Fiscal Decentralization
Rationale for Decentralisation
DECENTRALISATION
POLITICAL MOTIVATION
POWER SHARING MORE POPULAR ECONOMIC MOTIVATION
INCREASED STABILITY PARTICIPATION
EFFECTIVENESS EFFICIENCY
BETTER TARGETING GAINS
LESS VOICE IMPROVED / INCREASED ACCESS
VULNERABILITY to SERVICES
Poverty Reduction / Better Lives
Source : Joint Annual Review of Decentralisation 2004, Government of Uganda; Modified from Jütting et. Al.
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Principles of Decentralization
A municipal or local government is the layer of government that is closest to the people. The principles of fiscal equivalence
and correspondence provide a strong rationale for decentralization on the grounds of efficiency and accountability.
Correspondingly, the principle of subsidiarity makes the case for transfer of revenue generating powers to local governments.
• The principle of fiscal equivalence states that an overlap of the benefit area and political jurisdiction ensures the optimal
provision of public services
• The principle of correspondence states that the jurisdiction that determines the level of provision of a good should
precisely include the individuals who consume that good
• The principle of subsidiarity states that taxing and spending should be exercised by lower levels of government unless a
convincing case can be made to the contrary
Types of Decentralization
The term "decentralization" embraces a variety of concepts- Political, administrative, fiscal and market decentralization
• Political decentralisation – democratic decentralisation. presence of elected local governments- e.g. 74th amendment
• Administrative decentralisation – (functional decentralisation) – three major forms of administrative
decentralization – de-concentration, delegation, and devolution
• Fiscal Decentralisation – ensuring appropriate expenditure and revenue responsibilities at local level. It is a core
component of decentralization
• Market Decentralization – private sector participation, deregulation
Observations about Emergence of Fiscal
Decentralisation around the World
• It is often history and politics - not economics - that determine sub-national government structure and drive fiscal
decentralisation reforms
• Many fiscal decentralisation reforms shifted financial resources to the local government level, but failed to
decentralise the discretion to manage these resources
• Balancing amongst political, administrative and fiscal aspects is critical
First Generation Theory of Fiscal Federalism
• Arrow-Musgrave-Samuelson
• In a multi-level government setting, each level of government would seek to maximize the social welfare of its
respective constituency
• For “local public goods,” local governments can provide levels of public outputs that meet the demands of the
residents of their respective jurisdictions
Oats W E (2005), Toward A Second-Generation Theory of
Fiscal Federalism, International Tax and Public Finance, 12, 349–373, 2005
Second Generation Theory of Fiscal Federalism
• Tradeoff in terms of local “accountability” versus a coordination of policies under centralization
• Fiscal autonomy of different levels of government in the context of electoral processes
• Political-economy of fiscal decentralisation
• Efficient credit markets, Efficient land markets, reliable and effective local system of taxation
• The system of intergovernmental grants must function so as to meet its basic allocative and redistributive functions
without being subject to manipulation
Oats W E (2005), Toward A Second-Generation Theory of
Fiscal Federalism, International Tax and Public Finance, 12, 349–373, 2005
Fiscal Decentralization - Four Pillars
Fiscal Decentralization
Four basic building blocks or “pillars”
1. The assignment of expenditure responsibilities to different government levels: what are the functions and
expenditure responsibilities of each level of government?
2. The assignment of tax and revenue sources to different government levels: which tax or non-tax revenue
sources are be made available to sub-national governments in order to meet their expenditure responsibilities?
3. Intergovernmental fiscal transfers: in addition to assigning revenue sources, central governments may provide
regional and local governments with additional resources through a system of intergovernmental fiscal transfers or
grants.
4. Sub-national borrowing: local governments can borrow (in a variety of ways) to finance revenue shortfalls
Expenditure assignments
Expenditure Assignment
• Assigning services /functions to levels of government
• Oates-Musgrave: Central government should have the basic responsibility for the macroeconomic stabilization
function and for income redistribution in the form of assistance to the poor
• “subsidiarity principle”. This principle suggests that government functions should be assigned to the lowest level of
government that is capable of efficiently undertaking this function (such as providing a good or service).
Oates W. E. (1999), An Essay on Fiscal Federalism, Journal of Economic Literature, Vol. XXXVII (September 1999) pp. 1120-1 149
Local government and services
• local governments are the closest partners of National Government in implementation of national development
agenda
• Motivation for decentralisation has varied, but “ improving service delivery is an implicit motivation behind most of
these decentralisation efforts” (Ahmed et al)
• When this is done, it is argued, resources will be allocated with the greatest efficiency, accountability, and
responsiveness.
• Geographically specific – low externalities/spillovers, e.g. garbage collection, fire services, internal roads, streetlights,
etc
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Expenditure assignments to ULBs: India
• Assignment Issues:
• Twelfth Schedule lists 18 functions which is an omnibus list – and one size fits all approach to ULBs irrespective of
the size. In reality, large corporations have been assigned more functions.
• States are often reluctant to transfer functions that are with state agencies (e.g. UDA, water)
• Need for clear activity mapping exercises of who does what – planning, service delivery, regulation, etc.
• Independent service providers: lack of accountability to local governments
• Responsibility is looked at independently from revenue sources.
Revenue assignments
The revenue assignment question
Which revenue sources (tax sources or non-tax revenue sources - including fee revenues) should be made available to
subnational governments in order to meet their expenditure assignments?
Why have sub-national taxation?
• Sub-national governments are often more accountable for controlling their spending (expenditure) if they are also
responsible for revenues
• Allows tax policy (tax levels and structure) to be tailored to the conditions and preferences of sub-national
governments
• Reduces excessive demand on transfers by sub-national governments from the centre
Finance should follow function
• One cannot establish the required level of subnational government revenues independent of an estimate of expenditure
needs
• If finance does not follow function it becomes difficult to effectively impose a hard budget constraint at the subnational
level if there is an insufficient revenue assignment
• The economically efficient assignment of revenues requires a prior knowledge of expenditure assignment
Features of ‘ideal’ local revenue sources
• Taxes that achieve a ‘correspondence’ between the tax and the benefits from local government services –
easy for tax payers/citizens to understand
• Relatively easy to administer
• Incidence of local taxes should be equitable
• Avoid mobile tax bases
• Should avoid ‘perverse incentives’ to taxpayers
• Should be adequate and buoyant
Taxes and fees in India by ULBs
General taxes:
• Property taxes
• vacant land tax
• Transfer fees, betterment levies, Impact fees
• Business fees (profession taxes), local business tax (LBT) on turnover
• Octroi – now only in Mumbai
• Entertainment tax (shared)
Taxes / charges for Specific for excludable
• User charges for water, sewerage, solid waste management
• Water/ sewerage benefit tax (general water tax /special water tax)
NOT included: share /surcharge on personal income tax
Intergovernmental Transfers
Intergovernmental fiscal transfers
Own source revenues are (almost) never enough to cover local expenditure responsibilities
Central (or regional) governments may provide local governments with additional resources through a system of
intergovernmental fiscal transfers
In most countries, transfers are (by far) the main funding source for local government, esp. for social sector services
Article 280 of Indian Constitution
The Finance Commission shall make recommendations as to the following matters:
• (i) the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided
between them under Chapter I, Part XII of the Constitution and the allocation between the States of the respective shares
of such proceeds;
• (ii) the principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of
India and the sums to be paid to the States which are in need of assistance by way of grants-in-aid of their revenues under
article 275 of the Constitution for purposes other than those specified in the provisos to clause (1) of that article; and
• (iii) the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayat and
Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.
Objectives of Intergovernmental fiscal transfers
• “vertical” fiscal balance (providing additional resources to the local level, so that there is a balance between the
fiscal needs and resources available to different levels of government – centre-state-local);
• “horizontal” fiscal balance (ensuring fiscal balance in resource allocations between government units at the same
level of government) – regional /Local Government equalization;
• the funding of specific national or state priorities
Flow of funds – IGT in India
Central Finance
Plan Funds
Centr Commission
Tax State Centrally
e plan
Central
sponsored
Devoluti Grants schemes
on schemes schemes
State Finance
State Commission State
Tax schemes
Devoluti Grants
on
Urban Revenue from Inter-Governmental Transfers
Local
Body Revenue from own sources
An effective transfer system should satisfy
several criteria
• Revenue adequacy: LGs should have sufficient resources to carry out devolved responsibilities.
• Local tax effort and expenditure control: Ensuring sufficient tax efforts by local authorities. Don’t encourage
fiscal deficits.
• Equity: Transfers should increase with local fiscal needs and decrease with local fiscal capacity.
• Transparency and stability for predictability: Formula should be announced and localities should be able to
forecast own revenues in order to prepare budgets. Formula should be stable, allowing long-term local planning.
Design of IGTs
• Determining the ‘divisible pool” of funds for distribution:
1. as a fixed share of national/state government revenues – e.g. For central govt income tax, excise, For states: total
state own receipts or specified revenue receipts (e.g. Entertainment tax, % surcharge on VAT for octroi
compensation)
2. as a proportion of approved specific local expenditures to be reimbursed (e.g. % of education expenditure by LGs).
3. As a proportion of annual budget
• Distribution among sub-national governments
1. Required versus available revenues (Gap-filling model) – as assessed by population, area
2. Equity concerns – income (distance method), fiscal capacity
3. Incentives for Local government efforts – tax effort, fiscal discipline,
Finance Commission approach
• Divisible Pool
• The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States.
The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of
collection charges.
• Fiscal capacity/Income distance
• The income distance criterion was first used by Twelfth FC, measured by per capita GSDP as a proxy for the
distance between states in tax capacity. When so proxied, the procedure implicitly applies a single average tax-
to-GSDP ratio to determine fiscal capacity distance between states.
CFC allocations for ULBs
• Measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and
Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State.
• Added following the 73rd and 74th amendments to the Constitution in 1992 conferring statutory status to the
Panchayats and Municipalities
• 11th FC – adhoc grant of Rs 2000 crore
• 12th FC – adhoc grant of Rs 5000 crore
• 13th FC – 0.4% of divisible pool for general grant + 0.3% for performance grant – Rs 23455 crore (2011-12 to 2014-
15)
• 14th FC – Rs 488 per capita per year including 20% performance grant Rs 87,144 Cr (2015-16 to 2019-20)
14th CFC Performance Grants
To be eligible, the urban local body will have to submit audited annual accounts that relate to a year not earlier than
two years preceding the year in which it seeks to claim the performance grant. It will also have to show an increase in
own revenues over the preceding year, as reflected in these audited accounts. In addition, it must publish the service
level benchmarks relating to basic urban services each year for the period of the award and make it publically available.
Performance Based Grants
Although there are many variants, in essence a PBGS operates such that the extent to which LGs access transfers from
central government is conditioned upon their overall performance. In most PBGSs, LGs need to show that they have
complied with basic or Minimum Conditions (MCs) in order to access their grants (or part of them). MCs, which are
usually based on statutory provisions and are either complied with or not (there is no “half-way house”), are intended to
measure the basic capacity of a given LG to perform its functions. Unless LGs can demonstrate this performance, they
are unable to access all or part of their (most often, capital development) grants. However, when LGs are able to
demonstrate compliance with MCs, which are designed to ensure a minimum capacity to handle grants, they become
eligible to receive their grants. Many MCs are designed as basic safeguards to bring down fiduciary risks to an acceptable
level. Many PBGSs, however, go one step further – by either increasing or decreasing the size of basic LG grants in
relation to the assessed performance of LGs. This performance is usually based on assessing pre-determined and agreed
Performance Measures (PMs)
Sub-National Debt and Borrowing
Finally, the fourth pillar of sub-national
finance: debt through local borrowing
In many developed economies, local borrowing is an appropriate way for local governments to fund capital
infrastructure:
(i) it corrects the inter-temporal mismatch between costs and benefits (in terms of efficiency, equity, timing and
practicality)
(ii) there are numerous mechanisms to ensure responsible borrowing
An example of the USA – in 2012 the municipal bond market was estimated to be $3.7 trillion – about 10% of total
bond market size
Source: for US municipal bond market size: http://www.sec.gov/spotlight/municipalsecurities.shtml, accessed on 12/2/2015
Restrictions on borrowing
In many LDCs, the absence of market-based mechanisms to enforce a ‘hard budget constraint’ requires restricting
local borrowing:
• Rules-based restrictions – on debt limit, etc
• Permission required – though this tricky !!
• Only from local government bank / loan fund
• No borrowing allowed
Experience from Brazil, China suggested that un-regulated sub-national borrowings can affect national economy
Sub-national borrowing
• Borrowing for long-term capital development projects is relevant – as housing finance is for households
• Relevant in India due to relatively well developed financial markets
• Need for a well-defined local government framework for borrowing and issuing bonds
• Development of Credit assessment and rating of local government issues Emergence of a municipal bond system,
pooled finance
Municipal bonds
References
• Crane, Randall (2006), Public Finance Concepts for Planners, working paper (WP06RC1), Lincoln Institute of Land
Policies, Cambridge, USA
• Anwar Shah (Ed). 2006. Local Governance in Developing Countries. The World Bank. Washington D.C.
• Todaro Michael, and Stephen Smith (2012), Economic Development, Tenth Edition, Pearson Education UK. Indian
edition published by Dorling Kindersley India Pvt Ltd
• Buchanan, James M. 1949. The pure theory of government finance: A suggested approach. Journal of Political Economy
57 (December)
• Tiebout Charles (1956) A Pure Theory of Local Expenditures : The Journal of Political Economy, Vol. 64, No. 5,
(Oct., 1956), pp. 416-424
