March 24-25, 2005 CONFERENCE “Russia’s Social Sectors under Decentralization: Issues of Financing, Performance and Governance” World Bank Moscow Office PRINCIPLES FOR THE DESIGN OF EQUALIZATION GRANTS Jorge Martinez-Vazquez Georgia State University

What are equalization grants? Unconditional, general purpose transfers Total amount of fund typically determined by a funding rule Total amount or divisible pool of funds distributed among regional and local governments based on a formula that considers expenditure needs and/or local revenue-raising ability (fiscal capacity)

Purposes of equalization grants Restore horizontal balance by equalizing fiscal conditions among local governments: fiscal disparities are substantial within Russia regions Contribute to closing vertical imbalances (the differences in expenditure needs and revenue availability for different levels of government) Contribute to “region and nation building”

Need to Focus on the Important Issues in Russian Regional Practices Get rid of negotiation and discretion Watch for lingering negative incentives in actual equalization practices (e.g.," claw back” of revenues or incentives to keep idle infrastructure Do not use conditionality for equalization funds Rely on conditional transfers for other ends

Positive Steps in the Kozak Commission Recommendations Extending the principle of uniformity of tax sharing (discontinuing “regulation”) Which call for the introduction of an effective equalization system (but more options of approach can be given) Possibility of using fraternal system (with negative and positive transfers Separate equalization for districts and settlements Special compensation fund for delegated functions

How simple: Why not give local governments “what they need”? Can’t we just do the following? Transfer region i = Actual expenditures region i – Actual revenues region i Region may not have funds to fill entire gap

How simple: Why not give local governments “what they need”? (Cont.) Actual expenditures generally do not equal needs Actual revenues generally do not reflect ability to collect revenues (fiscal capacity) Negative incentives will be provided: local governments will collect lower revenues on their own and will not use prudence in establishing expenditures.

Components of an Equalization Mechanism Determine the exact objective(s) of equalization: What should be equalized and by how much (This is fundamentally a political choice) Determine the sources (regional government revenues versus fraternal (“Robin Hood”) contributions)

Components of an Equalization Mechanism (Cont.) Determine the size of the equalization fund (vertical allocation of resources): stable rule, such as a fixed percentage of regional government revenues versus ad hoc determination in the annual budget Determine the equalization mechanism (formula)

Components of an Equalization Mechanism (Cont.) Determine the variables or allocation factors that will be used (i.e., measures of fiscal capacity, fiscal need, fiscal effort) Adjustment of actual payments for other transfers? Implementation and administration

Universal Principles for Equalization Grants Fund should provide adequate resources; balance regional priorities and local autonomy Fund should be distributed in equalizing manner Allocation should be predictable over time

Universal Principles for Equalization Grants (Cont.) Mechanism should be simple and transparent Mechanism should use reliable and generally accepted data not subject to manipulation by either regional or locals Approach should not provide negative incentives

Universal Principles for Equalization Grants (Cont.) Grants should be unconditional Reform should avoid sudden large changes (or use a “hold harmless” or a phase-in approach) Use separate funds for different levels of local governments

Different Approaches to Computing Expenditures Needs - retrospective methods (historical data) -weighted indexes (population, area, etc) -aggregate financial per capita norms - adding up micro costs from individual norms

Different Approaches to Computing Fiscal Capacity Historical data Simple proxies (income per capita, etc.) Average effective tax rates Representative revenue systems

Importance of simulating the allocation of intergovernmental fiscal transfers Spreadsheet model increases transparency Allows analysis of alternative scenarios Helps to consider fiscal decentralization as a complete system Necessary to update equalization mechanism on a regular basis

Importance of analyzing the impact of intergovernmental fiscal transfers How much equalization has been achieved? Winners and losers? How have horizontal and vertical fiscal balances changed?