Issues in Program Design
Contributor: World Bank
Author: Decentralization Thematic Team
Contact: Jennie Litvack
Intergovernmental Transfers/Grants Design
Intergovernmental transfers are the dominant source of revenues for subnational governments in most developing countries. The design of these transfers is of critical importance for efficiency and equity of local service provision and fiscal health of subnational goverments.
For the purpose of economic analysis, grants can be broadly classified into two categories: non-matching and selective matching.
Non-matching transfers may be either selective (conditional) or general (unconditional).
Selective non-matching transfers offer a given amount of funds without local matching, provided they are spent for a particular purpose. Such conditionality will ensure that the recipient governments spending on the specified category will be at least equal to the amount of grant monies. If the recipient is already spending an amount equal to grant funds, some or all of the grant funds may be diverted to other uses. In theory, due to fungibility of funds, increase in expenditures on the specified category would only at the limit equal to grant funds; in practice it is possible that the lumpiness of investments in areas such as infrastructure may result in increases in expenditures exceeding grants.
If the non-matching grant is unconditional or general, no constraints are put on how it is spent and unlike conditional grants, no minimum expenditure in any area is expected. Since the grant can be spent on any combination of public goods or services or to provide tax relief to residents, general non-matching assistance does not modify relative prices and is the least stimulative of local spending.
In some empirical studies, it has been observed that the portion of these grants retained for greater local spending tends to exceed local governments own revenue relative to residents income; that is grant money tends to stick where it first lands. This is referred to as the "flypaper effect." The implication is that for political, technical and bureaucratic reasons, grants to local governments tend to result in more local spending than if the same transfers were made directly to local residents.
We can identify five broad economic arguments for central-state transfers each of which is
based on either efficiency or equity, and each of which may apply to varying degrees in actual federal economies.
An imbalance between the revenue-raising ability of subnational governments and their expenditure responsibilities (the "vertical imbalance") might arise for two reasons. First, there may be (often inappropriate) assignment of taxing and spending responsibilities such that expenditure needs of subnational governments exceed their revenue means. Second, many taxes are more efficiently collected at the central level responsibilities to avoid tax competition and interstate tax distortions, so transfers are necessary to enable local levels to carry out their expenditure responsibilities.
A country which values horizontal equity (i.e., the equal treatment of all citizens nationwide) will need to correct the fiscal inequity which naturally arises in a decentralized country. Subnational governments with their own expenditure and taxation responsibilities will be able to provide their residents different levels of services for the same fiscal effort owing to their differing fiscal capacities. If desired, these differences may be reduced or eliminated if the transfers to each jurisdiction depend upon its tax capacity relative to others, and upon the relative need for and cost of providing public services.
The argument for such transfers is reinforced by the fact that the same differentials which give rise to fiscal inequity also cause fiscal inefficiency.
This is the traditional argument for matching conditional grants. Normally, subnational governments will not have the proper incentive to provide the correct levels of services which yield spillover across jurisdictions. In theory, a system of matching grants based on the expenditures giving rise to the spillovers will provide the incentive to increase expenditures. In practice, the extent of the spillover will be difficult to measure so the correct matching rate to use will be somewhat arbitrary.
To the extent that the central government is interested in redistribution as a goal, there is a national interest in redistribution that occurs via the provision of public services by the subnational governments. Expenditure harmonization can be accomplished by the use of (non-matching) conditional grants, provided the conditions reflect national efficiency and equity concerns, and where there is a financial penalty associated with failure to comply with any of the conditions. In choosing such policies there will always be a trade-off between uniformity, which may encourage the free flow of goods and factors, and decentralization which may encourage innovation, efficiency and accountability.
As Bahl and Linn (1992) show and as discussed earlier, the most appropriate form of a transfer depends in large part upon its objective. (See Chart) Regardless of the particular design, however, experience demonstrates that good intergovernmental transfer programs have certain characteristics in common:
Many countries attempt to achieve various of the objectives ascribed above to transfers through systems variously described as "tax sharing" or "revenue sharing." While there are a wide variety of such systems, most of them - perhaps most markedly in the transitional countries - suffer from several common problems. First, if they are partial, that is, do not apply to all national taxes but only to a subset of such taxes, they may bias national tax policy. Second, if - as is often the case - they share the revenues from origin-based (production) taxes to the jurisdictions from which the revenues are collected, they break the desirable link between benefits and costs at the local level and hence reduce accountability and the efficiency of decentralization. Third, since in such systems tax rates are invariably set by the central government, and in addition since the sharing rate is often applied uniformly throughout the country, once again the accountability link is broken and subnational governments have no incentive to ensure that the amount and pattern of their spending is efficient. In addition, if, as in some of the transitional countries, such taxes are collected by local governments and then supposedly shared with national governments - and in this case perhaps especially if the sharing rates are higher (more flows upwards) for richer areas - either an undesirable disincentive for collection effort is created or, more usually, the temptation to "cook the books" is likely to be overwhelming.
Practical guidance on the design of these transfers is summarized in the following:
The various criteria specified above could be in conflict with each other and therefore a grantor may have to assign priorities to various factors in comparing policy alternatives.