A Practitioner’s Guide to Intergovernmental Fiscal Transfers Anwar Shah, World Bank Budgeting and Public Financial Accountability Workshop, Pretoria, South Africa June 18-22, 2007

Perceptions on intergovernmental finance are generally negative Federal/Central View: Giving money and power to sub-national governments is like giving whiskey and car keys to teenagers. Provincial and Local View: We need more grant monies to demonstrate that “money does not buy anything”. Citizens: The magical art of passing money from one government to another and seeing it vanish in thin air.

Intergovernmental Fiscal Transfers edited by Robin Boadway and Anwar Shah Anwar Shah, World Bank INFOSHOP Book Launch Event April 18, 2007

Ironically these perceptions are well grounded in reality Primary focus on dividing the spoils Passing the buck transfers – revenue sharing with multiple factors (Brazil, Argentina, India, Philippines and more) Asking for more trouble grants – deficit grants (China, Hungary, India, and more) Pork barrel transfers or political bribes (Brazil, India, Pakistan, USA e.g. $200m bridge to nowhere in Alaska ) Command and control transfers (most countries) Overall: Intergovernmental finance is the dominant source of revenue but creates perverse incentives for fiscal management and accountability.

No need to despair …. As properly designed fiscal transfers can be part of the solution rather than part of the problem.

How to do it ? Realigning incentives (grant design) with grant objectives Ensuring local autonomy and flexibility while providing incentives for accountability External, Competitive Results Based Focus Reinforcing accountability for service delivery to citizens Reducing transaction costs for redress Institutional arrangements that overcome the commitment problem

Considerations in the Design of Fiscal Transfers uConsistency of design with a single objective uSimple and transparent allocation criteria uCreate incentives for competitive service delivery and support citizen-centered governance u Provide incentives for fiscal prudence u Ensure flexibility in use but accountability for results u Stable and predictable uEquitable ( entitlements vary inversely with fiscal capacity and directly with fiscal needs) u One size does not fit all – urban vs. rural, large vs. small u Sunset clauses to ensure periodic review and assessment

Instruments of intergovernmental finance Unconditional vs conditional transfers –Unconditional: preserving local autonomy and enhancing inter- jurisdictional equity –Conditional: providing incentives to undertake specific activities Conditional Transfers –matching vs non-matching –open-ended vs. closed-ended matching –Input based conditionality vs output based conditionality –Input based conditionality often intrusive and unproductive. Output based conditionality can advance grantor’s objectives while preserving local autonomy

Conditional transfers with conditions on spending impair recipient’s autonomy without furthering grantor’s objectives

Traditional versus Output-based grants -1 CriterionTraditional grant Output-based grant ObjectiveSpending levelsQuality and access to public services DesigncomplexSimple and transparent EligibilityGovernmentProvides through government conditionsinputsoutputs AllocationProject proposalService population

Traditional versus Output-based grants -2 CriterionTraditional grant Output-based grant ComplianceInspections and audits Client feedback. Comparison with base year PenaltiesAudit observationsPublic censure, voice and exit Managerial flexibility NoneAbsolute LG AutonomyLittleHigh TransparencyLittleHigh

Traditional versus Output-based grants -3 CriterionTraditional grant Output-based grant FocusInternalExternal AccountabilityTop down input based Bottom up, results based

Output-based transfers: Results Chain Application in Education Program objectives Inputs Intermediate inputs Improve quantity, quality, and access to education services Educational spending by age, sex, urban/rural; spending by level; teachers, staff, facilities, tools, books Enrollments, student- teacher ratio, class size Outputs Outcomes Impact Reach Achievement scores, graduation rates, drop-out rates Literacy rates, supply of skilled professionals Informed citizenry, civic engagement, enhanced international competitiveness Winners and losers from government programs

Citizens as Clients National Government Providers Local Government State Government Long Route to Accountability Inputs Control Grants

Citizens as governors National Government Competitive Provision Local Government State Government Govt Non Govt Short Route to Accountability Output-Based Grants

ObjectiveGrant DesignBetter PracticesPractices to Avoid Fiscal GapReassign, tax base sharing CanadaDeficit & wage grants (China), tax by tax sharing (China, India pre-2006) Regional fiscal disparities Fiscal capacity equalization (FCE) FCE with an explicit standard as in Canada, Germany, Denmark General revenue sharing with multiple factors (Brazil, India), Fiscal eq. with a fixed pool as in Australia, China Setting national minimum standard Output-based transfers non- matching, conditions on service standards and access Ex-Indo. roads and primary education; Education (Chile, Brazil, Colombia) Health transfers (Brazil, Canada) Conditions on inputs/ spending (most countries, USA “bridge to nowhere”) Capital grant with matching inverse to FC School construction (Indonesia), Highway matching (USA) Capital grant with no matching and no upkeep Influencing local priorities Open-ended matching Canada social assistance (pre-2004) Ad hoc grants

Transfers to deal with fiscal gap u Fiscal Gap: Structural imbalance as a result of a mismatch between revenue means and expenditure needs. Reasons: Inappropriate assign: Reassign Limited tax bases: Allow joint occupancy or tax decentralization. Tax competition: Federal collection and general (not on a tax-by-tax basis) revenue sharing. Tax room lacking: Tax abatement and tax base sharing (Canada ). Practices to avoid: deficit grants; tax by tax sharing.

Transfers to set national minimum standards uRationale: uNational economic union or internal common market u Redistributive role of the public sector and the national government uDesign: conditional non-matching block transfers with conditions on standards of service and access. uBetter practices: Indonesia roads and primary education grants; Brazil health transfers, Colombia and Chile education transfers; Canada health and post-secondary education transfers. uPractices to avoid: Conditional transfers with conditions on spending; ad hoc grants.

An example : A performance oriented education grant to set national minimum standards and encourage competition and innovation and citizen empowerment Allocation basis among local governments: school age children (ages 6-17) Distribution to providers: equal per pupil to both government and private schools Conditions: Universal access to all, private school admissions on merit regardless of parents’ income, improvements in school achievement scores, graduation and drop out rates, no condition on spending Penalties: public censure, reduction of grant funds Incentives for cost efficiency: retention of savings

International practices in transfers to reduce regional fiscal disparities uDesign: General non-matching fiscal capacity equalization transfers. uBetter practices: Fiscal equalization programs (sources of data: CGC, Morris, Finance Canada, Dafflon, Lotz, Shah, Spahn & Werner) uPaternal: Australia (fiscal capacity plus fiscal needs) and Canada (fiscal capacity only) u Solidarity, Fraternal or Robin Hood: Germany (fiscal capacity) uMixed: Switzerland, Sweden, Denmark uPractices to avoid: General revenue sharing with multiple factors e.g. practices in Brazil and India

Equalization programs are concerned with inter-jurisdictional equity (horizontal fiscal equity) not with with interpersonal equity (vertical equity) Australia: capacity to provide services at the same standard with same revenue effort and same operational efficiency Canada: “reasonably comparable levels of public services at reasonably comparable levels of taxation across provinces” Germany: “to equalize the differences in financial capacity of states” Switzerland: “to provide minimum acceptable levels of certain public services without much heavier tax burdens in some cantons than others”.

Fiscal Equalization Program AustraliaCanadaGermanySwitzerland Legal StatusFederal Law Constit- ution Constitution Paternal or Solidarity Paternal SolidarityMixed Total Pool determination Ad hocFormula Ad hoc AllocationFormula Fiscal capacity equalization Yes, RTS Yes, Actual Revenues Yes, major macro tax bases

Fiscal Equalization Program AustraliaCanadaGermanySwitzerland Fiscal Need Equalization YesNoNo (only pop size and density) some Program Complexity HighLow Medium Political Consensus No?Yes (?) Yes Who recommends Independent agency Intergov. Committee s Solidarity pact II Federal Government Sunset clausenoYes (5 years) no Dispute resolution Supreme court Supreme Court Constitution al court Supreme court

Germany – Fiscal Equalization in 3 stages Stage 1: Equal per capita distribution of 75% of States’ share of VAT revenues (47.8% of total) to all 16 states and remaining 25% as supplement to financially weak states. Stage 2: Formal Fiscal Equalization Program through Solidarity Pact II – Rich state contribute to the pool through a progressive tax (45 –72.5% rate) and poor states receive progressive subsidy from the pool. Stage 3: Federal Supplementary grants

Denmark: Equalization models and standards Equalization type Counties Metropolitan areas Local Govts. Fiscal capacity 85% Robin Hood 90% Robin Hood 50% central grant Fiscal Needs 85% Robin Hood 60% Robin Hood 35% Robin Hood

Alternate Institutional Arrangements for ET Central government agency Intergovernmental Forums Intergovernmental cum civil society forums Sub-national government forums Independent agency model – reporting to executive – permanent or periodic Independent agency model reporting to legislature

Fiscal Transfers: Negative Lessons or Practices to Avoid General revenue sharing with multiple factors Deficit grants Fiscal Effort Provisions Input or process based or ad hoc grants Capital grants without assurance for upkeep Negotiated or discretionary transfers One size does not fit all

Fiscal Transfers: Positive Lessons or Practices to Strive For K.I.S. (keep it simple) Focus on single objective Introduce sunset clause Output based conditional transfers with citizens’ evaluations Fiscal capacity equalization to a defined standard Political consensus on the standard of equalization Institutional arrangements for broad based consultation

Fiscal Equalization Grants: Some Lessons from International Experiences Equalization formula must determine both the pool and allocations. Fiscal capacity equalization with an explicit standard is desirable and do-able in most countries. Fiscal need equalization is much more complex – desirable but may not be worth doing. Rough justice may be better than precise justice. Output based transfers offers a promising alternative for fiscal need compensation. Enhance results based accountability. Equalization transfers must not be looked at in isolation of the broader fiscal system especially conditional transfers. For local equalization – one size does not fit all. Important to have societal consensus on the standard of equalization Must have a sunset clause and provision for a review and renewal Institutional arrangements for a continuous review and periodic revision require serious thoughts as independent grants commission typically recommend more complex formulae.

From Dividing the Spoils to Creating An Enabling Environment for Responsive and Accountable Local Governance Tax Decentralization Output based fiscal transfers – operating – capital Fiscal equalization transfers Responsible borrowing