1. Challenges of Budget Management in Decentralization Budget Management and Financial Accountability Course Dana Weist Lead Public Sector Specialist, PRMPS 2 March 2004

2. Decentralization: A World-Wide Phenomenon
Underway in over 85 countries
Political and economic rationales
Varieties
Deconcentration
Delegation
Devolution

3. Decentralization Trends
Subnational Expenditure Shares
Subnational Tax Shares
Developing Countries
1970s
13.0% (48)
10.4% (43)
1980s
13.2% (43)
7.7% (35)
1990s
13.8% (54)
9.3% (28)
Transition Countries
26.1% (23)
16.6% (14)
OECD Countries
33.8% (22)
18.7% (22)
32.3% (23)
32.4% (23)
19.1% (23)
Source: International Monetary Fund. Government Finance Statistics Year Book , various years, Country Tables

4. Differences Across Regions
Subnational Share of Expenditures
Subnational Share of Revenues
Note: Simple average of most recent observations in available countries. Numbers in parenthesis indicate number of countries represented.
Source: International Monetary Fund. Government Finance Statistics Year Book 1998, Country Tables.

5. Positive or Negative Outcomes?
If designed well, decentralization can
Move decision making closer to people (subsidiarity principle)
Enhance efficiency and responsiveness of service delivery
Improve economic growth
Potentially alleviate poverty
But, design is complicated, since it spans political, fiscal, and administrative policies and institutions

6. Key PE Questions
Who is doing what?
How is it being financed?

7. Macroeconomic Stability
Key factor is “hard budget constraint”
Creates incentives for subnational fiscal discipline
Limits risk of central government
Can be “softened” through several channels (intergovernmental fiscal system, financial system, SOEs, borrowing, etc.)
One often hears about the potential (and sometimes realized) risk of macroeconomic stability in decentralized countries. The critical factor influencing subnational fiscal behavior and central government liabilities is the presence of “hard budget constraints”.
A hard budget cosntraint exists when the central government can and does refuse to provide additional resource to a sub-national government beyond a pre-agreed resource envelope. The problem often in decentralized countries is that despite local governments being”autonomous”, they will tend to overspend, under tax or overborrow if they believe that the central governent will provide additional resources to them (or “bail them out”) If central governments do bail out local governments, their discipline is compromised, national fiscal deficits can grow and this can ultiamtely be destabilizing.
A budget constraint can be softened by a number of channels:

8. Equity Extent of fiscal equalization
Ways and means for targeting poor places and poor people
Add comment that experience with local solidarity will depend, amongst other things, on social capital and homogeniety of local populations.

9. Four Pillars of Intergovernmental Fiscal System
Expenditures
Revenues
Intergovernmental transfers
Subnational borrowing/debt

10. Expenditure Issues
Objective: significant and clear expenditure responsibility and autonomy
Subsidiarity principle: provide services at lowest level of government compatible with "benefit area" associated with those services
Distinction between production and provision
Do local services respond to local needs?
Do citizens have meaningful opportunities for voice?
Do officials face incentives to respond?
Assign expenditures first, then assign revenues that match expenditure needs

11. Local Revenue Issues
Own resources typically inadequate to carry out assigned functions
Revenues not adequately responsive to changing needs
Striking variations in size and capacity – one size doesn’t fit all
Local revenue mobilization strengthens accountability -- link taxes with benefits derived from local government services
Simplest and most effective form of tax autonomy: discretion to set tax rates

12. Rationales for Intergovernmental Transfers
Vertical imbalances
Horizontal imbalances
Inter-jurisdictional spillovers (externalities)
Enhancing national objectives at the subnational level
Paying for national programs implemented by subnational governments

13. A “Good” Transfer System
Transfers should be transparent and predictable (formula-based)
Equalization transfers should include
A measure of “need”
A measure of “capacity”
Adequate sub-national revenue autonomy
Stable but flexible financing
Avoid a proliferation of conditional grants

14. Local Borrowing Benefits Risks
Finance long-lived assets efficiently and equitably
Overcome liquidity problems of lumpy investments
“Pay-as-you-use” financing
Improve selection of investments
Risks
“Soft” budget constraint
Macro-instability

15. Borrowing Risks Can Be Managed
Strengthen intergovernmental fiscal system
Apply administrative controls
Implement rule-based framework
Establish market-based system
Impose other controls

16. Decentralization Challenges
Balance responsibilities with resources, capacity and accountability
Subsidiarity
Finance follows function
Responsibility with capacity (learn by doing)
Accountability through political channels, own source revenues, participation and transparency
Create incentives for implementation to match formal arrangements

17. Operational Implications of Decentralization
Many more potential clients
Weaker client capacity
Limited knowledge of Bank processes and requirements
Weak capacity in project preparation and procurement
Local accountability may be weak and potential for local corruption may be high
Shorter time frame for local officials
Need for
Improved data
Streamlined Bank processes?
Experimentation and new solutions?

18. Public Expenditure Management Lens
Clarity in expenditure assignment?
Adequacy of resources?
Formula-based transfer system?
Hard budget constraint?
Budgeting and reporting systems
Uniformity vs. flexibility
Carrots vs. sticks