Fiscal Decentralization Flashcards
What are the two elements of fiscal decentralization?
- *Functional/Expenditure assignments**: functional assignments allocate responsibilities to different levels of government, while expenditure assignments allocate spending powers to various levels of government.
- *Revenue assignments**: these allocate corresponding revenues and fiscal functions to the same levels of government to enable them to carry out their mandates. Note that this includes the distribution of various sources of revenue, namely:
- allocation of power to generate own tax and non-tax revenues
- intergovernmental transfers systems
- borrowing powers.
Expenditure assignments
Expenditure assignments are processes whereby governments disaggregate spending responsibilities by function and roles—policy setting and service provision —and allocate them to various levels and entities.
- Public services are seldom funded exclusively by one single level of government.
- Local governments play a role in many sectors. In some sectors they only have a service provision role, but they also play a role in setting policies in a wide variety of sectors.
- Expenditure assignments identify areas of ‘shared responsibilities’. Helping to identify potential sources of risk and on where to concentrate efforts to improve intergovernmental coordination.
- Looking at expenditure assignments allows you to map out the areas where local governments are expected to act aspolicy makers, policy implementers or as a mix of both.
- Expenditure assignments also help to identify functions where private actors and other entities play a role.
Intergovernmental cooperation in spending decisions
How does central government exercise macroeconomic control of local governments?
This dimension looks at how governments can manage to keep fiscal discipline indecentralised contexts, the risks at play and possible mitigating measures.
Are there mechanisms to facilitate specific budget cooperation when needed?
This area relates to how arising expenditure needs are taken into consideration over time. This is particularly important when new functions are delegated to subnational governments, as they need to be accompanied by
adequate transfer of resources.
How does intergovernmental cooperation on fiscal and expenditure policies work?
This dimension looks at cooperation and coordination. Governments may establish formal coordination meetings to discuss specific issues. Yet, to be effective, such mechanisms need to be accompanied by enabling environments and appropriate incentives.
Revenue assignments
- *Contribution to national targets on fiscal discipline**: own resources contribute to fiscal responsibility and long-term sustainability. They are key ingredients to achieve national targets on fiscal discipline and they help off-set irresponsible fiscal behaviour of subnational governments: i) they strengthen the link between taxing and spending powers; ii) the link between services provided and tax compliance is more visible to thetax payer; iii) local taxation takes place against the backdrop of an obligation to balance the budget, at least on the day-today spending.
- *Promoting economic growth**: well-designed fiscal systems and tax assignments can generate positive incentives for LGUs to contribute to growth efforts and increase tax revenues accordingly.
- *Contribution to accountability**: citizens who pay taxes or users who pay fees are more likely todemand accountability for the services they expect to receive in exchange. And this is more easily done at subnational level as the link between taxes and services provided is more visible for the tax-payer at local than at central level. For their part, LGUs are more likely to pay attention to citizens’ demands the more they rely on their funding.
Which taxes at which level?
Central government may best handle the following taxes:
• Taxes that contribute to macroeconomic stability, such as corporate income taxes, trade taxes etc. This is due to the fact that LGUs require stable taxes.
• Progressive taxes targeting interpersonal redistribution: this holds particularly true when (i) tax bases are mobile so that it avoids unhealthy competition between jurisdictions; (ii) the objective is to tax income that is generated in several LGUs.
• Taxes that are complicated to administer.
Local government may best handle the following types of taxes:
• High yielding taxes responsive to income increase, costs of services, inflation and population size. Concentration on high yielding taxes does not mean thriving towards a single tax, as there is a need to diversify fiscal risks. Rather, it refers to the need to avoid overly concentrating taxes on a very small number of tax payers who would, as a consequence, become a too influential minority in budget decisions, thus damaging accountability relations.
• Relatively stable and non-distorting taxes, that are relatively equally distributed across LGUs, thus avoiding any increase of territorial inequalities and complicated equalisation systems.
• Taxes that are easy to administer and visible to the taxpayer. Visibility concerns the input (tax) but also the taxation output (quality of the services).
Desirable characteristics of the local tax base (1)
- They should minimise the distortion in resource allocation.
- The chosen tax base(s) should, ideally, be broad enough to provide sufficient revenues to finance local spending without unduly high tax rates. In order to minimise the excess burden of such taxes, revenue should grow in line with any increase in local service provision costs, so the tax base should be able to cover future budgetary needs. In other words, a local tax should be elastic, with respect both to the tax base and in relation to income growth, so that small changes in the tax rate result in considerable changes in revenues and increased incomes also result in considerable additional revenues.
Desirable characteristics of the local tax base (2)
- Another desirable characteristic of local taxes is a reasonably even tax base throughout the country; this will reduce intergovernmental transfers to compensate for variations in tax capacity among SNGs; it is also an argument which suggests that taxes on natural
resources, because of their uneven geographical spread, are best suited to national taxation. - In addition, the tax should be changeable to allow SNGs to vary the tax in line with local preferences, and its yield has to be substantial if SNGs are to play a significant role (James and Nobes, 2014).
Desirable characteristics of the local tax base (3)
- The influence of vertical tax competition (between SNGs) suggests that local taxes are best imposed on immobile factors, especially land and property, while taxes on mobile factors, especially corporate taxes, are best centralised. A progressive (as opposed to a proportional) local tax might offer encouragement for richer residents to migrate to lower tax SNGs (Sanford, 2000).
- They should show accountability; local taxes should be politically transparent and visible in order to ensure that the SNGs imposing such taxes are clearly accountable to their residents (Bird and Wilkie, 2013).
- A local tax should be economical to operate on a small scale and difficult to evade.
- A local tax should be perceptible – that is, taxpayers should know when they are paying a state or local tax (Sanford, 2000).
Revenue assignments and shared taxes
Taxes can be allocated in various ways and can be subject to different ‘regimes’.
- *Exclusive taxes**: taxes for which only one level of government can exploit the case on which it is based and collect all the revenue from the tax.
- *Shared taxes**: several levels of government have access to the same tax base. There are several variants of shared tax, depending on the discretion of each level: tax sovereignty (each level defines tax base); partial tax sovereignty (each level can set part of the taxation criteria such as exemptions, deductions etc.); tax flexibility (the government level involved only sets the coefficient); mandatory tax (the government does not choose and must levy the tax in compliance with criteria set by higher levels).
- *Revenue-sharing arrangement**s: the central government sets the tax base, the rate and collects the tax. Yet, the yields are distributed across different levels of governments on a predetermined basis, which can follow the ‘origin’ principle or resource redistribution concerns. Revenue-sharing arrangements are similar to transfers, as collected tax revenue is made available to subnational levels by another level of government.
Intergovernmental transfers
- *Correcting vertical imbalances** or closing the gap between expenditure and revenue assignments.
- *Compensating LGUs for complying with** central government requirements or implementing central government programmes that are delegated to LGUs.
- *Correcting horizontal imbalances** through equalisation grants to level up LGUs conditions for service provision and to make them converge (e.g. transfer of additional resources to LGUs with lower fiscal capacity or with greater needs compared tonational average).
- *Correcting positive externalities** with public goods provision aimed at compensating LGUs for services they provide, that have positive impact beyond their jurisdiction.
- *Incentivising coordination and harmonisation of LGUs’ spending with national goals**; even in these cases, transfers are more successful when they allow sufficient budget autonomy.
- *Ensuring efficiency in LGUs’ revenue mobilisation, financial management and utilisation of funds**: it is key that transfers do not create negative incentives for the mobilisation of local revenues and that they can be used to stimulate LGUs performance in specific areas, such as tax collection, financial management etc.
- *Providing** central government with adequate flexibility to pursue macroeconomic stabilisation policies and influence the overall activity level within the LGU sector.
Types of transfer mechanism
Transfers can be distinguished according to the use of funds, method of calculation and fund availability.
- *Use of the transfer (specific versus general-purpose grants)**: specific grants are conditional, as they have to be spent on specific functions. Inversely, general-purpose grants are unconditional, as LGUs can use them to finance a broad range of services. Some of these grants target development initiatives and capital investment (sector specific and non-sector grants) whereas others target recurrent costs.
- *Method of calculation**: some of these mechanisms take the form of lumpsum grants whereby a fixed amount is transferred. Others are based on a matching principle according to which LGUs have to co-finance a share of the expenses.
- *Availability of funds**: they can be close ended or open ended depending on whether there is a ceiling, or the amount is aligned on real costs.
Allocation of borrowing powers
Governments can also allocate borrowing powers to different levels of government. Some reasons that justify subnational borrowing are the potential strategic source of revenue, the satisfaction of cash-flow needs, long-term capital investment and strategic
borrowing for growth.
However beneficial, subnational borrowing also entails risks, such as:
• soft budget constraints and bail-outs leading to acute debt crises such
as some Latin American countries experienced during the ’80s
• challenges with intermediate borrowing institutions, such as in some African countries, such as Tanzania
• informal and ‘off-budget’ borrowing practices.
