This selected issues paper on Sudan was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on September 7, 2012. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Sudan or the Executive Board of the IMF.

Abstract

This selected issues paper on Sudan was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on September 7, 2012. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Sudan or the Executive Board of the IMF.

IV. Fiscal Decentralization: Trends, Challenges and Perspectives1

This chapter reviews the current state of intergovernmental fiscal arrangements in Sudan and presents a set of challenges and policy options to inform fiscal adjustment efforts and improve the overall approach to fiscal federalism.

A. Introduction

1. Sudan has undertaken fiscal decentralization reforms since 1995, devolving more expenditure functions and revenue sources to lower levels of government. Accordingly, total revenue in Sudan’s northern states has increased substantially over the past decade and concurrently states have increased their dependency on transfers to meet their responsibilities for basic service delivery. Large increases in transfers to states have contributed to rapid growth in state spending and weakened incentives to raise state own revenue.

2. The decentralized provision of goods and services is intended to increase the efficiency of public services by better taking into account differing local preferences, and enhancing the accountability of subnational authorities. Fiscal decentralization is expected to improve interregional equity and regional economic development by addressing vertical imbalances between the center and subnational levels of government, and horizontal interstates imbalances due to differing own revenue potential and needs. In this respect, fiscal decentralization is expected to redistribute resources to match local demand and enhance public service delivery, with a view to improving subnational autonomy and extend access to public services across all Sudan’s states.

3. The loss of oil revenues following the secession of South Sudan is causing a major fiscal adjustment which will inevitably impact the flow of federal transfers to state governments. Sudan lost more than half of its government revenues following the secession in July 2011. An inevitable fiscal adjustment is already taking place, the bulk of which has came from cuts in investment spending. However, transfer to states has increased by about 8 percent in 2012, breaking the constitutional ceiling of 30 percent of government total revenues and grants; more than 60 percent of transfers are allocated to wage and salaries, with excess resources relocated from the capital budget. The fiscal shock at the federal level will need to be transmitted to states as the fiscal tightening pressure intensifies and resources need to be rebalanced toward social service delivery and capital spending.

4. This chapter reviews the current state of intergovernmental fiscal arrangements and presents a set of challenges and policy options to inform fiscal adjustment efforts and improve the overall approach to fiscal federalism. Section II reviews the institutional foundation of fiscal devolution. Section III looks at the degree of fiscal decentralization and recent trends. Section IV introduces the concept of vertical fiscal imbalance and relates it to fiscal outcomes. Section V studies the horizontal distribution of natural resources across states. Section VI looks into the link between fiscal decentralization and poverty reduction. Section VII analyzes budget managements at the state level. Section VIII highlights the main challenges and provides policy advice.

B. Institutional Background

5. The process of fiscal decentralization started in 1995 when the revenue-sharing agreements of the federal and state governments were declared. Since then Sudan has operated a federal system with three tiers: federal, state and local. The Interim National Constitution (INC) and Comprehensive Peace Agreement (CPA) set the principles of wealth sharing between the federal government, the government of South Sudan and lower levels of government to address regional disparities and trace the root causes of conflict. The Constitution grants governments of Northern States the right to legislate for raising revenue collection through a variety of local taxes and charges for services provided by the state. The federal government is assigned the power to collect customs revenues, business profit taxes, personal income taxes, and VAT and also accrues non-tax revenues, mainly from oil. This vision of fiscal decentralization led to substantial increases of transfers from the federal to the state levels with the aim of effectively delivering public service and broader development outcomes.

6. States have three distinct sources of revenues: (i) own revenues; (ii) shared revenues; and (iii) federal transfers. Own revenues are collected directly by the states through taxes, fees, and user charges, and the states have the highest degree of autonomy, including rate-setting authority. Shared revenues mainly consist of 43 percent of VAT collection, 10 percent of public enterprise profits and 2 percent of petroleum revenue determined on a derivation basis. Federal transfers from the budget through the National Revenue Fund (NRF) are determined by agreed formula, by existing establishment costs, or based on ad hoc considerations (Table IV.1). Local government revenues comprise taxes on property, local transportation, local livestock production (40 percent of which is transferred to the state governments), and other local taxes or duties, as well as transfers from the state governments of some profits from public enterprises.

Table IV.1.

Sources of State Revenue

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Sources: World Bank (2007).

7. Federal transfers include (i) current earmark transfers; (ii) block transfers; and (iii) development transfers. Current earmarked transfers are allocated to wages, operations, and social subsidy and are determined by existing establishment costs (Table IV.1). Block transfers are determined according to a formula based on weighting criteria including population size, minimum requirement for government responsibility, social development (health and education), and the states’ ability to collect own revenues. The allocation of development transfers is based on alternative indicators such as the states’ development neediness and absorptive capacity. However, difficulty in identifying and quantifying the underlying indicators implied significant variation in the implementation of development projects across states.

8. States’ expenditure responsibilities are broadly set in the constitution, with the main outlays going for primary health care, basic education, and safe drinking water. The Financial Allocation and Monitoring Commission (FFAMC) is accorded a horizontal decision making and monitoring role with regard to the allocation of federal transfers in order to ensure transparency and fairness. The allocation of funds among the different states is based on a set of criteria, which include (weight in brackets): budget performance and revenue potential (10); Population size (15); Natural resources and their exploitation (10); Human resources (15); Infrastructure (5); Education, including standards of pupil-to-teacher ratios (10); Health, including access and costs (10); Security (10); Average per capita income (5); Distance from the center and ports, including road quality (10). The High Council on Resources (HCR) allocates to the states their share of the VAT and public enterprise profits. The HCR designates the public enterprises or joint ventures whose profit is to be allocated to the states and determines each state’s share.

C. Measuring Fiscal Decentralization

9. The Government of Sudan remains relatively centralized. As a measure of the degree of decentralization, this section uses the execution rate by the state governments of four general government fiscal indicators: total revenues, tax revenue, total expenditures, and compensation of employees. Figure IV.4 shows that in 2010 the decentralization of government finances was still very limited and the central government retained most of the execution power—ranging from 71 to 97 percent—on each of the four fiscal indicators.

10. There has not been significant trend toward more decentralization since 2000. Figure IV.1 below shows the evolution of the fiscal aggregates since 2000. The ratios are relatively stable and there is no significant change between 2000 and 2010. Tax effort was the fiscal indicator with the lowest dispersion over time while expenditure and compensation of employees showed a visible if minor increase in decentralization. Revenue, on the other end evolved toward a more centralized structure over the same horizon.

Figure IV.1.
Figure IV.1.

Selected Fiscal Indicators by Government Level

(Percent)

Citation: IMF Staff Country Reports 2012, 299; 10.5089/9781616355722.002.A004

11. Overall, spending decentralization has outpaced revenue decentralization, resulting in the emergence of vertical fiscal imbalance (VFI). VFI materializes when the devolution of spending responsibilities is not matched by the devolution of revenue responsibilities. In 2010 the Central Government of Sudan collected about 97 percent of the taxes of the General Governments and 86 percent of total revenues (Figure IV.2). On the other hand, the state governments executed a relatively high level of government employment, captured as compensation of employees, and expenditures. Here, the central Government accounted for only 71 and 74 percent respectively. In other words, the Central Government has maintained control on the revenue collection while assigning more expenditure responsibilities to state governments.

Figure IV.2:
Figure IV.2:

Central Government Execution for Selected Fiscal Indicators, 2010

(Percent)

Citation: IMF Staff Country Reports 2012, 299; 10.5089/9781616355722.002.A004

Sources: MOF; States Final Accounts Reports; and IMF staff calculations.

D. Vertical Fiscal Imbalances and Fiscal Performance in Sudan

12. The vertical fiscal imbalance, measured as the gap between own spending and own revenues at the state level, is very high in Sudan. While there is no consensus on a specific definition of VFI, this chapter follows Eyraud and Lusinyan (2011) and defines the vertical imbalance as the share of state own spending not financed through own revenues. This ratio was equal to 70 percent in 2010, meaning that only about one-third of states’ expenditures are mobilized from states’ own revenue sources. In contrast, international evidence shows that subnational governments in developing countries finance up to 70 percent of their spending from own sources.

13. The vertical fiscal imbalance has increased overtime due to a progressive devolution of spending responsibility coupled with increasingly centralized revenue functions. Between 2000 and 2010 the VFI increased from 25 to 70 percent indicating that the mismatch of spending and revenue decentralization has increased (Figure IV.3). This trend reflects increased expenditure decentralization on the back of declining revenue decentralization (Figure IV.1): while the share of state expenditure in general government expenditure has risen from 19 to 26 percent, the revenue share has fallen from 23 to 14 percent (Figure IV.3) likely due to the limited capacity of states to collect own revenues which, in turn, has increased states’ reliance on central transfers.

Figure IV.3:
Figure IV.3:

Fiscal Decentralization and VFI

(Percent)

Citation: IMF Staff Country Reports 2012, 299; 10.5089/9781616355722.002.A004

Sources: MOF; States Final Accounts Reports; and IMF staff calculations.

14. The centralization of revenues has also increased the dependency of states on central transfers, which have increasingly weighted on the central government budget. Although the States’ revenue collections increased, their structures have also shifted away from a majority of own revenues to a heavy dependence on federal transfers. According to the states’ final account reports, the ratio of state own revenues to total revenues fell from 76.4 percent in 2000 to 38.9 percent in 2010. On the other hand, transfers to states (capital and current), which accounted for 7.7 percent of total central government expenditure in 2000, rose to 19.5 percent of total government disbursement in 2010 (Figure IV.4). About 57 percent of such increase occurred in 2005 with the signature of the CPA and the introduction of the INC. In fact, federal transfers have formed the backbone of resources available for Northern States since fiscal decentralization deepened in 2004/05.

Figure IV.4.
Figure IV.4.

Central Transfers to Northern States

(Percent)

Citation: IMF Staff Country Reports 2012, 299; 10.5089/9781616355722.002.A004

Sources: MOF; States’ final account reports., and IMF staff calculations

15. The increasing role of transfers to meet the state’s budgetary needs stems in part from their weak capacity to mobilize own resources, which contrasts with their expenditure obligations. The state own revenue mobilization showed relatively modest growth, especially over the CPA interim period; this draws attention to the need to substantially enhance their financial capacity to meet their expenditure responsibilities. The weak own revenue mobilization efforts can be attributed to several factors, including lack of infrastructure and human capacity, and depressed economic activity due to security problems.

16. The composition of subnational government revenues varies greatly across states, resulting in significant differences in vertical imbalances. The VFI averaged about 70 percent in 2000–10. However, VFIs present a large dispersion, varying from 34 percent in Khartoum and Red Sea, to 89 percent in Blue Nile. This heterogeneity is largely related to the dispersion of expenditure across states, the standard deviation of expenditure being 43 percent higher than the standard deviation of own revenues. This indicates that, while there are significant differences in the capacity of states to raise own revenue, the latter varying from 9 SDG per capita in North Darfur to 142 in Khartoum, the variation of expenditure across states is mostly determined by the amount of central transfers.

17. Large VFIs may relax fiscal discipline, and reducing imbalances can generate large fiscal gains. Although some level of discrepancy between subnational own revenues and spending is inevitable and may even be desirable, large gaps present risks. A common view in the normative literature is that a high reliance on intergovernmental transfers “softens” the budget constraint of local governments because the cost of spending is not adequately internalized (Rodden and others, 2003). However, the empirical literature shows conflicting results; some papers find that intergovernmental transfers improve fiscal performance by strengthening control over sub-national spending (De Mello, 2000). Empirical results in Eyraud and Lusinyan (2011) show that higher reliance on transfers or borrowing reduces the general government balance, other factors being equal, thus supporting the view that decreasing VFIs can potentially generate large fiscal gains. This negative effect seems to be more pronounced when regional disparities are large, as is the case in Sudan. The same authors also find that spending decentralization is not detrimental to fiscal performance when financed through additional sub-national own revenues.

E. Horizontal Imbalances and Distribution of Transfers

18. The horizontal allocation of federal transfers is characterized by significant variation. Transfers per capita accrued to the top recipient state were on average six times higher than the bottom recipient in 2000–10. Blue Nile and Northern State are the highest recipients of federal transfers on a per capita basis, along with River Nile State. On the other hand, North Kordofan, Red Sea and South Darfur figure at the lower end of the ranking.

19. Overall, the current modalities for allocation of national resources are not entirely transparent and leave space for discretionary allocations. There is little clarity as to the current allocations for VAT and agriculture compensation is made on an annual derivation basis or based on historic collection and agriculture production level estimates. Current transfers are largely based on existing public-sector establishment costs or defined by a formula. While the former may distort incentives and limit the flexibility of state balances, the latter is based on criteria difficult to reproduce based on readily accessible data, thus discouraging the identification and applicability of a fair and equitable system. In this respect, state reports suggest that some states might be under-resourced by virtue of their population size and the geographical distribution of poverty (Figure IV.5).

Figure IV.5.
Figure IV.5.

Per Capita Central Transfers by State

(Average 2000–2010, SDG million)

Citation: IMF Staff Country Reports 2012, 299; 10.5089/9781616355722.002.A004

Sources: States’ Final Account Reports; and IMF staff calculations

F. Fiscal Decentralization and Poverty Reduction

20. Conventional wisdom postulates that decentralizing government finances should contribute to poverty reduction through efficiency gains and participatory governance. Decentralization might affect poverty directly through regional targeting of transfers, and indirectly through higher efficiency in local public service delivery and the related growth effect.

21. The regional targeting of transfers in Sudan, however, does not seem to have reduced interstate inequalities in income. Poverty is widespread in Sudan, and has a clear regional dimension. According to the National Budget Household Survey (NBHS) 2009 overall 46.9 percent of the population is below the poverty line. With a poverty ratio of 69 percent Northern Darfur is the poorest state, followed by Southern Darfur, Southern Kordofan, Red Sea and Northern Kordofan. On the other end, Khartoum, River Nile and Northern are the richest states with poverty ratios equal respectively to 26, 32 and 36 percent of the population, respectively. When the regional distribution of transfers is linked to poverty trends, with the exception of Khartoum and the Blue Nile, the poorest states are also those who receive fewer transfers.

22. The current system also made limited progress toward the improvement of social indicators and there is a case for refocusing expenditure to those states with higher poverty rates. Although increased central funding has been delivered to Northern states with a view to devolving expenditure responsibility for service delivery, budget data point to a generally low level of public spending devoted to the provision of basic services while most of the transfers are allocated to wage and salaries. Under the current system central and state governments share the responsibility for social spending: expenditure on primary health and education is intended to be gradually shifted to state governments while the central government is to maintain a major role in secondary and tertiary education and health. Trends in education, health and access to safe water show that more than 10 years of devolution have not led to a visible improvement in social service delivery in Sudan.

G. Budget and Fiscal Management in Northern States

23. A successful fiscal decentralization depends on adequately autonomous and accountable sub-national governments with credible budgets and sound fiscal management practices. This section reviews the budgetary performance at the state level by looking at different dimensions of fiscal governance at the subnational level. Overall, the fiscal capacity of state governments is shackled by several weaknesses.

24. States’ own revenue mobilization capacity is very low. The states’ low collection capacity can be traced back to: i) lack of infrastructure, trained staff and adequate databases to manage collections; ii) disruption of revenue collection due to security problems especially in conflict areas such as Darfur, Blue Nile, South Kordofan; iii) depressed economic activity due to low productivity, lack of competitiveness, weak technology and insufficient diversification of markets for agricultural exports; and vi) a weak private sector and underdeveloped financial sectors at the state level. Moreover, local tax collection is undermined by the poor quality of data on state economic activity and tax base on which to found state taxes.

25. Budget credibility is poor due to recurrent spending rationing, and results in crowding out of developing spending. The lack of transparency regarding the allocation of central transfers and their erratic delivery, make these revenues difficult to predict and translate into weak capacity to estimate budget constraints. This causes misalignments between expenditure assignments and revenue allocations, resulting in revenue shortfall. The rationing of spending within the fiscal year is therefore a recurrent practice, and the mismatch is often absorbed by developing spending due to centrally imposed wage policies. This compromises the budget execution and results in crowding out of developing spending with the related consequences on service delivery.

26. Financial management is weak. There are no transparent guidelines clarifying roles and responsibilities among various government levels. Cash management procedures are weak and there is no systematic reporting. The lack of intergovernmental cooperation also hinders fiscal management by limiting the available functional information. For example, a comparison between central and state government accounts shows significant negative discrepancies between the consolidated transfers reported by states and the expenditure in transfers to Northern States reported by the central government, the latter being considerably higher since 2005 (Figure IV. 6). Administrative drawbacks and limited human capacity compounded by institutional weaknesses impedes the authorities ‘ability to plan, execute and monitor state budgets.

Figure IV.6:
Figure IV.6:

Discrepancy in Transfers Reported by States and Central Government

(SDG Million)

Citation: IMF Staff Country Reports 2012, 299; 10.5089/9781616355722.002.A004

Sources: MOF; States Final Accounts Reports; and IMF staff calculations.

H. Going Forward: Challenges and Policy Options

27. Important reforms are needed to improve basic social service delivery and budget management at the state level, and thereby establish the basis for a successful fiscal decentralization. The above analysis indicates that fiscal institutions are weak, social service delivery is inadequate and fiscal decentralization has so far been ineffective in reducing inequality and widespread poverty. Major areas for reform include i) building capacity at the sub-national level to meet administrative and institutional requirements; ii) improving the transparency and predictability of central transfers to the states; iii) strengthening fiscal institutions and budget credibility at the state level; iv) improving project management and social delivery to advance poverty reduction; v) refocusing central transfers toward the poorest states to reduce disparities across states; vi) improving the capacity of states to mobilize own revenues to reduce vertical imbalances and improve fiscal responsibility.

  • Building capacity at the subnational level is necessary to allow states to fulfill their governance roles and responsibilities and support the institutional capacity to implement devolution. The pursuit of capacity building for decentralized governance requires a programmatic approach to improving the potential of state and local governments to manage economic and social development. Capacity building refers to both human capital and technological development and demands support for training activities as well as technological endowments; for both of these, development partners can play a significant role. Selected areas of need include revenue estimation, overall budget process, collection procedures, and development planning and execution.

  • Greater transparency in the allocation of resources would promote legitimacy, enhance equitability, and improve the budget process. Options for reforming current practices include (i) a fully formula-based system based on proxies for state needs readily available and clearly identifiable, including fiscal capacity; or (ii) a combination of derivation basis and a formula for needs. Sharing revenues on a derivation basis potentially provides a more direct link between economic development in the states and transferred revenues, thus providing incentive for pro-growth policies, but might result in more disparities across states. In any instance, the allocation criteria should be clearly determined and enforced in a transparent way and the transfer of funds should occur without delay to allow states to predict their revenue flow and facilitate the budget process.

  • Fiscal management practices need to be strengthened via improved revenue estimation and more credible state budgets. Making the transfers of funds from the central to the subnational level predictable and transparent would allow states firm estimates of intergovernmental transfers. Improved monitoring of basic economic activity in the states and a more reliable system of recording of all sources of tax and non-tax revenues would enable the estimation of own revenues. Reliable estimates of monthly cash flows would in turn enhance budgetary procedures and improve fiscal management.

    Extending the GFSM 2001-compatible economic classification to all the states would enhance the quality of accounting at the state level and make it consistent with central government accounts.2 This in turn would permit expanding the coverage of the fiscal accounts to the general government level thus internalizing the capacity of states to create debt and offset the country’s fiscal adjustment efforts. A comprehensive and consistent database of government finance for documentation purposes could also improve fiscal reporting by making budget plans and execution publicly available. Finally, transparent guidelines clarifying revenues and expenditure assignments between states and localities would enhance revenue collection, streamline expenditure assignments and set the basis for sound wage and salary policies.

  • Effective social service delivery requires higher capital spending on social projects and more efficient procedures for development planning and management. Sudan expenditure in social spending, in relation to GDP, is low by regional standards. Increasing the share of public spending in health, education, and access to safe water, while shifting expenditure assignments to the states, would help improve the provision of social services. This however requires strengthening state-level development institutions and building capacity in project planning and management. Immediate needs include: identification of development priorities, project appraisal, execution capacities, and strategic management of funding.

  • Refocusing federal transfers to the poorest states would enable more targeted development spending and reduce inequality across states. Aligning federal transfers with poverty trends would improve the distribution of capital investment to those areas where the delivery of basic services is inadequate. At the same time the devolution of social spending would better respond to local necessities. This in turn would decrease horizontal inequality and ignite economic growth.

  • Boosting state own revenue mobilization capacity would reduce vertical imbalances and lessen the need for central transfers, thus minimizing the burden on the central budget. Higher revenue collection at the state level will lessen the dependency of states on transfers and assist the necessary fiscal consolidation at the central level. By internalizing budgetary expenditures, moreover, the reduction of vertical imbalances would improve budget efficiency and fiscal responsibility, thus improving financial performance at the state level.

28. There may be unique opportunities to combine efforts toward fiscal consolidation and decentralization as sound state governance stands as a prerequisite to the necessary fiscal adjustment. The need to reform the design and implementation of intergovernmental finance goes hand in hand with the central government consolidation efforts. A smooth transition toward a more sustainable fiscal stance requires good governance at the state level to be durable as cutting central transfers has as a prerequisite enhanced revenue mobilization capacity and higher expenditure responsibility at the state level. Ultimately, effective fiscal decentralization can constitute a catalyst to economic prosperity and sustainable peace.

References

  • De Mello, L., 2000. “Fiscal Decentralization and Intergovernmental Fiscal Relations: A Cross-Country Analysis,” World Development, Vol. 28, No. 2, pp. 36580.

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  • Eyraud, L., and L. Lusinyan, 2011, “Decentralizing Spending More than Revenue: Does It Hurt Fiscal performance?IMF Working Paper No. 226 (Washington: International Monetary Fund).

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  • Rodden, J., G. S. Eskeland, and J. Litvack, 2003, “Fiscal Decentralization and the Challenges of Hard Budget Constraint,” (Cambridge, MA: The MIT Press).

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  • World Bank, 2007, “Sudan Public Expenditure Review,” Report No. 41840-SD (Washington, DC).

  • World Bank, 2011, “From Spending More to Spending Smart – Case Study of the Health Sector,” PETS for Northern Sudan (Washington, DC).

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  • World Bank, 2011, “A Poverty Profile for the Northern States of Sudan,” (Washington, DC).

1

Prepared by Valentina Flamini.

2

As of March 2010 good progresses had been done to extend the GFSM 2001 compatible budget classification to nine northern states.

Sudan: Selected Issues Paper
Author: International Monetary Fund. Middle East and Central Asia Dept.