Harmonisation, Decentralisation and Local Governance

DPWGs Country Specific Guiding Principles: Strengthening fiscal decentralisation and local authorities financing: Fiscal decentralisation is a key factor and driver for successful decentralisation. Support to fiscal decentralisation should aim at strengthening the long-term financial development and sustainability of local governments.

Session overview Understanding the context of fiscal decentralisation Assigning expenditure responsibilities Instruments for financing local government intergovernmental transfers local taxation and user fees investment capital Budget implementation Harmonisation and alignment of support to fiscal decentralisation

First and second generation fiscal federalisms Costs and benefits Revisiting the wall of wonders

Decentralisation - Traditional definition Decentralisation is the transfer of authority and responsibility for public functions from the central government to subordinate or quasi-independent organisations or the private sector. (Litvack and Seddon 1999)

Observations about fiscal decentralisation around the world It is often history and politics -not economics- that determines subnational government structure and drives fiscal decentralisation reforms Many fiscal decentralisation reforms shifted the financial resources to the local government level, but failed to decentralise the discretion to manage these resources

New consensus on decentralisation (Fiscal) decentralisation is the empowerment of people by the (fiscal) empowerment of their local governments. (Roy Bahl, 2005)

Benefits associated with fiscal decentralisation? More accountability on the part of government officials More willingness on the part of the local population to pay for services Promise of increased revenue mobilisation Increases potential for innovation in economic decision-making

Costs associated with fiscal decentralisation Less macroeconomic control National priorities for capital investment do not conform to local government choices Lead to a lower rate of spending on infrastructure, perhaps jeopardising national growth Revenue centralisation gives a greater potential for equalisation

Linkages with administrative and political decentralisation The system of intergovernmental fiscal relations should be well-designed in its own right The fiscal, political and administrative dimensions of decentralisation should be properly aligned For every element of decentralisation (including fiscal decentralisation), there is a need to balance discretion with accountability

Linking fiscal decentralisation to domestic accountability The provision of fiscal discretion to local governments - whether in the form of expenditure discretion or discretion over revenues - helps strengthening the downward accountability by: encouraging the citizens to participate in decision- making process encourages them to monitor local government finances making sure that local finances are actually used in accordance with the priorities set forth in the budget

Intergovernmental finance: Four pillars

Musgraves economic roles of government Finance should follow function

Musgrave s economic roles of government The role of the public sector is to: Provide a stable economic environment Promote a more equitable distribution of income/resources Assure a more efficient allocation of resources (when markets fail) But, no-one says that these can all be done best by the central government!

Finance should follow function One cannot establish the required level of subnational government revenues independent of an estimate of expenditure needs. If finance does not follow function it becomes difficult to effectively impose a hard budget constraint at the subnational level if there is an insufficient revenue assignment. The economically efficient assignment of revenues requires a prior knowledge of expenditure assignment.

Finance should follow function (1)

Finance should follow function (2)

Revenue assignment Intergovernmental transfers

The revenue assignment question (second pillar) Which tax sources or non-tax revenue sources (including fee revenues) will be made available to subnational governments in order to provide them with revenue sources?

Why have sub-national taxation? Sub-national governments are often more accountable for controlling spending if they are also responsible for revenues Reduces excessive demand by sub-national governments for transfers from the centre Allows tax policy (tax levels and structure) to be tailored to the conditions and preferences of sub- national governments

Features of an ideal local revenue source Taxes that achieve a correspondence between the tax and the benefits from local government services Relatively easy to administer Should not be easy to give perverse incentives to taxpayers Suitable local taxes are: Property taxes; Market fees and other local user fees; A piggy-back personal income tax; Motor vehicle taxes

Lessons learnt Local revenues should be an important part of a well- functioning intergovernmental fiscal system, both for economic and accountability reasons But, raising more local revenues is only efficient if the revenues are well-spent, and Neither central politicians nor local politicians have a strong incentive to rely heavily on local government revenues As a result, local revenues are often an under- emphasised part of fiscal decentralisation

Reasons Design

Intergovernmental fiscal transfers (the third pillar) Own source revenues are (almost) never enough to cover local expenditure responsibilities Central (or regional) governments may provide local governments with additional resources through a system of intergovernmental fiscal transfers In most countries, transfers are (by far) the main funding source for local government, esp. for social sector services

Reasons for intergovernmental fiscal transfers Providing incentives for efficient spending and utilisation of the municipal revenue base Guaranteeing sufficient funds for managing local functions by mitigating vertical imbalances Supporting regional equalisation of communities by mitigating horizontal imbalances

Design Determining the distributable pool: 1. as a fixed share of national government revenues; 2. as part of the annual budget decision; 3. as a proportion of approved specific local expenditures to be reimbursed. Distribution of the pool among subnational governments 1. Gap-filling model 2. Local government respects hard budget constraint 3. Fiscal capacity based methods

Design implications Centralised control and the uncertainty associated with this: Can lead to poor budgeting practices Undermines the accountability to citizens Affects the stability and predictability in local policy making Makes the system more prone to political pressures DPWG-LGD underline the need for Development Partner (DP) dialogue, analytical work and technical assistance on this issue

Lessons learnt There is a need for: Close dialogue amongst all core stakeholders in the design work Proper buy-in to the introduction of the reforms from core stakeholders, champions of the reform and clear institutional framework Current follow-up and support to the administration of the transfer system (particularly regarding performance-based systems) Transparency and accountability in all phases of the work on transfer systems

Importance Restrictions to subnational borrowing

Finally, the fourth pillar of subnational finance: deficits and debt In many developed economies, local borrowing is an appropriate way for local governments to fund capital infrastructure: (i) it corrects the inter-temporal mismatch between costs and benefits (in terms of efficiency, equity, timing and practicality) (ii) there are numerous mechanisms that can assure responsible borrowing

Restrictions on borrowing In many LDCs, the absence of market-based mechanisms to enforce a hard budget constraint requires restricting local borrowing: Rules-based restrictions Permission required Local government bank / loan fund No borrowing allowed

Lessons learnt (1) Local government borrowing should be backed by a robust and transparent legal framework and systems and procedures for where to borrow, for which purposes, and possible ceilings and monitoring and supervision frameworks Central governments should maintain a hard line against subnational debt relief. Intermediate borrowing institutions need to be carefully designed to avoid pitfalls

Lessons learnt (2) Debt thresholds may be established to ensure that local governments borrowing is not getting out of hand. Strong incentives for local governments to ensure creditworthiness should be supported Local governments are not in a good position to function as borrowing institutions for others In cases where there is no formal regime in place for local government borrowing, there are examples of severe informal borrowing.

Purpose Performance based grant systems

Purpose of local PFM At their best, these mechanisms balance political and economic risks, by: Providing a reliable account of money spent and received. Showing evidence that finance is being used responsibly for the public good and in compliance with regulations. Demonstrating value for money and good governance in terms of economy, efficiency, effectiveness and equity. Supporting good decision-making and assisting leaders and managers to assess the financial consequences of policy choices. Serving as a basis for planning for the future, maximising income sources and aligning these resources with service delivery objectives.

Performance based grant systems Shift from traditional ex ante control on budgetary inputs to accountability ex post on the basis of results. In a performance-based system, there is a need to monitor the quantity and quality of outputs, and to measure the result of delivering these outputs. A key publication in this regard is UNCDFs 2010 publication on Performance Based grant systems.

Example of PFM in the education sector

Lessons learnt PFM reforms should: Be part of the overall support to fiscal decentralisation and other components of decentralisation in a mutually strengthening manner Focus on incentives in addition to more traditional focus on technical improvements Apply a step-wise approach where there is focus on the basic issues, while preparing for more advanced reforms Support the intergovernmental fiscal transfer system Use a learning-by-doing approach whenever appropriate

Good practices in harmonisation and alignment of support Small group discussion

Supporting the implementation of FD in partner countries What is the policy objective of decentralisation in my country? What is the current status of (fiscal) decentralisation in my country? What reforms are government and donors already pursuing to enhance decentralised local governance? What more can be done?

Challenges and opportunities for harmonisation & alignment Support to FD reforms has often been fragmented, scattered and without and overall strategy and action plan But there are several initiatives that show great potential to improved harmonisation and alignment: Performance Based Grant Systems Joint Financing Agreements Integrated fiscal decentralisation

Key lessons for development partners support for FD reforms In small-groups, try to come up with a list of around 10 key lessons on support to fiscal decentralisation reforms What are – according to you - the most promising opportunities for harmonisation and alignment within the field of fiscal decentralisation reforms? (20 min) Assign one group member to present your findings.