Fiscal Policy Resource Center

Principles of Fiscal Decentralization

An Introductory Overview
of Intergovernmental
Fiscal Relations








http://isp-aysps.gsu.edu/fprc/

International Studies Program
Andrew Young School of Policy Studies
Georgia State University
Atlanta, Georgia 30303
United States of America

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Fax: (404) 651-3996
Email: ispaysps@gsu.edu



Copyright 2001, the Andrew Young School of Policy Studies, Georgia State University. No part
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An Introductory Overview Of
Intergovernmental Fiscal Relations

Jamie Boex
1




Overview
This background paper provides an introductory overview of intergovernmental
fiscal relations, or the study of fiscal relations between different levels of
government. The purpose of this paper is to answer some of the most basic
questions about intergovernmental fiscal relations and establish a common
vocabulary among government officials, policy makers and stakeholders. In doing
so, we will answer three basic questions. First, what is fiscal decentralization?
Second, what are policy dimensions of fiscal decentralization? Third, what are the
advantages and disadvantages of decentralization?


What is fiscal decentralization?
Intergovernmental fiscal relations and fiscal decentralization deal with how the
government sector is organized and financed. The government sector of virtually
every country consists of more than one level of government. Typically, a country
has a central government that exercises jurisdiction over the entire national
territory (in federal countries, the central government is known as the federal
government). In addition, many countries have one or more levels of subnational
governments, which only exercise jurisdiction over a particular region, district or
locality. Some countries have two levels of government (central and local); many

1
This overview was edited by Jameson Boex, Assistant Research Professor, Department of
Economics / International Studies Program, Andrew Young School of Policy Studies, Georgia
State University. Parts of this overview were extracted from Roy Bahl. 1998. Implementation
Rules for Fiscal Decentralization.




2
others have three levels of government including a central (or federal)
government, regional (or state) governments, and local governments.
2

Intergovernmental fiscal relations studies how different levels of government
interact with each other on fiscal issues.

The division of responsibilities between different levels of government varies
greatly between countries. In highly centralized countries, most decision-making
and fiscal power lies with the central government. The government sector is
highly centralized in small, developed countries (such as the Netherlands), as well
as in many formerly socialist transition countries (such as Ukraine) and
developing economies (for instance, Malawi).

However, since in a system of centralized government all decisions are made by
the central government, there is a big distance between the central government
and a countrys citizens, where a countrys residents are the ultimate recipients of
public goods and services provided by the government. As a result of the distance
between the government and the citizenry, chances are that a highly centralized
government is not aware of and therefore is unable to provide-- the basket of
government goods and services that is desired by the population. Also, central
governments often only provide a standard set of government services across the
entire national territory; as such, central governments are not able to respond to
variations in conditions in different regions or variations in preferences for public
goods and services across the country. Alternatively, highly centralized
governance can result in a situation in which the central government will
accommodate the public service needs of the capital city (where the central
government officials reside), but fail to provide any substantial public services
outside the large urban areas.

In order to reduce the centralized nature of government, governments could do
three things: deconcentrate, delegate or decentralize. Deconcentration is the
process of shifting decision-making power within the central government
structure from central government officials in the capital to central government
officials that are located outside the capital, at the regional or local level.
Delegation is the process of shifting expenditure responsibilities from the central
government to semi-autonomous government bodies that are not wholly
controlled by the central government, but that are still ultimately accountable to it.

2
Regional level governments are called different names in different countries. They may be
called regional governments, states, provinces, territories, oblasts, or Lnder. Similarly, local
governments include different types of local authorities, including county or district governments,
municipalities, city or town governments, commune, village or townships, school district
governments, or special function district governments.




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Fiscal decentralization is the assignment of fiscal decision-making powers and
management responsibilities to lower levels of government. This definition
implicitly assumes that local governments have a certain degree of fiscal
discretion of autonomy, and that subnational governments are primarily
accountable to their regional or local constituents. Note that neither
deconcentration nor delegation provides local governments with real decision-
making power, as local governments continue to be first and foremost accountable
to the center, as opposed to being accountable to the local populace that they
serve.

Thus, an important pre-condition of fiscal decentralization is political
decentralization. Political decentralization aims to decentralize political power by
establishing semi-autonomous subnational government bodies that have a
corporate charter (they should be able to hold property, generate revenue and
incur expenditures) and that are politically accountable to the local electorate. Of
course, regional and local governments cannot be completely autonomous from
the central government, because they need to operate within the larger public
sector. As such, subnational governments should act within the legal and
administrative framework established by the higher-level government.

It should be noted that fiscal decentralization is relevant to all countries,
regardless whether they are unitary countries, federal countries or confederations.
Of course, the political and legislative context varies within each of these three
groups. In a unitary country, all subnational governments are subordinate to the
central government; the central government has absolute authority over
subnational governments in a unitary state, and subnational governments exist
solely at the discretion of the central government. In federal countries, the federal
constitution defines the power relationship between the different levels of
government. Often federal constitutions provide regional-level governments with
rights that cannot be abrogated by the federal government. However, in many
federal countries, local governments do not have the same level of autonomy as
states, as they are frequently creations of (and accountable to) either federal or
state governments. The power base of confederations lies at the regional (or state)
level, as defined in the confederate constitution; the confederation government
acts based on the rights assigned to it by the virtue of the collective regions.






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What are the dimensions of fiscal decentralization?
Experts consider that intergovernmental fiscal relations or fiscal decentralization
reforms can be divided into several interrelated dimensions. In sequence, the four
building blocks or pillars of fiscal decentralization are:

1. The assignment of expenditure responsibilities: what are the functions and
expenditure responsibilities of each level of government?
2. Assignment of tax sources: once subnational governments are assigned certain
expenditure responsibilities, which tax or non-tax revenue sources will be made
available to subnational governments in order to provide them with resources?
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. Subnational deficits, borrowing and
debt: if subnational governments do not
carefully balance their annual expenditures
with revenues and transfers, this will result
in subnational deficits and the incurrence
of debt. Since this would have important
ramifications for national macroeconomic
conditions, central governments often
require subnational governments to
balance their budgets of tightly regulate
their ability to hold debt.




Assignment of expenditure responsibility. The key principle in determining
which level of government should do what in a fiscally decentralized system of
governance is known as the subsidiarity principle. This principle suggests that
government services should be provided at the lowest level of government that is
capable of efficiently providing this good or service. This principle results in a
situation where, as much as possible, the area where the benefits of a government
service are felt coincides with the government boundaries at each level of
government. For instance, since national defense benefits people in the national
territory of a country, this expenditure function should be a national affair funded
by the central government. However, since the benefits from a local park are
Figure 1
The Four Pillars of
Fiscal Decentralization




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mostly felt by local residents, the responsibility for local parks should be placed
with local governments.

The subsidiarity principle suggests that three types of activities are best performed
or funded by central governments: (1) provision of public goods and services that
benefit the entire nation; (2) income redistribution or social policies, and (3)
government activities that involve spillovers or externalities between districts.
Subnational governments would not be able to effectively engage in income
redistribution programs for two reasons: first, by their very nature subnational
governments would not be able to address income differentials between regions
(which are often quite substantial) and, second, wealthy households and firms
would have an incentive to move away from subnational jurisdictions that engage
in income redistribution. Similarly, it can be shown that subnational governments
produce inefficient levels of certain public goods if these activities involve
spillovers benefits (or costs) in neighboring jurisdictions. For instance, while
residents of a locality are the primary beneficiaries of local immunization
programs, surrounding local governments also benefit from this immunization
program by reducing their risk of contagious diseases spilling over from the
neighboring jurisdiction. If local public health would be left solely to the
discretion of local governments, localities would likely under-fund these
programs because in their cost-benefit analysis local governments would ignore
the benefits that accrue to the residents of neighboring localities.

It is important to recognize that the assignment of expenditure responsibility
actually has a multi-dimensional component: expenditure responsibility is often
broken down into the responsibility to provide, finance, and regulate a certain
government function. For example, while local governments often provide
elementary education, higher-level governments often share the responsibility of
financing and regulating local education. Thus, additional policy issues need to be
resolved if the responsibilities to provide, finance and regulate a certain
government function do not all fall within the jurisdiction of a single level of
government in order to assure that different levels of government effective work
together

While there is no single best assignment of expenditure responsibilities,
government functions typically provided by central governments include national
defense, national social policy and inter-regional transportation networks.
Examples of government services typically provided by subnational (regional or
local) governments include primary and secondary education, primary health care,
and local streets and public infrastructure.





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Assignment of tax resources. Once the assignment of expenditure responsibility
has been determined, the second key question is: who gets what resources?
Obviously, an important determinant of the assignment of revenue sources to
subnational governments is the assignment of expenditure responsibilities, giving
rise to the adage: finance should follow function.

In addition to determining how much revenue subnational governments need, it is
also of important to consider which revenues sources local governments should
receive. Some taxes are better suited for local governments, while others are
better for national governments. For instance, we would like local governments
to be assigned stable sources of revenue. Local taxes should be easy to administer
and it should be easy to separate the tax base (the base that is being taxed, such as
property of income) across jurisdictions. In addition, it is preferable if local taxes
are related somehow to benefits received by local residents. As a result, examples
of good local revenue sources include real estate property taxes, retail sales taxes,
business fees, regional personal income taxes, motor vehicle fees, and user
charges. Revenue sources that are often considered bad local taxes include the
value-added tax (VAT), corporate income taxes, and trade (import/export) taxes.

One problem regarding the assignment of revenue sources in many countries is
that while subnational governments need to have at least some revenue discretion
in order to fully benefit from fiscal decentralization reforms, central governments
often seem unwilling to provide any degree of real revenue autonomy to
subnational governments. In these cases, intergovernmental fiscal transfers
become necessary to ensure that subnational government have adequate revenues
to fulfill their expenditure responsibilities.

Intergovernmental fiscal transfers. Since revenue assignment often do not
provide regional and local governments with sufficient revenues to fund their
expenditure functions, intergovernmental transfers are often necessary to assure
revenue adequacy. Transfers are grants from one level of government to another
(often from higher to lower governments) for the purpose of funding government
activities. The term transfer is often used interchangeably with the term
grant. In some countries, transfers may also be known under different names
such as subventions or subsidies.

Transfers come in a variety of forms depending on the purpose for which they are
used. For instance, transfers can be unconditional or unconditional (targeted)
transfers. Transfers can come as block grant, as a reimbursement of actual local




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expenditures, or matching in some proportion to local government expenditures.
Transfers can even come in the form of revenue sharing, where the subnational
government receives a share of certain revenues collected within its boundaries.
Revenue sharing is considered a form of transfers because the local government
has no control over the tax base, the tax rate, tax collections, or the sharing rate.

Transfers can be used for a wide variety of purposes. They can be used to assure
vertical fiscal balance (assuring a balance between the fiscal needs and resources
available to different levels of government), horizontal fiscal balance (assuring
fiscal balance in resource allocations between government units at the same
level), to fund specific national priorities or to counteract the effects of inter-
regional spillovers or externalities. Transfers can also be used to compensate
subnational governments for complying with central government mandates or
implementing central government programs that are delegated to the subnational
level. Unfortunately, despite many good fiscal policy applications for
intergovernmental transfers, in practice transfers are often used simply for a
political reason: to assure central government control over local government
activities.

Subnational deficits, borrowing and debt financing. The final pillar of fiscal
decentralization is a logical corollary to the first three pillars. A local
governments fiscal balance can be defined as the difference between its
expenditure responsibilities on one hand and its own source revenues and
transfers on the other hand. If for any local government expenditure needs are not
properly balanced with the resources available to it, this could result in
subnational deficits and the incurrence of debt. Of course, just like central
government debt, the incurrence of substantial debts by subnational governments
would have the potential of driving up interest rates and crowding out private
sector investments. Since this would have important ramifications for
macroeconomic conditions and the ability of the central government to rely on
fiscal policy as a tool to manage macro-economic conditions, central governments
often require subnational governments to balance their budgets of tightly regulate
their ability to hold debt.


What are the advantages and disadvantages
of decentralization?
Intergovernmental fiscal relations are relevant to each and every country, and
fiscal decentralization reforms are being discussed virtually worldwide. Fiscal
decentralization is being discussed not only in large countries such as Russia and




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Indonesia, but also in small countries such as Latvia, Malawi and Suriname.
Fiscal decentralization is an issue in wealthy, developed countries, as well as in
developing and transitional economies. However, decentralization means many
different things to different people. Naturally, the benefits and disadvantages of
fiscal decentralization will vary greatly with the intended objectives. Possible
arguments in favor of fiscal decentralization include:

q The mix of services provided will better match the demands of the local
population.
q Government officials will become more accountable to voters for the
quality of services they provide.
q Local populations will be more willing to pay for public services, since
their preferences will be honored.
q Decentralization may enhance revenue mobilization, as local governments
may be in a better position to raise certain types of revenues
q Decentralization allows fiscal experiments in regions, thereby creating an
environment for fiscal and budgetary innovations.
q Politically, a decentralized system of governance may be considered more
democratic.
q Politically, decentralized governance might accommodate calls for greater
regional autonomy and thus prevent centrifugal forces and national
fragmentation.
These possible advantages do not apply equally across the board. These
arguments, particularly the efficiency argument, are not always valid in the real
world. Can local governments actually respond to citizens preferences for more
or few local services, or to a willingness to pay more tax to receive local services?
This is not often the case in developing and transition countries. This is partly
because voter preferences are not as readily translated into budget outcomes as in
industrial countries. Local councils are often not elected, chief officials are often
not locally appointed, and adjustments in the allocation of local resources are
often severely constrained by central government controls. These controls include
approval of the budget, central appointment of chief local government officers,
central government regulation of tax administration, mandates as to salary levels
of local government employees, and the general absence of a mechanism by
which local voters can reveal their preferences for a larger or smaller government.
In this setting -- where the devolution of revenue authority and expenditure
responsibility is not accompanied by a relaxation of central government control
over local fiscal decision making -- there is less to be gained from
decentralization of taxes and expenditure than would be the case in industrial
countries.




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Given this state of affairs, the situation in a transition or a developing country
which could give maximum gains from a more decentralized local government
structure would include: (a) enough skilled labor, access to materials, and capital
to expand public service delivery when desired, (b) an efficient tax
administration, (c) taxing power sufficient to capture significant portions of
community income increments, (d) an income-elastic demand for public services,
(e) popularly elected local officials, and (f) some local discretion in shaping the
budget and setting the tax rate. When these conditions are present, it is usually in
the wealthier provinces of lower income and transition countries. This suggests
that fiscal decentralization initiatives might have their best chance of success in
the higher income regions and might initially be limited to such places. This
would not likely be a politically popular feature of a decentralization reform
movement.

On the other hand, there are also arguments against decentralization (i.e.,
arguments for a more centralized government structure). These arguments
include:

q Central government control results in more control over overall fiscal
policy, economic stability and macroeconomic conditions.
q Building national infrastructure
q Better central grip over income distribution
q Politically, fiscal decentralization might discourage national unity;
decentralization reforms might lead to calls for even greater regional
autonomy and ultimately, possibly, regional independence.
Again, the validity of arguments against fiscal decentralization vary in different
settings. However, in many cases the arguments in favor of fiscal centralization
are stronger in transition and developing than in industrial countries. History has
shown that stabilization policy is an especially important concern in developing
economies and in those economies that are in transition to a capitalist system.
This argues for central government control of the main fiscal instruments
(taxation, spending, and borrowing). Under a highly decentralized system where
the local governments have a built-in claim on a share of total revenues raised, the
central government will find itself in a difficult position insofar as increasing
revenues to reduce the total deficit, or passing structural tax reforms that might be
aimed at stimulating savings or reducing imports. By the same token, controlling
inflation by limiting government spending may be compromised if local
governments have the power to set their own budgets.




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A related issue is the relationship between control of the central government
budget deficit and intergovernmental fiscal relations. Where the central
government has power over all the major fiscal instruments, it can target on an
acceptable level of the deficit and control this with either tax increases or
expenditure control. In more decentralized countries, central governments
experiencing deficits are tempted to try and off-load their shortfalls onto local
governments by reducing grants or other subsidies. This has been the case in the
United States for the past few years, and in present day Russia. Countries with
chronic deficit problems would do well to avoid the dilemma of policy makers
being unable to disentangle the question of what to do about the central deficit
from the question of what is the right fiscal balance between the central and local
governments.
In transition countries that are undergoing privatization and building a public and
industrial infrastructure, the need for a coherent investment policy is also an
argument for fiscal centralization, because capital resources are scarce and must
be controlled by the central government to maximize returns. If local governments
are given access to major tax bases, they may compete with the central
government and therefore limit the amount available for the central tax. As a
corollary, centralization allows the national government to allocate fiscal
resources to goods and services with national benefits, whereas local autonomy
would inevitably lead to greater expenditures on those services that have more
local benefits.
Several arguments for income distribution also support fiscal centralization. The
most important is that regional (and rural-urban) disparities in income and wealth
may be accentuated by fiscal decentralization because wealthier urban
governments will benefit most from greater local taxing powers. Centralization
allows the national government more discretion in shaping regional differences in
levels of public service and taxation, which is an especially important
consideration for governments that intend to use tax and subsidy policy to shape
the spatial distribution of economic development. China, Russia, and the U.S. are
all characterized by significant fiscal disparities. China and Russia in particular
have faced difficult choices regarding equalization. China was forced to choose
between funneling more resources to the lower income provinces and leaving the
revenues in the higher income coastal provinces. Russia has faced the difficult
decision of choosing among equalization, central government fiscal solvency, and
appeasing the potential breakaway provinces. In both cases, the central
government retained control over the fiscal resources and was in a position to
make the important policy decision.





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Concluding remarks
The study of intergovernmental fiscal relations is an incredibly important and
broad field of study. The breakdown of fiscal decentralization into four
dimensions or pillars is helpful in starting to consider the impact of fiscal
decentralization on the fiscal structure of a country, but it is only a first step in
analyzing the full scope of such reforms. From a policy perspective, these pillars
can be further separated into three phases: policy design, policy implementation
and policy evaluation. A solid understanding of each of these dimensions is
absolutely crucial for government officials, policy makers and other stakeholders
to assure success in decentralization reforms.

Not only is the field of intergovernmental fiscal relations broad in itself, fiscal
decentralization is also closely entangled with other policy areas, such as national
macroeconomic policy, tax policy and tax administration, and local governance.
A sound understanding of the interrelationship between fiscal decentralization and
these other policy fields is equally important to the successful implementation of a
fiscal decentralization strategy.


Selected readings

q Roy Bahl. 1999. Implementation Rules for Fiscal Decentralization.
International Studies Program Working Paper 99-1. Atlanta: Andrew
Young School of Policy Studies, Georgia State University.

q Jennie Litvack, Junaid Ahmad and Richard Bird. 1999. Rethinking
Decentralization at the World Bank: A Discussion Paper. Internet
Document: <www.worldbank.org>.

q Jennie Litvack and Jessica Seddon (eds.) 1999. Decentralization Briefing
Notes. WBI Working Paper Series. Washington: World Bank Institute.