Lessons from International
Practices of Intergovernmental
Fiscal Transfers
Anwar Shah, World Bank
XVI Regional Seminar on Fiscal Policy
CEPAL/ECLAC, Santiago de Chile
January 26-29, 2004
Anwar Shah, World Bank
Instruments of intergovernmental
finance
• Unconditional vs conditional transfers
– Unconditional: preserving local autonomy and enhancing interjurisdictional equity
– Conditional: providing incentives to undertake specific activities
• Conditional Transfers
–
–
–
–
matching vs non-matching
open-ended vs. closed-ended matching
Input based conditionality vs output based conditionality
Input based conditionality often intrusive and unproductive.
Output based conditionality can advance grantor’s
objectives while preserving local autonomy
Anwar Shah, World Bank
Perceptions on intergovernmental
finance are generally negative
• Federal/Central : Giving money and
power to sub-national governments is like
giving whiskey and car keys to teenagers
• Provincial and Local : We need more
grant monies to demonstrate that “money
does not buy anything”.
• Citizens: The magical art of passing
currency from one government to another
and seeing it vanish in thin air.
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Ironically these perceptions are
well grounded in reality in LDCs
• Primary focus on dividing the spoils
• Passing the buck transfers – revenue sharing with
multiple factors (Brazil, Argentina, India, RSA,
Philippines and more)
• Asking for more trouble grants – deficit grants
(Hungary, India, and more)
• Pork barrel transfers or political bribes (Brazil, India,
Pakistan, USA)
• Command and control transfers (most countries)
• Overall: Intergovernmental finance is the
dominant source of revenue but creates
perverse incentives for fiscal management
and accountability
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No need to despair ….
As properly designed fiscal
transfers can be part of the
solution rather than part of
the problem.
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Governance Structure:
20th Versus 21st Century









Unitary
Centralized
Center manages
Bureaucratic
Focused on inputs
Command and control
Internally dependent
Closed and slow
Intolerance of risk









Federal / confederal
Globalized & localized
Center leads
Participatory
Results matter
Responsive and Accountable
Competitive
Open and quick
Freedom to fail/ succeed
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From Dividing the Spoils to Creating An
Enabling Environment for Responsive
and Accountable Local Governance
• Tax Decentralization
• Output based fiscal transfers
– operating
– capital
• Fiscal equalization transfers
• Responsible borrowing
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Considerations in the Design of
Fiscal Transfers
 Consistency of design with a single objective
 Simple and transparent allocation criteria
 Create incentives for competitive service delivery and
support citizen-centered governance
 Provide incentives for fiscal prudence
 Ensure flexibility in use but accountability for results
 Stable and predictable
 Equitable ( entitlements vary inversely with fiscal
capacity and directly with fiscal needs)
 One size does not fit all – urban vs. rural, large vs. small
 Sunset clauses to ensure periodic review and
assessment
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Objective
Grant
Design
Better
Practices
Practices
to Avoid
Fiscal Gap
Reassign, tax
base sharing
Canada
Deficit grants, tax
by tax sharing
Regional fiscal
disparities
Fiscal capacity
equalization
Australia,
Canada,
Germany,
Denmark, ECA
General revenue
sharing with
multiple factors
Setting national
minimum standard
Block transfers,
Ex-Indonesian
roads and
education, Chile
Conditions on
spending
Benefit spillovers
Matching grant
S. Africa teaching
hospitals
Influencing local
priorities
Open-ended
matching
Canada social
assistance
Stabilization
Capital grant with
conditions on
service standards
Political and
upkeep Anwar Shah, World
policy
risk
Bank
requirements
guarantee
Ad hoc grants
Stabilization
without upkeep
Transfers to deal with fiscal gap

Fiscal Gap: Structural imbalance as a result of a
mismatch between revenue means and expenditure
needs.
Reasons:
Inappropriate assign: Reassign
Limited tax bases: Allow joint occupancy or tax
decentralization.
Tax competition: Federal collection and general (not on
a tax-by-tax basis) revenue sharing.
Tax room lacking: Tax abatement and tax base sharing
(Canada ).
Practices to avoid: deficit grants; tax by tax sharing.
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Transfers to set national
minimum standards
 Rationale:
 National economic union or internal common market
 Redistributive role of the public sector and the national
government
 Design: conditional non-matching block transfers with
conditions on standards of service and access.
 Better practices: Indonesia roads and primary
education grants; Colombia and Chile education
transfers; Canada health and post-secondary
education transfers.
 Practices to avoid: Conditional transfers with
conditions on spending; ad hoc grants.
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An Example: Education grant to encourage
competition and innovation
 Allocation basis to state/local governments:
Population aged 5-17
 Distribution basis to providers: Equal per pupil to
both public and private schools
 Conditions: Universal access to primary and
secondary education. Private school access to poor
on merit. Improvements in achievement scores and
graduation rates. No conditions on the use of funds
 Penalties: Public censure, reduction of grants funds
and termination
 Incentives: Retention of savings
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Indonesia - Specific Purpose Transfers to Local
Governments (now defunct)
L2. District/Town Road Improvement Grant
 Length
of roads
 Condition
 Density
 Unit cost
L3. Primary School Grant
 School
age children (ages 7-12)
 Needs for facilities
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Federal financing of health care
in Canada
Per capita transfers tied to rate of growth of GDP (plus transfer of
tax points - for health and post secondary education in
1977,13.5% points of PIT and 1% point of CIT)
Conditions:
(1) Universality
(2) Portability
(3) Public insurance but public/private provision
(4) Opting in and out
(5) No extra billing
Penalties:
Threat of discontinuation for breach of the conditions (1)- (4)
above.
Dollar for dollar reduction for breach of the condition (5).
Sunset clause: Parliamentary review every 5 years.
Anwar Shah, World Bank
Fiscal Equalization Transfers:
Rationale
• Political : Large regional fiscal disparities can be
politically divisive. May even create threat of
secession. Fiscal equalization grants to create a
sense of political unity
• Makes it possible for all citizens to be treated
alike regardless of the places of residence.
Thereby advances social justice ( fiscal equity)
and efficiency in market resource allocation
(fiscal efficiency).
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Transfers to reduce regional
fiscal disparities
 Design: General non-matching fiscal capacity equalization
transfers.
 Better practices: Fiscal equalization programs (sources of data:
CGC, Finance Canada, Lotz, Shah & Spahn)
 Paternal: Australia (fiscal capacity plus fiscal needs) and Canada
(fiscal capacity only)
 Solidarity, Fraternal or Robin Hood: Germany (fiscal capacity),
Sweden, Denmark
 Practices to avoid: General revenue sharing with multiple factors
e.g. practices in Brazil, India and South Africa.
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Fiscal
Australia
Equalization
Program
Canada
Germany
Legal
Status
Constitution
Constitution
Paternal
Solidarity
Formula
Formula
Law
Paternal or Paternal
Solidarity
Total Pool
Ad hoc
determination
Allocation
Formula
Formula
Formula
Fiscal
capacity
equalization
Yes, RTS
Yes, RTS
Yes, RTS
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Fiscal
Australia
Equalization
Program
Fiscal Need Yes, RES
Equalization
Canada
Germany
No
No
Program
High
Complexity
Low
Medium
Political
No
Consensus
Yes
May be ?
Who
Independent
recommends agency
Intergov.
Committees
Bundesrat
Dispute
resolution
Supreme
Court
Constitutional
court
Supreme
court
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A Representative Tax System approach
to fiscal capacity equalization
Equalization from revenenue source i =
National
average
tax ratei
Per capita
base in
all statesi
—
State’s
own base
per capitai
=
Per capita
potential
revenue in —
All states (i)
Per capita
standardized
revenue in
state A (i)
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A Representative Expenditure System approach to
Fiscal Need Equalization
Equalization entitlement from expenditure category i
EQUALS
Per capita potential expenditure of State A for category i
based upon own need factors if it had national average
fiscal capacity
MINUS
Per capita potential expenditure of State A on expenditure
category i if it had national average need factors and
national average fiscal capacity
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Federal Fiscal Equalization Program of
Canada is enshrined in the constitution
____________________________________
__
Canada Constitution Act 1982, Article 36.(2)
Parliament and the Government of Canada are
committed to the principle of making
equalization; payments to ensure that
provincial governments have sufficient
revenues to provide reasonably comparable
levels of services at reasonably comparable
levels of taxation.
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Anwar Shah, World Bank
An Example of Expenditure Need Determination in Australia:
Secondary Education Expenditure Need Factors
Table 4 - Government Secondary Education Factors - 1995-96
Disability Factors
NSW
Vic
Qld
WA
Dispersion
0.9973 0.9921 1.0093 1.0106 0.9972 0.9952 0.9885 1.0710
Grade Cost
1.0014 1.0028 0.9966 0.9950 0.9992 0.9998 1.0016 0.9979
Input Costs
1.0120 0.9950 0.9860 1.0030 0.9910 0.9900 1.0080 1.0340
Relevant Population
0.9749 0.8874 1.0983 1.1639 0.9679 1.1422 0.9750 1.2226
Administrative Scale
0.9946 0.9946 0.9946 1.0065 1.0105 1.0304 1.0463 1.1139
Service Delivery Scale
0.9922 0.9906 1.0031 1.0153 1.0166 1.0380 0.9714 1.1141
Vandalism & Security
1.0023 1.0023 0.9973 0.9973 0.9973 0.9923 0.9923 0.9923
Cross-border
0.9965 1.0001 1.0001 1.0001 1.0001 1.0001 1.0660 1.0001
Category Disability
0.9692 0.8658 1.0815 1.1941 0.9772 1.1917 1.0440 1.6605
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SA
Tas
ACT
NT
Figure 3 - Australia - Relative Cost of Service Provision Ratios - 1995-96
274
275
250
225
200
175
150
125
100
98
92
99
109
101
109
93
75
NSW
VIC
Qld
WA
SA
Tas
ACT
NT
Figure 4 – Australia - Relative Revenue Raising Capacity Ratios - 1995-96
125
113
106
104
96
100
98
92
88
77
75
50
NSW
VIC
Qld
WA
SA
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Tas
ACT
NT
Germany
Germany :: How
How does
does the
the
Finanzausgleich
Finanzausgleich work
work ??
• A fiscal capacity yardstick is defined per
capita (national average with modifications)
• Each State’s fiscal capacity per capita is
measured against this yardstick
• ‘Poor’ States obtain 95 % of fiscal yardstick
• ‘Rich’ States pay in progressive steps
• The Finanzausgleich is a pure horizontal
clearing mechanism
The World Bank
TWURD
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How
How does
does the
the Finanzausgleich
Finanzausgleich
work
work ?? (2)
(2)
'Marginal levy' on State fiscal capacity in excess of
average fiscal capacity
118
State per
capita 115
fiscal 112
capacity
relative to 109
average 106
per capita
fiscal 103
capacity 100
0
20
40
Marginal rate in percent
The World Bank
TWURD
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60
80
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Denmark: Equalization models and
standards
Equalization
type
Counties
Fiscal
capacity
85% Robin 90% Robin 50%
Hood
Hood
central
grant
85% Robin 60% Robin 35% Robin
Hood
Hood
Hood
Fiscal
Needs
Metropolitan
areas
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Local
Govts.
Institutional Arrangements for
Fiscal Transfers
• Intergovernmental committees: Canada,
Germany (with strong role of Bundesrat)
• Independent grant commissions: Australia
(permanent secretariat), India (limited
duration) and South Africa (permanent)
• Intergovernmental cum civil society
commissions: Pakistan (limited duration)
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Fiscal Equalization Grants: Some
Lessons
• Fiscal capacity equalization with an explicit standard is
desirable and do-able in most countries.
• Fiscal need equalization is much more complex –
desirable but may not be worth doing. Rough justice may
be better than precise justice.
• For local equalization – one size does not fit all.
• Important to have societal consensus on the standard of
equalization
• Must have a sunset clause and provision for a review
and renewal
• Institutional arrangements for a continuous review and
periodic revision
Anwar Shah, World Bank
Negative Lessons: Practices to
Avoid
• General revenue sharing with multiple
factors
• Deficit grants
• Fiscal Effort Provisions
• Input or process based or ad hoc grants
• Capital grants without assurance for
upkeep
• Negotiated or discretionary transfers
Anwar Shah, World Bank
Positive Lessons: Practices to
Strive For
•
•
•
•
K.I.S. (keep it simple)
Focus on single objective
Introduce sunset clause
Output based conditional transfers with citizens’
evaluations
• Fiscal capacity equalization to a defined
standard
• Political consensus on the standard of
equalization
• Institutional arrangements for broad based
consultation
Anwar Shah, World Bank