1. Intergovernmental Finance: Lessons from International Practices Anwar Shah, World Bank ashah@worldbank.org International Seminar on Tax Reform and Fiscal Federalism, Brasilia, 5-6 March, 2008

2. 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.

3. Perceptions about intergovernmental finance: Perspectives of The Australian Premiers’ Conference

4. Ironically these perceptions are well grounded in reality Primary focus on dividing the pie Passing the buck transfers – revenue sharing with multiple factors that work at cross purposes (Argentina, India, RSA, Philippines and more) Asking for more trouble grants – deficit grants (China, Hungary, India, and more) Pork barrel transfers or political bribes/ favors (Germany, India, Mexico, 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

5. No need to despair …. As properly designed fiscal transfers can be part of the solution rather than part of the problem. Intergovernmental finance can be an important tool in securing economic union; fostering results based accountability to citizens; facilitating a competitive edge in a globalized and localized world and advancing local governments’ lead role in local economic development and network governance at the local level.

6. Guidelines for Intergovernmental Finance uClarity in objectives, consistency of design with objectives and singular focus uSimplicity, objectivity and transparency of allocation criteria uIncentives for fiscal prudence and competitive service delivery and results based accountability to citizens u Autonomy: Independence in designing programs and flexibility in use of resources uRevenue Adequacy and responsiveness uPredictability uFairness: entitlements vary inversely with fiscal capacity and directly with fiscal needs; one size does not fit all – urban vs. rural, large vs. small uAffordability uReview :Sunset clauses to ensure periodic review and assessment

7. ObjectiveGrant Design Better PracticesPractices to Avoid Bridging vertical fiscal gaps Reassign, tax base sharing Canada Deficit grants, (China), tax by tax sharing (China, India pre-2000) Reducing regional fiscal disparities (equalization) Fiscal capacity equalization (FCE) Fiscal capacity equalization with an explicit standard as in Canada, Germany, Denmark General revenue sharing with multiple factors, (Brazil, India) Fiscal equalization with a fixed pool as in Australia, China Setting national minimum standard Output based transfers, conditions on service standards Conditional capital grants – matching inverse with fiscal capacity Roads and primary education (ex-Indonesia), Education (Canada, Chile, Brazil, Colombia); Health (Canada) School construction. (Indonesia, pre-2000) Federal highways grants to states (USA) Conditions on spending (e.g. USA: Bridge to nowhere in Alaska) Capital grants with no matching and no future upkeep requirements

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

9. REVENUE SHARING MERITS –Efficiency gains of centralized tax administration –Simple and transparent division of fiscal pie –State and local expenditure autonomy preserved –Possible to incorporate factors to accomplish grantor objectives DRAWBACKS –Lack of political and fiscal accountability if little discretion of revenue raising at the margin –States and local government have no discretion over the total amount –Growth in state and local funding dependent on growth in federal revenues and not on own expenditure needs –States and locals exposed to risks with changes in federal tax base or collection –Specific revenue sharing for individual taxes on narrow bases such as income and payroll taxes, not desirable due to perverse incentives –Revenue sharing with multiple factors that work at cross purposes introduces complexity and lack of clarity in impact –Tax effort provisions can introduce inequity –Equal per jurisdiction component, if significant, can create incentives for breakup of existing jurisdictions

10. 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 (now defunct); 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.

11. An example : An Output based ( 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 Built-in bottom up results based accountability: competition with voice and exit options as parental choice of school determines school grant.

12. Challenge: Bridging Economic Divide within Nations Source: Shankar and Shah. 2001. “Bridging the Economic Divide within Nations”. Policy Research Working Paper 2717. Washington, D.C.: The World Bank.

13. Fiscal Equalization Transfers: Why? Political : Large regional fiscal disparities can be politically divisive. May even create threat of secession. Fiscal equalization grants to create a sense of political unity Fiscal efficiency and fiscal equity: Makes it possible for all citizens to be treated alike by the public sector regardless of the places of residence. Thereby advances social justice ( fiscal equity) and efficiency in market resource allocation (fiscal efficiency). Securing a Common Economic Union: Fiscal equalization transfers help create a level playing field for fiscally disadvantaged states and regions to integrate with the national economy.

14. 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, India and South Africa.

15. 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”.

16. 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

17. 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

18. 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 states 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

19. Compensation of marginal tax revenue Solidarity Pact II -2005 German Equalization Program -100 -80 -60 -40 -20 0 20 40 60 80 100 80828486889092949698100102104106108110112114116118120 Relative financial position in percent Marginal compensation in percent before Solidarity Pact II after Solidarity Pact II

20. The equalizing impact of distribution of VAT revenues

21. „Effectiveness“ of Finanzausgleich

22. Denmark: Equalization models and standards for central-local transfers 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

23. 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.

24. 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 Legislature itself

25. Institutional Choices: Intergovernmental Forums vs Independent Grant Commissions Criteron ForumCommission Transactions Costs: Participation and monitoring costs Low to Medium Low to high Legislative and executive costs High Agency CostsLowHigh Uncertainty costsLowMedium Potential outcomes: Political Compact Yes No Durability of compact Yes NA Pool determined by standard Yes? No Allocation by standard Yes No Stability of allocation criteria YesMay be?

26. Fiscal Transfers: Negative Lessons or Practices to Avoid General revenue sharing with multiple factors Tax by tax sharing for taxes with narrow bases 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 fits all

27. Avoid Conditional transfers with conditions on spending as they impair recipient’s autonomy without furthering grantor’s objectives

28. Fiscal Transfers: Positive Lessons or Practices to Strive For K.I.S.S. (keep it simple, sir) Focus on single objective Introduce sunset clause Tax base sharing 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

29. Traditional conditional grants versus Output-based grants CriteronTraditional conditional grant Output-based grant ObjectiveSpending levelsQuality and access to public services DesignComplexSimple and transparent EligibilityGovernmentService providers (govt. and beyond government) ConditionsInputsOutputs AllocationProject proposalService population ComplianceInspections and auditsClient feedback. Comparison with base year. PenaltiesAudit observationsPublic censure, voice and exit Managerial flexibility NoneAbsolute LG AutonomyLittleHigh TransparencyLittleHigh FocusInternalExternal AccountabilityTop down input basedBottom up, results based

30. From Dividing the Pie to Creating An Enabling Environment for Responsive and Accountable State-Local Governance Tax Decentralization and Tax Base Sharing Output based fiscal transfers – operating – capital Fiscal equalization transfers Responsible borrowing

31. References Boadway, Robin and Anwar Shah, editors (2007). Intergovernmental Fiscal Transfers: Principles and Practice. Washington, DC: World Bank Boadway, Robin and Anwar Shah (forthcoming, 2008), Fiscal Federalism. London and New York : Cambridge University Press.