Donor Partner Working Group on Decentralization and Local Governance (DPWG-DLG) Hosted by: EuropeAid & Swiss Agency for Development and Cooperation Brussels May 2011 Fiscal Decentralization and Linkages to PFM

2 Outline A. The Global State of Local Government Finances (GOLD II) B. General Relationship of PFM to Decentralization Reforms C. Constraints on Linking PFM and Decentralization Reforms D. Subnational PFM Reform & Decentralization: Diagnostics and Approaches

A. The Global State of Local Government Finances (GOLD II) There have been significant improvements in local finance systems in many developed and developing countries, including: –Increased local expenditure functions/efficiency –Enhanced local revenue opportunities –Adoption of local governance innovations, such as participatory budgeting Outstanding challenges in local finance systems, however, remain pervasive globally, albeit in different forms and to different extents given the great diversity across countries

Expenditure Assignment and Management Lack of clarity in expenditure assignment Inappropriate/insufficient/unenforced expenditure assignment Unfunded mandates/offloading of expenditure mandates Budget approval and control by higher level authorities (sometimes ad hoc) Lack of incentives for local expenditure efficiency

Local Revenue Generation and Autonomy Vertical fiscal imbalances Low revenue autonomy Problems with what is often recommended as a main local tax (property tax) Inadequate diversification of the local tax base Neglect of fees and user charges Political constraints on increasing local revenues Weak revenue collection capacity; balancing local and central roles in revenue collection

Intergovernmental Transfers Getting appropriate tax/revenue sharing systems in place (based on objective criteria) Lack of attention to horizontal fiscal imbalances across local jurisdictions Equalization transfer design challenges Conditional or specific transfer design challenges Limited use of innovative transfer mechanisms (e.g. performance based grants)

Local Government Borrowing and Investment Finance Local government borrowing and fiscal responsibility frameworks are often poorly developed and implemented Local governments often have poor and unreliable access to credit Special institutions commonly been set up to lend to local governments rarely perform well. Central government practices such as bailouts and automatic intercepts have disrupted the normal development of local credit markets Other aspects of the local finance system are sometimes not conducive to borrowing

8 B. General Relationship of Fiscal Decentralization to PFM PFM reforms are needed to assist with many of the documented fiscal decentralization problems and challenges More generally, a functioning PFM system is central to attaining the expected benefits of decentralization PFM is expected to play a role in enhancing transparency, managerial efficiency, and subnational government accountability both to higher levels of government and local constituents

9 General Relationship of Fiscal Decentralization to PFM Despite the important interrelationships between them, PFM reform is often managed entirely separately from decentralization and local governance reform Central issue: how can PFM reforms be operationally linked to decentralization reforms—at what stages, in which sequence and in what specific ways? How can PFM and decentralization reforms be linked a way that recognizes the considerable diversity/challenges of decentralization forms and contexts?

10 C. Constraints on Linking PFM and Decentralization Reforms Differences in the fundamental nature of the two reforms Differences in the objectives (and their priority) of the two reforms Differences in institutional management and perspective Differences in starting points and reform trajectories The role of international development partners, particularly in aid dependent countries

11 Differences in the Nature of Reforms PFM is on balance more technical in nature and reforms are generally relatively standardized Decentralization involves a greater variety of types of reforms—political, fiscal and administrative—that must work together for decentralization to be effective. Decentralization may play out in diverse ways in different contexts, with varying degrees of functional empowerment, fiscal self-sufficiency and autonomy across levels of government

12 Decentralized System “Prerequisites” Enabling Framework: constitutional/legal Fiscal Requirements –Clear assignment of service functions/ revenues (some autonomy) –Appropriately structured shared taxes/transfers –Fiscal responsibility and borrowing framework Political Requirements –Elections and other types of accountability mechanisms –Transparency in subnational processes and decision –Sufficient autonomy to facilitate responsiveness to citizens Administrative/Managerial Requirements –Institutional structures/relationships appropriately defined –Planning, budgeting & PFM systems and procedures –Civil service system (some degree of local control) –Contractual framework for partnering with private sector/NGOs

13 Differences in the Objectives of Reform Countries normally undertake PFM reform with the relatively straightforward objective of improving the efficiency and transparency of public sector finances Decentralization is often formally justified for similar reasons (plus democratization, citizen empowerment, etc.), but the range of actual objectives is commonly broader and often political, and particular objectives can have more or less importance in different cases

14 Differences in Institutional Management PFM reform is normally managed by the Ministry of Finance and/or National Treasury, and these agencies normally have considerable authority over other government institutions by virtue of their control over national budgeting, disbursement and financial management Decentralization reforms are usually managed by a Ministry of Local Government (e.g. Uganda and Kosovo), a Ministry of Interior (e.g. Cambodia), or a Ministry of Home Affairs (e.g. Indonesia), which rarely have much authority over other government agencies that have critical roles to play in reform

15 Differences in Starting Points and Reform Trajectories Although PFM systems can be in varying states in terms of the extent to which they are following internationally accepted standards of good practice when new reform processes begin, the path to achieving the objectives is normally relatively straightforward (even though there may be considerable obstacles to following the desired path) In contrast, decentralization may be occurring in extremely diverse base situations—e.g. where local governments exist but are performing poorly, where local administrations (deconcentrated) are being transformed into local governments (devolved), or where no local administrative units or local governments have previously existed—and this requires highly diverse and complex reform paths and capacity building

16 Role of International Development Partners International development partners (and sometimes their constituent departments) are also diverse and have their own objectives, priorities, modalities, and preferred counterpart agencies in the countries where they work In pursuing their respective objectives, they may generate new tensions or reinforce existing tensions between government agencies in charge of various aspects of public sector reform, including PFM and decentralization, and contribute to the development of public sector systems with inconsistent components and processes

17 D. Subnational PFM Reform and Decentralization: General Diagnostics Assess honestly the options for adopting decentralization and PFM reforms in the prevailing political and institutional context individually and in relationship to each other –Receptivity to reform (at various levels)? –Reforming existing or adopting new systems? –Initial status of both systems? –Any positive features of existing system to build on? –Levels of capacity (at various levels)? –Motivation for improved performance (from above or below)?

18 Approaching Subnational PFM Reform Look for ways to link and embed technical PFM reforms in decentralization reforms as much as possible Consider the relative incentives and urgency of the various reforms in determining sequencing—the common presumption that PFM reform is a prerequisite to decentralization may be politically infeasible Be careful of undermining achievements that have already been realized, such as using new PFM reforms to quickly replace systems and procedures that were just recently developed under decentralization reforms.

19 Approaching Subnational PFM Reform II Resist normatively purist or borrowed approaches to reform and to the extent possible proceed strategically: –Link PFM reforms to specific local functions that are going to be undertaken under decentralization, such as service delivery or revenue generation, rather than pushing comprehensive reform –Start with reforms that can be executed with a high probability of success and build on them in successive rounds of reform Look for creative ways to coordinate the actors responsible for the reforms

20 Approaching Subnational PFM Reform III Build capacity in a way that relates to the implementation strategy –Target capacity building to immediate functions/ tasks rather than provide only broad, generic training –Providing as needed periodic, on-site follow-up technical assistance –Recognize the need for capacity building that is both technically (training local governments to meet their functional responsibilities) and governance (training/facilitating citizens, elected officials and LG staff to work with each other) oriented

21 Approaching Subnational PFM Reform IV Consider potential roles for innovative mechanisms that may help to facilitate successful implementation: –Asymmetric approaches that allow some degree of local government choice in defining and pursuing reform trajectories –Enforceable accountability mechanisms, such as central government contracts with local governments –Financial incentives for adoption of reforms and improvements in performance, such as compliance or performance based grants