of responsibilities at all levels and improvements in the capacity of subnational governments to execute spending effectively.
B. The Framework for Subnational Governments
6. Subnational governments in Peru share many of the shortcomings of the central government in the area of public financial management. Peru consists of three levels of government: national, regional, and local.3 As in many countries, shortcomings of the central government in the area of public financial management, including information generation, are magnified at the lower levels, due to limited human capital and organizational capacity. As noted by Tanzi (2002), the probability for poor governance, and lower quality of institutions and staff, are more common at the subnational level. Indeed, in Peru the technical capabilities of subnational governments to assess and execute investment projects has proven to be very limited, resulting in part in an under execution of budgeted resources. In addition, the central government has not been able so far to obtain comprehensive financial information on the activities of subnational government on a timely basis. A priority should thus be to build up the administrative capacity of subnational governments since this is crucial for an effective use of public resources.
7. Since 2002, the legal framework for a fiscally-neutral decentralization process has been put in place gradually. Building upon the 2002 constitutional mandate, laws were enacted to guide the sequencing and procedures for the devolution of responsibilities, the transfer of resources, and the reporting provisions and fiscal rules for subnational governments. The legislation also provided for the creation of larger regions resulting from the merger of existing regions.
8. Five main laws have been enacted to guide the process of fiscal decentralization:4
The 2002 Framework Decentralization Law, which mandates a clear, gradual, and fiscally-neutral devolution of expenditures and revenue. It regulates expenditure assignments among levels of government and specifies which functions are exclusively assigned to a particular level and which ones are shared. It also established stages for the devolution process, under which devolution of responsibilities was to start with social and infrastructure programs, continue with other sectoral functions, and end with the transfer of education and health functions.
The 2002 Organic Law of Regional Governments and the 2003 Organic Law of Municipalities detail regional government and municipal expenditure responsibilities, respectively. However, neither these laws nor the Framework Decentralization Law did clarify the assignment of shared responsibilities (Table A.1).
The 2004 Accreditation System Law. This law aims at establishing a system to assess whether regional and local governments meet minimum capacity standards to qualify for the transfer of functions and corresponding resources. This law also regulates the procedures for the devolution process (Box 1).
The 2004 Fiscal Decentralization Law (FDL), which establishes the sequencing of transfers to regional governments and sets fiscal rules and reporting provisions for subnational operations.
List of Expenditure Responsibilities
List of Expenditure Responsibilities
| Central government | Regional government | Municipal government | |
|---|---|---|---|
| Exclusive |
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| Shared |
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List of Expenditure Responsibilities
| Central government | Regional government | Municipal government | |
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| Exclusive |
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| Shared |
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9. Subnational governments rely heavily on transfers from the central government. Although local governments can collect their own taxes, most of their revenue accrues from central government transfers, including from shared-revenues (such as the canon for natural resources). Other specific transfers are to fund social programs, such as Vaso de Leche (Table 1).5 Local governments can also borrow in the domestic or international markets, subject to certain fiscal rules.6 While regional governments receive transfers from the central government and can borrow from the financial markets, they cannot levy taxes.
The Accreditation Process
The Accreditation System Law defines the procedures for the transfer of functions from the central government to regional and local governments.
As a first stage, the functions that may be transferred are defined in an annual transfer plan. Based on the responsibilities assigned to subnational governments, the National Decentralization Council (NDC) prepares annual transfer plans. These plans integrate the annual plans prepared by each line ministry and specify the functions that may be transferred during the next budget cycle. They also establish the criteria that subnational governments need to meet in order to qualify for the transfer of functions and corresponding resources. By end-March of each year, the NDC annual plan is approved by the Council of Ministers.
In a second stage, the capacity of subnational governments to undertake the functions to be devolved is assessed. In the context of the annual transfer plan, the regional and local governments may request the devolution of functions and their capacity to undertake the new responsibilities is assessed. The subnational governments’ capacity assessment—which may be performed by the NDC or a non-public agency—is undertaken in August-September. By end-October, the NDC certifies the subnational governments for the devolution of functions during the next budget cycle.
Financial Sources of Subnational Governments
Financial Sources of Subnational Governments
| Regional government | Local government |
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Financial Sources of Subnational Governments
| Regional government | Local government |
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Current Revenue Sources of the Local Governments, 2005
Includes property tax, and casino taxes.
Municipal fees, fines, and revenues from the sale of goods and services
Canon and sobrecanon.
Foncomún, Vaso de Leche, and other transfers.
Current Revenue Sources of the Local Governments, 2005
| Millions of soles | In percent of general government total current revenues | In percent of GDP | |||
|---|---|---|---|---|---|
| Total current revenue | 6,703 | 14.0 | 2.6 | ||
| Local revenues | |||||
| Taxes 1/ | 689 | 1.4 | 0.3 | ||
| Nontax revenues 2/ | 1,671 | 3.5 | 0.6 | ||
| Contributions | 8 | 0.0 | 0.0 | ||
| Transfers from the central government | |||||
| Shared-revenues 3/ | 1,568 | 3.3 | 0.6 | ||
| Other transfers 4/ | 2,767 | 5.8 | 1.1 | ||
Includes property tax, and casino taxes.
Municipal fees, fines, and revenues from the sale of goods and services
Canon and sobrecanon.
Foncomún, Vaso de Leche, and other transfers.
Current Revenue Sources of the Local Governments, 2005
| Millions of soles | In percent of general government total current revenues | In percent of GDP | |||
|---|---|---|---|---|---|
| Total current revenue | 6,703 | 14.0 | 2.6 | ||
| Local revenues | |||||
| Taxes 1/ | 689 | 1.4 | 0.3 | ||
| Nontax revenues 2/ | 1,671 | 3.5 | 0.6 | ||
| Contributions | 8 | 0.0 | 0.0 | ||
| Transfers from the central government | |||||
| Shared-revenues 3/ | 1,568 | 3.3 | 0.6 | ||
| Other transfers 4/ | 2,767 | 5.8 | 1.1 | ||
Includes property tax, and casino taxes.
Municipal fees, fines, and revenues from the sale of goods and services
Canon and sobrecanon.
Foncomún, Vaso de Leche, and other transfers.
10. The 2004 Fiscal Decentralization Law (FDL) addresses the issue of the sequencing of transfers to regional governments. Under the law, transfers must be such as to ensure a neutral and fiscally sound decentralization process. The law establishes a two-stage process for transferring revenues to regional governments:
During the first stage, regional governments are to be funded through transfers from the central government, earmarked for certain social programs and infrastructure projects, and consistent with the principle of fiscal neutrality.
Regional governments that voluntarily merge to constitute larger regions qualify to enter the second stage.7 At this stage, they will receive 50 percent of certain taxes collected in their jurisdictions, including VAT and personal income taxes. They also receive additional transfers from the central government if expenditures (excluding the wage bill) exceed shared-transfers because of external factors (such as a natural disaster or a drop in regional income). Also, regions can receive a bonus (earmarked for investment and maintenance of infrastructure) equivalent to the increase in tax collections above their estimated potential level resulting from efforts to improve tax administration and reduce tax evasion.8, 9
11. The implementing regulations of the FDL, issued in September 2005, clarified that shared-transfers should not exceed the estimated cost associated to the devolved functions. This clause was aimed at ensuring fiscal neutrality in decentralization. Moreover, the regulations also clarified that fiscal savings resulting from the efficient provision of public functions by the regions should be used for capital spending or infrastructure maintenance.
12. While legislation on the sequencing of decentralization was being prepared, fiscal rules on subnational governments were introduced to ensure fiscal sustainability. The 2003 amendment to the Fiscal Responsibility Law (FRL), together with the 2004 Fiscal Decentralization Law (FDL), placed a number of responsibility rules on subnational operations. These rules (for both local and regional governments) include the following:
The three-year average primary balance must be positive.
There is to be a 3 percent annual limit on real primary expenditure growth.
A central government guarantee is required for contracting external debt.
Domestic or external indebtedness operations must be used exclusively to finance investment projects.10
The debt-to-current revenue ratio and annual debt service-to-current revenue ratio must be below 100 percent and 25 percent,11 respectively.12
The non-guaranteed debt-to-current-revenue ratio and the annual non-guaranteed debt service-to-current-revenue ratio must be below 40 percent and 10 percent, respectively.13
Short-term debt (including floating debt) at end-year cannot exceed one-twelfth of annual current revenues.
13. The legal framework also contains reporting provisions for subnational operations. The FDL established that regional and local governments needed to provide their medium-term fiscal projections (indicating the planned external and domestic indebtedness operations) to the central government, consistent with the three-year Multi-annual Macroeconomic Framework (MMM) published by the Ministry of Economy and Finance. Also, subnational governments need to report on their quarterly fiscal performance and describe adjustment measures, if needed, to comply with their annual targets.14
14. Additional legislation is needed to complete the decentralization framework. Despite the concerted efforts to shore up legal underpinnings, the legal decentralization framework is still not complete. There is a need to clarify the spending responsibilities of each level of government and to issue regulations with sanctions for subnational governments not complying with their fiscal rules or their reporting requirements. There is also a need to establish precise conditions for central government intervention and procedures when the implementation of fiscal adjustment programs is required in subnational governments.
C. The Experience with Decentralization
15. Peru’s progress under its decentralization process has remained relatively limited so far. Local governments continue to carry out only a small fraction of general government expenditure. Following a significant increase during the late 1990s, and a subsequent correction, the share of general government expenditure executed by local governments rose from 10 percent in 1999 to about 13 percent in 2004 (Figure 1). No information is available about the impact of this increase on public service delivery or on poverty rates, however.
Percentage of General Government Primary Expenditures Executed at the Local Level
Citation: IMF Staff Country Reports 2007, 053; 10.5089/9781451831092.002.A002
Source: Staff with BCRP dataPercentage of General Government Primary Expenditures Executed at the Local Level
Citation: IMF Staff Country Reports 2007, 053; 10.5089/9781451831092.002.A002
Source: Staff with BCRP dataPercentage of General Government Primary Expenditures Executed at the Local Level
Citation: IMF Staff Country Reports 2007, 053; 10.5089/9781451831092.002.A002
Source: Staff with BCRP data16. This limited progress is partly due to delays in clarifying spending responsibilities among levels of government. As noted above, the FDL specified which functions were exclusively assigned to a particular level of government. The law also listed the shared responsibilities and provided that these responsibilities be clarified either in a new Organic Law of the Executive Power or in sectoral legislation. However, because of a lack of consensus, neither the draft Organic Law (presently under debate at Congress) nor sectoral legislation have addressed the important issue of expenditure assignments.15 Instead, in the implementing guidelines prepared by the NDC, responsibilities are being gradually clarified through medium-term sectoral transfer plans elaborated by the relevant Ministries, in coordination with local and regional governments.
17. Delays and shortcomings in the accreditation system have also led to delays in the devolution process. Each year, the NDC prepares a list of subnational governments complying with the certification criteria and thus qualifying under the annual transfer plan for the transfer of functions and associated resources. The transfer plan approved in 2003 and with effect in 2004 included specific social and infrastructure programs, and most of the subnational governments which were recipients of those programs were certified (Table 3). Lacking an accreditation system, a simplified provisional system for the certification of subnational governments’ capacity to deliver some social and infrastructure programs was implemented in 2003. Starting in 2004, the accreditation system had to be in place to proceed with the transfer of functions for 2005. The transfer plan approved in May 2004 included functions in the agriculture, fishing, tourism, trade, industry, energy, and mining sectors. However, because of delays in passing the implementing regulations of the Accreditation System Law, no further functions were devolved in 2005.
Devolution of Functions, 2003
Number of governments.
Devolution of Functions, 2003
| Program or Project Recipient 1/ | Certified 1/ | ||
|---|---|---|---|
| Regional governments | Special programs of INADE (National Institute of Development) | 9 | 8 |
| Maintenance of rural roads of PROVIAS RURAL | 12 | 4 | |
| Projects of rural electrification | 17 | 17 | |
| Local governments | Food programs of PRONAA (National Program for Food Assistance) | 194 | 67 |
| Maintenance of rural roads of PROVIAS RURAL | 22 | 12 | |
| Reconstruction projects of ORDESUR (Organization for the Reconstruction and Development of the South) | 29 | 29 | |
| Social infrastructure projects of FONCODES | 498 | 241 |
Number of governments.
Devolution of Functions, 2003
| Program or Project Recipient 1/ | Certified 1/ | ||
|---|---|---|---|
| Regional governments | Special programs of INADE (National Institute of Development) | 9 | 8 |
| Maintenance of rural roads of PROVIAS RURAL | 12 | 4 | |
| Projects of rural electrification | 17 | 17 | |
| Local governments | Food programs of PRONAA (National Program for Food Assistance) | 194 | 67 |
| Maintenance of rural roads of PROVIAS RURAL | 22 | 12 | |
| Reconstruction projects of ORDESUR (Organization for the Reconstruction and Development of the South) | 29 | 29 | |
| Social infrastructure projects of FONCODES | 498 | 241 |
Number of governments.
18. The creation of larger regions, a key component of the decentralization process, has not yet materialized. The Law on Incentives for the Integration and Creation of Regions of June 2004 provided incentives for the voluntary merger of regional governments (via referendum) to obtain an optimum number of economically-viable regions. Referenda were scheduled to take place at end-October 2005, 2009, and 2013. For the 2005 referendum, the NDC had approved technical requests for consolidating 16 departments into 5 regions.16 However, 15 out of the 16 departments rejected the proposal by referendum. As a result, none of the regional governments have merged into larger regions. Part of this result is thought to have reflected a lack of information from voters and a lack of clarity as to how the resources from the canon, which provides the bulk of public resources for investment by subnational governments, would be allocated. For some analysts, the shared-transfers were interpreted as automatic transfers (not linked to the devolution of functions) while, for others, these transfers were linked to the devolution of functions. The FDL regulations subsequently clarified that the shared-transfers should be linked to the cost of devolved responsibilities.17
D. Priorities Ahead for a Sound Fiscal Decentralization
19. A set of measures need to be in place before decentralization proceeds, to ensure that it does not pose risks to macroeconomic stability. This section identifies next steps and medium-term priorities, including in the area of public financial management and reporting of fiscal operations.
Next steps
20. Spending responsibilities need to be clarified, with a view to avoiding a duplication of tasks. As expenditure assignments are yet to be clarified (for example in areas such as education and health), it is difficult to assess whether the process of decentralization is based on the principle of subsidiarity. This lack of clarity poses a risk of duplication of expenditures. Furthermore, the emphasis on revenue-sharing rather than expenditure responsibilities opens up the possibility of overall imbalances, if the central government is left with more responsibilities than revenue. Therefore, the legislation should aim at clarifying spending responsibilities.
21. To ensure effective service delivery, the devolution of responsibilities needs to be in line with subnational capacity. Subnational governments often face capacity limitations in executing spending and responding to the needs of the population. To avoid a deterioration in service delivery and creating false expectations, the expenditure management capacities of subnational governments will need to be developed, including through training programs administered by the central government. These programs could start being implemented on a pilot basis first, before more expenditure responsibilities are devolved.18 The accreditation system needs to be strengthened to ensure that subnational governments meet the criteria to qualify for the transfer of functions and corresponding resources.
22. Monitoring of the fiscal operations of subnational governments would need to be strengthened, to ensure fiscal prudence and macroeconomic stability. In recent years, the overall primary balance of the local governments has been positive, reflecting both fiscal prudence and a limited capacity to use the sizable canon transfers (Tables 4 and 5). As decentralization proceeds, the level of subnational spending is likely to rise and, thus, to contribute to a deterioration in the overall balance of the nonfinancial public sector (NFPS).19 It is critical that subnational governments comply with the fiscal reporting and fiscal responsibility rules, for an enhanced coordination between central and subnational fiscal policies. Legislation will need to be enacted to introduce sanctions for subnational governments not complying with their fiscal rules or reporting requirements, and to make more precise the conditions under which the central government would intervene.
Peru: Fiscal Operations of the NFPS
(Percent of GDP)
Note: Regional governments are included together with the central government, since during this period they were deconcentrated organs of the center.
Peru: Fiscal Operations of the NFPS
(Percent of GDP)
| 1997 | 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | |||
|---|---|---|---|---|---|---|---|---|---|---|---|
| NFPS Primary balance | 2.09 | 1.19 | -0.87 | -0.84 | -0.23 | -0.11 | 0.43 | 1.01 | 1.63 | ||
| Central government | 0.97 | 0.75 | -1.04 | -0.60 | -0.65 | -0.15 | 0.22 | 0.59 | 1.13 | ||
| Rest of general government | 0.44 | 0.54 | 0.14 | 0.25 | 0.21 | 0.17 | 0.26 | 0.28 | 0.29 | ||
| of which local governments | -0.02 | 0.06 | -0.08 | 0.10 | 0.05 | 0.10 | 0.16 | 0.14 | 0.28 | ||
| Public entities | 0.68 | -0.10 | 0.03 | -0.49 | 0.21 | -0.12 | -0.05 | 0.14 | 0.21 | ||
| Interest payments | 2.03 | 2.18 | 2.35 | 2.48 | 2.25 | 2.13 | 2.15 | 2.05 | 1.94 | ||
| Overall balance | 0.06 | -0.99 | -3.22 | -3.32 | -2.48 | -2.24 | -1.72 | -1.03 | -0.30 | ||
Note: Regional governments are included together with the central government, since during this period they were deconcentrated organs of the center.
Peru: Fiscal Operations of the NFPS
(Percent of GDP)
| 1997 | 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | |||
|---|---|---|---|---|---|---|---|---|---|---|---|
| NFPS Primary balance | 2.09 | 1.19 | -0.87 | -0.84 | -0.23 | -0.11 | 0.43 | 1.01 | 1.63 | ||
| Central government | 0.97 | 0.75 | -1.04 | -0.60 | -0.65 | -0.15 | 0.22 | 0.59 | 1.13 | ||
| Rest of general government | 0.44 | 0.54 | 0.14 | 0.25 | 0.21 | 0.17 | 0.26 | 0.28 | 0.29 | ||
| of which local governments | -0.02 | 0.06 | -0.08 | 0.10 | 0.05 | 0.10 | 0.16 | 0.14 | 0.28 | ||
| Public entities | 0.68 | -0.10 | 0.03 | -0.49 | 0.21 | -0.12 | -0.05 | 0.14 | 0.21 | ||
| Interest payments | 2.03 | 2.18 | 2.35 | 2.48 | 2.25 | 2.13 | 2.15 | 2.05 | 1.94 | ||
| Overall balance | 0.06 | -0.99 | -3.22 | -3.32 | -2.48 | -2.24 | -1.72 | -1.03 | -0.30 | ||
Note: Regional governments are included together with the central government, since during this period they were deconcentrated organs of the center.
Evolution of Canon, 2000–05
(Millions of nuevos soles)
Evolution of Canon, 2000–05
(Millions of nuevos soles)
| 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | ||
|---|---|---|---|---|---|---|---|
| Mining canon | 55 | 81 | 136 | 286 | 451 | 888 | |
| Petroleum canon | 407 | 333 | 351 | 401 | 440 | 576 | |
| Hidroenergetic canon | 0 | 0 | 51 | 92 | 109 | 113 | |
| Fishing canon | 0 | 0 | 0 | 8 | 40 | 29 | |
| Forestry canon | 0 | 0 | 1 | 1 | 2 | 1 | |
| Gas canon | 0 | 0 | 0 | 0 | 73 | 302 | |
| Total | 463 | 414 | 539 | 788 | 1,115 | 1,908 | |
| in percent of GDP | 0.25 | 0.22 | 0.27 | 0.37 | 0.47 | 0.73 | |
Evolution of Canon, 2000–05
(Millions of nuevos soles)
| 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | ||
|---|---|---|---|---|---|---|---|
| Mining canon | 55 | 81 | 136 | 286 | 451 | 888 | |
| Petroleum canon | 407 | 333 | 351 | 401 | 440 | 576 | |
| Hidroenergetic canon | 0 | 0 | 51 | 92 | 109 | 113 | |
| Fishing canon | 0 | 0 | 0 | 8 | 40 | 29 | |
| Forestry canon | 0 | 0 | 1 | 1 | 2 | 1 | |
| Gas canon | 0 | 0 | 0 | 0 | 73 | 302 | |
| Total | 463 | 414 | 539 | 788 | 1,115 | 1,908 | |
| in percent of GDP | 0.25 | 0.22 | 0.27 | 0.37 | 0.47 | 0.73 | |
23. Public financial management shortcomings that lead to difficulties in monitoring subnational operations need to be addressed. Peru is working toward a Treasury Single Account that would operate at all levels of government. Once in place, this would help ensure higher transparency and better cash management. This will also minimize the danger of a build-up of idle cash balances in some areas of the general government while some other areas are borrowing from the financial sector. To ensure a smooth and efficient process, very clear reporting requirements for subnational governments are necessary, in line with standard budget classification.
Timely information on subnational debt is needed. At present, it is difficult to estimate the extent of debt exposure at the municipal level. The General Public Debt Law mandated that regional and local governments should register all their indebtedness operations using a debt module in the subnational government financial information management system (SIAF-GL). However, such a module is not yet operational. The absence of a centralized risk register (which should cover all debt, including floating debt) also makes it difficult to assess compliance with fiscal rules.20 In addition to the need to establish a registry of subnational debt, the definition and recording of floating debt (which is not covered under the definition of indebtedness operations under the General Public Debt Law) still needs to be addressed.
Medium-term priorities
24. Greater subnational government reliance on own-source revenues would help create the conditions for better management. Local governments do not have discretion over revenues (that is, they do not have control over the rates or bases), as all tax policy issues at the local level are determined by Congress. Regional governments do not have their own sources of revenues, since no taxes have been created for this level of government. Providing subnational governments with discretion over their own sources of revenue would help strengthen subnational accountability and responsibility.21
25. Various arrangements are conceivable to introduce some discretion over own-source revenues at the subnational level. Specifically, congress could retain control over the tax rate structure by enacting a band for local tax levels, within which local governments would be able to set their particular rates, taking into account their spending needs. Discretion over own-source revenues does not necessarily imply that there must be local administration of taxes. Indeed, suitable arrangements could involve contracting the national tax administration agency SUNAT to collect some subnational taxes, which would be facilitated if there were shared bases.
26. Earmarking further restricts the operations of subnational governments. Earmarking in Peru is extensive at the subnational level, largely for investment expenditure. Some shared-revenues are earmarked for investment, such as revenues from the canon and mining royalties.22 Other earmarked transfers include FONCOR (the regional government compensation fund), which is also allocated to investment projects distributed among regional governments, taking into account population needs.23 The recent sharp increase in canon revenues (due both to the extensive new operations as well as the upturn in commodity prices), together with limited capacity to prepare and execute investment projects, has led to significant capital under-spending in relation to budgeted allocations, while current spending is fairly close to budget estimates.24 In Cajamarca, for instance, in 2004 current spending of the regional government was broadly in line with budgeted amounts, while capital spending only reached 55 percent of the budgeted figures.
27. Finally, an equalization transfer system should be part of the decentralization program, given that the current transfer design may lead to growing regional disparities. The range of transfers in Peru poses the risk that the decentralization initiative might exacerbate geographical disparities. While in itself the decentralization process is assumed not to exacerbate geographical disparities, some of the existing transfer schemes not linked to the decentralization process (such as canons) may clearly lead to larger geographical disparities. They may also limit the capacity of the central government to equalize access to public services across regions.25 Therefore, the establishment of an equalization transfer system should be integrated as part of the decentralization design.26
E. Conclusion
28. While the ongoing decentralization effort in Peru has been based on considerations of fiscal sustainability, more work needs to be done to ensure that the conditions for a successful decentralization are in place. Given the dangers of decentralization for the effective use of public resources and macroeconomic stability, key steps need to be taken in the legal and institutional areas before decentralization proceeds. In the legal area, this would include clarifying better the shared spending responsibilities among levels of government, and establishing sanctions on subnational governments when they do not comply with the fiscal rules. Other steps include ensuring more accountability at the subnational level through greater reliance on own-source revenues and the introduction of an equitable transfer mechanism that would help reduce geographical disparities.
29. Work is also needed in the area of public financial management. Monitoring of subnational operations should be strengthened to ensure the consistency of subnational fiscal operations with their fiscal rules and the overall macroeconomic fiscal framework. A system of treasury single accounts needs to be implemented, the budget classification brought closer to international standards, and a registry of subnational debt established. The capacity of subnational governments to deliver public services needs to be enhanced to ensure an efficient provision of decentralized public services. There is also a need to strengthen the accreditation system and to monitor the quality of services delivered by subnational units.
References
Ahmad, Ehtisham, and Maria Albino-War, eds., 2006, Managing Subnational Finances (Washington: International Monetary Fund).
Ahmad, Ehtisham, and Giorgo Brosio, eds., 2006, Handbook of Fiscal Federalism (Northampton, Massachusetts: Edward Elgar).
Ahmad, Ehtisham, and Vito Tanzi, 2002, eds., Managing Fiscal Decentralization (London: Routledge).
Casas, C., and G. Yamada, 2005, “Medición de impacto en el nivel de vida de la población del desempeño macroeconómico para el período 2001–04,” Universidad del Pacífico. Documento de trabajo.
Dabán, Teresa, 2004, Peru—“Fiscal Decentralization in Latin America: Lessons for Peru”, in Peru: Selected Issues, IMF Staff Country Report No 04/156 (Washington: International Monetary Fund).
Tanzi, Vito, 2002, “Pitfalls on the Road to Fiscal Decentralization,” in Managing Fiscal Decentralization, ed. by Ahmad and Tanzi (London: Routledge).
Prepared by Mercedes García-Escribano (FAD). This chapter builds on the IMF WP/06/120 “Fiscal Decentralization and Public Subnational Financial Management in Peru” by E. Ahmad and M. García-Escribano.
In 2005, local governments carried out about 13 percent of total primary expenditure of the general government.
Before the 2002 constitutional amendment, there were only two levels of government: the national and local levels. At present, in addition to the national level, there are 25 regional governments and 1,840 local governments.
Organic Law of Regional Governments of 2002 (Law No. 27867); Organic Law of Municipalities of 2003 (Law No. 27972); Framework Decentralization Law of 2002 (Law No. 27783); Accreditation Law of 2004 (Law No. 28273; implementing regulations were issued in November 2004); and Fiscal Decentralization Law of 2004 (Decree No. 955).
In 2005, local current revenues accounted for 35 percent of total local government current resources.
A central government guarantee is needed for external indebtedness operations of subnational governments (Organic Law of Regional Governments of 2002, Organic Law of Municipalities of 2003, and General Law of Public Indebtedness of 2005). As a result, external indebtedness operations by subnational governments are counted against the annual limit on indebtedness operations that the central government may contract or provide in a given year (this limit is established each year in the Annual Public Indebtedness Law).
The Framework Decentralization Law provided for passing legislation on the creation of regions (resulting from the merger process of regional governments) and incentives for the merging process.
The assignment of revenues of the second stage does not apply to Callao or Lima.
According to the law, a bonus to reward efforts to increase revenue collections may also be implemented in the first stage.
All investments are subject to the evaluation of their social return by the National System of Public Investment (SNIP).
This requirement is more restrictive than the limit of 30 percent imposed by the Organic Law on Municipalities.
The definition of current revenues used to compute the ratios includes transfers from other levels of government but excludes the operating balance from previous years, financing from domestic and external indebtedness sources, and revenues earmarked to trust funds (fideicomisos) (Regulations for the FRL, November 2004).
The limit on the ratio of non-guaranteed debt to current revenue and the annual limit on the ratio of non-guaranteed debt service to current revenue were raised to 45 percent and 25 percent, respectively, for local governments contracting debt associated with the purchase of machinery and equipment.
The FDL established that by end-2005, local and regional governments would provide a fiscal management report to the Ministry of Economy and Finance, to inform on compliance with the fiscal rules and suggest adjustment measures, if necessary. Financial management weaknesses at the subnational level have led to an extension of the period to start the report submission. A Resolution was passed in June 2006 with the list of municipalities (93 total) that have to submit their reports by end-2007.
The Council of Ministers is currently working on the draft Organic Law of the Executive Power that aims at clarifying responsibilities among levels of government.
These departments were: Tumbes, Piura and Lambayeque; Ancash, Huánuco, Lima provincias, Pasco, and Junín; Apurímac and Cuzco; Ica, Ayacucho and Huancavelica; Arequipa, Puno, and Tacna.
However, there is an incentive in the FDL regulations: each region created in the 2005 referendum, would receive an annual fixed transfer (S/. 210 million, equivalent to 0.08 percent of GDP) during four years.
In addition to training, the Ministry of Economy and Finance is planning to establish offices at the regional level to provide assistance to subnational governments in the preparation of investment projects.
The central government would have to take corrective measures in order to offset this deterioration and stay within the 1 percent of GDP deficit ceiling stipulated by the Fiscal Responsibility and Transparency Law (FRL). Further, more fiscal flexibility by the central government will be needed (for example, to adjust to unexpected revenue shortfalls during the annual budget execution) as adjustments and coordination at the subnational level becomes more difficult.
The Ministry of Economy and Finance is collecting data from creditors to estimate subnational debt. The World Bank has undertaken a study to assess the magnitude of subnational debt stock and identify municipalities that might face debt problems. Preliminary conclusions of this study show that unregistered debt is about 4 times as large as registered debt; debt is highly concentrated (in particular, 40 percent of total debt is held by 20 municipalities); a significant number of municipalities also do not comply with FRTL rules.
Discretion over own-source revenues does not automatically guarantee accountability, since the incentives may be offset, for example, if there are automatic transfers to meet subnational deficits.
While restricting the operations of subnational governments, earmarking has helped contain demands to increase current expenditures in the current context of high canon transfers.
Some other transfers like Foncomún (the municipality compensation fund), which is distributed according to criteria that include the needs of the population, can be used in part for current spending.
Investment projects have to meet the standards of the National System of Public Investment (SNIP).
Canon revenues and mining royalties accrue to local and regional governments where the economic activity takes place. Therefore, they tend to further increase disparities between producing and non-producing areas. Within each region, however, canon resources are distributed taking into consideration the needs of the local populations, thus helping reduce intra-regional inequalities.
Best international practices suggest that consideration could be given to a mechanism that takes into account the differential costs in the provision of services (which are particularly important in a country with the difficult topography and linguistic differences of Peru), as well as the capacity of subnational governments to raise their own sources of revenue. Details of international experiences and models are summarized in Ahmad (1997).
