Principles for
Designing Transfers
Jorge Martinez-Vazquez
Georgia State University
The Challenge of Designing Intergovernmental Fiscal Transfers in
Bolivia
The World Bank Institute
Rationales for Intergovernmental
Transfers





Vertical imbalances
Horizontal imbalances
Externalities (inter-jurisdictional spillovers)
Enhancing national objectives at the
subnational level
Paying for national programs implemented by
subnational governments
Features of a Good Transfer
System

Promote budget autonomy at the
subnational level
– Lump-sum versus conditional transfers

Provide adequate revenue to
subnational governments
– Transfers are not a substitute for revenue
assignments
– The role of revenue sharing
Features of a Good Transfer
System (cont.)

Provide positive incentives
– Encourage tax effort and revenue
mobilization
– Promote expenditure efficiency
– Discourage fiscal deficits or a “soft budget
constraint”
Features of a Good Transfer
System (cont.)

Enhance equity and fairness
– Overall, transfers increase with fiscal
(expenditure) needs and decrease with
fiscal (revenue) capacity
Stability
 Transparency
 Simplicity

Types of Intergovernmental
Grants
Unconditional or lump-sum
 Categorical or conditional (for capital
and/or recurrent expenditures)

– Non-matching
– Matching
• Open-ended
• Close-ended

Direct cost reimbursement
Designing Transfer Systems:
Determining Pool of Funds
Ad hoc at budget time
 Using rules

– Percent of central government total
revenues
– Percent of some types of central revenues

Direct reimbursement
Funding Approaches

Vertical funding: the center provides the
funds)

Horizontal (“Robin Hood”) funding:
subnational governments provide some
funds
Design of a Transfer System:
Distribution of Funds
Ad hoc
 Formula
 Cost reimbursement
 Competition
 Derivation basis

Design of a Transfer System:
Institutional Requirements

Data requirements
 Institutional responsibility for design and
monitoring
– Central government agencies (micromanagement)
– An independent “Grants Commission”

Developing subnational capacity
 Phasing-in to hold (partially) harmless
 Periodic evaluation
Economic Impact of Grants

Potentially substantial impact on level and
composition of subnational spending
 Lump-sum grants tend to increase spending more
than an equal increase in aggregate local income
(“flypaper effect”)
 Unconditional grants have an income effect
 Conditional grants have a restricted income or
“voucher” effect
 Matching, conditional grants tend to be most
stimulative because of an added price effect
(matching rates can be made to vary across
jurisdictions by fiscal capacity, etc)
Types of Conditional Grants






Recurrent versus capital expenditures
Transitional or special purpose versus permanent
needs
Block grants versus restricted grants
Spend the funds any way you want to as long as
they are spent on a particular type of good
Impose service standards, minimum expenditure
requirements, access levels and other
restrictions on the use of funds
Conditional grant programs often spell out in
great detail how funds must be spent
Issues in the Design of
Conditional Grants




Pursuing too many conflicting objectives:
explicitly address priorities or use different grants
Local spending is most responsive to matching
arrangements and minimum expenditure
mandates: which to use?
Without matching arrangements, minimum
expenditure mandates may be needed to prevent
retrenchment in expenditure effort
Use of fiscal capacity in the formulas helps
leverage central government resources
What are Equalization Grants?

Unconditional, general purpose transfers

Total amount of fund typically determined by
a funding rule

Total amount or divisible pool of funds
distributed among regional and local
governments based on a formula that
considers expenditure needs and/or local
revenue-raising ability (fiscal capacity)
Purposes of Equalization Grants

Restore horizontal balance by equalizing
fiscal conditions among subnational
governments

Contribute to closing vertical imbalances (the
differences in expenditure needs and revenue
availability for the central and subnational
governments)

Contribute to “nation building”
How Simple: Why Not Give Local
Governments “What They Need”?

Can’t we just do the following?
Transfer regioni =
Actual expenditures regioni – Actual
revenues region i

Center may not have funds to fill entire
gap
How Simple: Why Not Give Local
Governments “What They Need”?
(cont.)

Actual expenditures generally do not equal
needs

Actual revenues generally do not reflect
ability to collect revenues (fiscal capacity)

Negative incentives will be provided: local
governments will collect lower revenues on
their own and will not use prudence in
establishing expenditures.
Components of an Equalization
Mechanism

Determine exact objective(s) of equalization:
what should be equalized and by how much

Determine sources (central government
revenues versus fraternal [“Robin Hood”]
contributions)

Determine size of equalization fund (vertical
allocation of resources): stable rule versus ad
hoc determination
Components of an Equalization
Mechanism (cont.)

Determine the equalization mechanism
(formula)

Determine the variables or allocation factors
that will be used (i.e., measures of fiscal
capacity, fiscal need, fiscal effort)

Adjustment of actual payments for other
transfers?

Simulation, implementation, and evaluation
Universal Principles for
Equalization Grants

Fund should provide adequate
resources; balance national priorities
and local autonomy

Fund should be distributed in equalizing
manner

Allocation should be predictable over
time
Universal Principles for
Equalization Grants (cont.)

Mechanism should be simple and
transparent

Mechanism should use reliable and
generally accepted data

Approach should avoid negative
incentives
Universal Principles for
Equalization Grants (cont.)

Grants should be unconditional

Reform should avoid sudden large
changes (or use a “hold harmless” or a
phase-in approach)

Use separate funds for regional and
local governments
Desirable Characteristics for
Allocation Factors

Accurately reflect specific
characteristics (i.e, statistically sound)

Regularly updated in the future (every
1-2 years)

Come from an independent source
respected by all stakeholders
Desirable Characteristics for
Allocation Factors (cont.)

Be drawn from a source that cannot be
manipulated by the central government
or one or more local governments

Reflect needs or demands for public
goods (e.g., number of clients) rather
than outputs such as infrastructure
Goals for Capital Transfer
Address externalities across local
governments
 Assist in financing “lumpy” capital
investments
 Offset significantly different
infrastructure endowments (when these
are not the result of voluntary decisions)
 Pursue sectoral objectives

Capital Transfers: Issues and
Constraints

Is there a bias? Do central authorities believe
capital expenditures are always more efficient
than recurrent expenditures?
 How to achieve “additionality” or
“maintenance of effort”? (Earmarking and the
fungibility of funds)
 Will local governments take ownership and
maintain the infrastructure? (The use of
matching arrangements).
Flexibility in Use of Capital
Grants
Project-based grants: closely
administered and monitored by line
ministries
 Use of categorical or block grants

Allocation of Capital Grants

Ad hoc decisions and negotiation (e.g., Italy
until recently, many countries in transition)
 Use of a pre-established formula (e.g.,
Australia funds schools building by no. of
students and price/cost factors) (not always
feasible)
 Use of a competition process with defined
application procedures (possibly subject to
manipulation)
Design of Capital Transfers:
Summary
No single best approach to design
capital transfers.
 However, non-transparent, highly
detailed and discretionary procedures
should be avoided.
 Matching requirements carry many
benefits.
