1. FISCAL EQUALIZATION IN SPAIN J. Ruiz-Huerta IEF-URJC (Madrid) (May 30th, 2006)

2. What can we expect from an equalization transfer? How can we evaluate the Spanish equalization system? This is a transfer that allows all regional/local governments to provide similar levels of public services with a similar level of fiscal effort (equity and efficiency reasons). Therefore: –It should allocate more resources to those regions with the lowest potential revenue (= fiscal capacity). –It should allocate more resources to those regions with the highest costs of providing public services (= expenditure needs).

3. In order to guarantee the political autonomy of regions, equalization grants should be unconditional. Therefore, they do not necessarily duplicate the results of a unitary state. It is an instrument for interregional redistribution, which should reflect the intensity of the interregional solidarity desired by the country as a whole. What can we expect from an equalization transfer? How can we evaluate the Spanish equalization system?

4. The objective is to reduce (or even eliminate) differences in the ability to provide public services, when there are differences in the fiscal capacity of regions. Equalization transfers have different objectives/designs/results than capital transfers for development purposes. What can we expect from an equalization transfer? How can we evaluate the Spanish equalization system?

5. Fiscal equalization in Spain What equalization instruments are available to Spanish Autonomous Communities? –Fondo de Suficiencia (“Sufficiency Fund”): unconditional, periodic and “integrated” transfer that is aimed at resolving both vertical and horizontal imbalances. –Asignaciones de Nivelación (“Equalization Grants”): conditional and extraordinary transfers that guarantee a minimum level of basic public services (health and education) in all of the regions, given certain circumstances (not applied in Spain).

6. Fiscal equalization in Spain: how does the Sufficiency Fund work? It attempts to eliminate the gap between regional fiscal capacity and regional expenditure needs. Fiscal capacity: “Normative” collection of ceded taxes and actual collection of shared taxes. Expenditure needs: population, dispersion, non- mainland location, size of region and population over 65 (+ ad hoc adjustments).

7. Status quo (Initial restriction)Expenditure needsResources General services and education: + Ceded taxes revenue (1999) + Regional share in PIT revenue (1999) + Shared State Revenues-PIE (1999) + Guarantee Fund (1999) + Effective cost of services transferred after 1999 General Fund: population (94%), area (4,2%), dispersion (1,2%), non- mainland location (0,6%) + Ceded taxes + Regional share in PIT collection (33%) + Shared taxes (VAT and excise taxes) + Sufficiency Fund Low Population Density Fund: AC with a density <27 persons/ km 2 and an area <50,000 km 2 Relative Income Fund: AC with per capita income below the national average Minimum Guaranteed Modulation Rules Health: + Health expenditure in 1999 General Fund: population covered by national health system (75%), population >65 (24.5%), and non- mainland location (0.5%) Minimum Guaranteed Social Services: + Social services expenditure in 1999 General Fund: population >65 Minimum Guaranteed THE DETERMINATION OF THE SUFFICIENCY FUND

8. Sufficiency Fund: Main Shortcomings in the design (I) Confusing “name”: is it a real equalization transfer? Imperfect design of the indicators of fiscal capacity and expenditure needs. Serious problems in the evaluation of results. No explicit equity target is available. Eliminating the entire gap between fiscal capacity and expenditure needs is apparently the implicit equity standard of the system.

9. Sufficiency Fund: Main shortcomings in the design (II) Assessment of fiscal capacity. “Normative” collection of ceded taxes: –Actual collection in the year of cession, updated by the growth rate of central government tax revenue. Thus: * Excessively linked to prior periods, ignoring the current development of tax bases and revenue. * Systematic underestimation of regional fiscal capacity.

10. Sufficiency Fund: Main Shortcomings in the original design Assessment of expenditure needs : –Based on the “effective cost” method: the national government is committed to guaranteeing sufficient resources to maintain services at the level available prior to the devolution of services. –“New investment” needs were not included in the method. –Perpetuation of the differences in the pre- devolution level of services.

11. Sufficiency Fund: Main shortcomings in the current design Assessment of expenditure needs: –Based on the relative size of regionally adjusted population. –The “status quo” rule: no AC may lose resources as a result of the reform of the system. –“Modulation rules”, in order to avoid an excessive geographical disparity in the increase of the resources resulting from the reform. –As a result, the expenditure needs index does not adequately reflect differences in the demand and supply conditions regarding public goods and services. It remains closely linked to the historical criterion of the “effective cost”

12. Sufficiency Fund: results Significant reduction of differences in per capita revenue, but not complete equalization. The results display no clear distributional pattern due to the ad hoc adjustments of the expenditure needs index. Re-ranking is performed with no clear criteria.

13. Tax revenue /inhabitant (euros)Index/AverageIndex/ MaximumPosition Total Res/Inh (euros)Index/AverageIndex/ Max.Position Bal. Islands 1.6961.41111.5050.830.6815 Madrid 1.6801.400.9921.6360.900.7313 Catalonia 1.4901.240.8831.7960.990.8111 Aragon 1.3511.120.8042.0321.120.915 La Rioja 1.2311.020.7352.2291.2311 Cantabria 1.2231.020.7262.1791.200.982 Asturias 1.20510.7171.9691.080.887 C. Valenc. 1.1900.990.7081.6360.900.7312 Cast-Leon 1.1280.940.6792.0641.140.934 Galicia 1.0000.830.59102.0041.100.96 Murcia 9560.790.56111.6160.890.7214 Cast-La Man. 9490.790.56121.9321.060.878 Andalusia 9440.780.56131.8271.010.829 Extremadura 7980.660.47142.1601.190.973 Canary Isles 5140.430.30151.7980.990.8110 Fuente: Herrero y Martínez-Vázquez (2006)

14. Autonomous Communities Financing System ( 2003) CommunitiesWith own fiscal capacity (Without Fondo de Suficiencia) All Guarantee Financing (homogeneus responsabilities/ Espenditure Needs) Euros per inhabitant Índex / Average PositionEuros per inhabitane adjusted Índex / Average Position Andalusia94478,1131.825,31103,98 Aragón1.351111,741.880,23107,06 Asturias1.226101,461.884,61107,35 Baleares Isles1.720142,211.470,2183,715 Canary Isles51742,7151.649,3593,912 Cantabria1.223101,172.025,43115,33 Castilla y León1.14894,991.920,99109,44 Castilla-La Mancha95078,5121.804.50102,79 Catalonia1.495123,631.712,4697,510 Extremadura81367,2142.061,22117,41 Galicia1.01984,3101.863,69106,17 La Rioja1.241102,652.057,53117,12 Madrid1.680138,921.601,6191,214 Murcia95679,1111.670,0495,111 Valencia1.19398,681.635,6593,113 TOTAL1.209100,01.756,40100,0

15. Reforming the Sufficiency Fund: main issues (I) What is the equity target? (a political decision) Who decides? National or regional governments. What must be the “Initial Restriction”: the “effective cost” method or the whole budget? What consideration must be given to the “Special Regime Regions” (“Comunidades Forales”)? How can distortions associated to political negotiation (“ad hoc adjustments”) be avoided or reduced? Can “re-rankings” be allowed? If so, to what extent? Reliable statistics and transparency are essential for the efficient performance of a decentralized system.

16. Reforming the Sufficiency Fund: main issues (II) Assessing fiscal capacity: –Realistic measurement, not necessarily coincident with current revenue. –Should this include all regional resources? Assessing expenditure needs: –Should an education needs index be included? –Ad hoc adjustments should be limited. Any inclusion (and the corresponding weight) of the variables must be empirically justified. –The simplest and most transparent expenditure needs index is probably the weighted number of potential users. –Trade-off- simplicity vs. accuracy.

17. Reforming the Sufficiency Fund: main issues (III) The future of equalization transfers: what rules can guarantee both regional and national budgetary stability? Is a periodic update of each region’s share of the total transfer necessary? If so, how and how often? How gradually should the system be changed? Which consequences will produce new (and higher) percentages of tax sharing?