Essays /

Local Government Essay

Essay preview

b675_Chapter-I.qxd

11/24/2008

5:52 PM

Page 1

Chapter I

Promise and Reality of Fiscal
Decentralization
ROY BAHL
Georgia State University

The growing interest in fiscal decentralization in Asia is part of a worldwide pattern. Most developing countries have long ago placed the strengthening of sub-national government on their development policy agenda. Decentralization is an important part of the transition strategy for many former socialist countries. Some industrialized countries are retuning their fiscal decentralization (Canada) while others have introduced major new initiatives in recent years (Japan, Spain).

In this paper, we consider the costs and benefits of fiscal decentralization, trends in the practice of decentralizing budgets, and the policy interventions that are being used to strengthen the financial position and the financial autonomy of sub-national governments. In particular, we examine inter-governmental transfers, local taxation and hard budget constraints as key policy issues. The focus in this paper is on developing countries. The process areas that are taken up have to do with comprehensive design of a decentralization reform, sequencing and politics. In outlining these issues, we draw heavily from the experiences of Asian countries, some of which are discussed in detail in the chapters in this volume.

DECENTRALIZATION POLICIES IN ASIAN DEVELOPMENT
© World Scientific Publishing Co. Pte. Ltd.
http://www.worldscibooks.com/economics/6888.html

1

b675_Chapter-I.qxd

11/24/2008

5:52 PM

Page 2

2 ✦ Decentralization Policies in Asian Development

1. The Benefits1
What are the major advantages to be gained from investing more fiscal powers in provincial and local governments? This is the fundamental question that sometimes gets lost in the political debate about fiscal decentralization. The most important benefit is the welfare gain that comes from moving governance closer to the people. This is the economic efficiency argument that drives the thinking of most economists who work on this subject (Oates, 1972). The argument is straightforward. Let us assume that people’s preferences for government services vary, e.g., because of religion, language, ethnic mix, climate, economic base or just because of the inclinations of the local political leadership. Let us assume further that people have sorted themselves so that those with similar preferences live in the same region. If sub-national governments respond to these preferences in structuring their budgets, decentralization will result in variations in the package of services delivered in different regions. The voters will see to this in a system where there is downward accountability. People will get what they want and so the welfare of the population will be enhanced. Under the same circumstances, but with a centralized system, accountability will be upward to a higher level of government, service provision will be more uniform and people in different regions will get less of the service mix that they want. The more heterogeneous the country, the greater will be the welfare costs of uniformity.

If governance is properly decentralized, two good things can come to pass. One is that there will be more accountability on the part of government officials because they are held responsible for the quality of services delivered to the local population that elected them. If the makeup of local public services is determined by the center and paid for by the center, sub-national government officials can largely escape taking responsibility for the quality of services provided. The other benefit from a well-functioning decentralization is that there will be more willingness on the part of the local population to pay for services, because they get what they want. If one advocates fiscal decentralization, one must believe this story, because it is the primary argument.

1

For more lengthy discussions of the pros and cons of fiscal decentralization, see Bahl and Linn (1992), Bahl and Wallace (2005), Litvak, Ahmad and Bird (1998), Bird and Vaillancourt (1998), Tanzi (1995) and Dillinger and Webb (1999).

DECENTRALIZATION POLICIES IN ASIAN DEVELOPMENT
© World Scientific Publishing Co. Pte. Ltd.
http://www.worldscibooks.com/economics/6888.html

b675_Chapter-I.qxd

11/24/2008

5:52 PM

Page 3

Promise and Reality of Fiscal Decentralization ✦ 3

True believers can point out that successful fiscal decentralization at once attacks several of the problems that face most developing and many transition countries: economic development, revenue mobilization, innovation in public service delivery, accountability of elected officials, capacity development at the local government level, and grassroots participation in governance.

Whether or not fiscal decentralization actually leads to accountability downward, however, depends on many things. Certainly there must be elections. Local governments must have the power to control their employees, and there must be enough accurate information available so that voters can evaluate the fiscal decisions of their local governments. In many developing countries, one or more of these conditions is not met.

A second important benefit of fiscal decentralization is the promise of increased revenue mobilization. This happens because decentralization can broaden the overall tax base. That is, if sub-national governments are more directly involved in taxation, a greater share of GDP might be reached by the tax system. If this hypothesis is correct, increases in sub-national government tax revenues would not be offset by equal amount reductions in central government tax revenues. In addition, the claim of sub-national governments on central revenues via inter-governmental transfers could be reduced by increased revenue mobilization at the sub-national government level.

The argument behind this hypothesis is that sub-national governments have the potential to reach the traditional income, consumption and wealth tax bases in ways that the central government cannot. Typically, central governments rely on a combination of company income tax, individual income tax, value added tax, excise and customs duties. All of these taxes, however, have a high entry threshold in most developing countries. Small firms, most individuals and owners of immovable property are “under-represented” in the tax base. In fact, local governments can broaden the overall tax base with a variety of tax instruments and administrative measures, and they do so in many countries. These instruments include payroll taxes, levies on the sales of assets of firms, licenses to operate, betterment charges and various forms of property taxation.2 As we discuss below, few Asian countries have acted on this comparative advantage in local taxation.

2

A good review of local tax practices in developing countries is in Bird (1999).

DECENTRALIZATION POLICIES IN ASIAN DEVELOPMENT
© World Scientific Publishing Co. Pte. Ltd.
http://www.worldscibooks.com/economics/6888.html

b675_Chapter-I.qxd

11/24/2008

5:52 PM

Page 4

4 ✦ Decentralization Policies in Asian Development

2. The Costs
There also are significant costs to fiscal decentralization, at least in the eyes of central governments, and perhaps this is why all countries do not embrace this policy route with the same degree of enthusiasm. Heading the list of costs is the loss of macro-economic control.3 Central governments would argue that they should have the flexibility to respond quickly to changes in national economic conditions, for example, to raise taxes, cut expenditures or limit credit in order to deal with a deficit. There also are external pressures on developing country governments to implement an effective stabilization policy. The pressures from the IMF and World Bank for more austere economic policy to bring about internal or external balance usually requires holding the fiscal deficit to an acceptable level and limiting the level of domestic credit.

In a truly decentralized governance system, stabilization policy is more difficult to implement than in a centralized system. One reason is because the central government may not be able to control sub-national government spending so as to reduce an overall deficit. If the lower levels of government have their own resources — either significant own source revenues or a guaranteed share of national government collections — they may set their own level of spending. In many decentralized countries, sub-national governments do not face a hard budget constraint, and a more serious challenge to macroeconomic stability can emerge. In India, the deficits of the state and local governments rose to 10 percent of GDP in the late 1990s, and in Japan local government debt outstanding increased to a level equivalent to about 40 percent of GDP in 2003. (Rao, 2008; Ikawa, 2008). In the Philippines, the growing share of national tax collections earmarked for local governments compromised the budgetary position of the central government (Diokno, 2008).

Even when the central government does not tie the vertical share of grants to national tax collections, it may not have the flexibility to cut subsidies (conditional grants) to local governments. These subsidies can be sticky downward, especially in cases where they support public employee salaries or direct payment to needy individuals, and where their champions include powerful central government ministries. 3

More detailed discussions of this may be found in Bahl and Linn (1992), Prud’homme (1995), Ter-Minassian (1997), Tanzi (1995) and Spahn (1997).

DECENTRALIZATION POLICIES IN ASIAN DEVELOPMENT
© World Scientific Publishing Co. Pte. Ltd.
http://www.worldscibooks.com/economics/6888.html

b675_Chapter-I.qxd

11/24/2008

5:52 PM

Page 5

Promise and Reality of Fiscal Decentralization ✦ 5

This “cost” of decentralization to the central government, however, may not be seen the same way when viewed from the provincial or local level. Where central governments are able to control the budgets of subnational governments, for example because the budget law does not clearly define expenditure assignments, central deficits have sometimes been offloaded on to regional and local governments. For example in the 1990s, Russia transferred expenditure responsibility for certain infrastructure and social welfare services to regional governments without assigning additional revenue responsibility (Martinez-Vazquez et al., 2006).

A second cost of decentralization to the central government is that it could lose some control over infrastructure development in cases where sub-national governments have discretionary spending power. The net result of fiscal decentralization will be a shift of resources from central governments that have higher rates of capital spending to provincial and local governments who spend at a greater rate on consumption goods and services. Fiscal decentralization, therefore, could lead to a lower overall rate of spending on infrastructure, and national growth could be slowed. Fiscal decentralization also may lead to a shift in the composition of public capital investments. This is because national priorities for capital investment are not the same as sub-national government priorities. The national government is interested in investments in infrastructure that have regional and national benefits, for example, large scale irrigation projects, national (interstate) roads, and power. State (provincial) and local governments will be focused more on capital investments with provincial and local benefits.

Central governments have tried to resolve this problem in a number of ways. The most used remedy is to provide local governments with conditional grants that require expenditures in certain functional areas (e.g., local infrastructure) and often carry conditions as to the nature of the expenditures (e.g., construction standards, pay scales etc.). From the point of view of the sub-national governments, however, this approach compromises their discretion and leads to sub optimal uses of resources because of the failure to recognize local conditions.

In some countries there is movement away from conditional grants. Indonesia replaced its Inpres, a large number of specific grants for purposes ranging from re-greening to the construction of public markets, DECENTRALIZATION POLICIES IN ASIAN DEVELOPMENT

© World Scientific Publishing Co. Pte. Ltd.
http://www.worldscibooks.com/economics/6888.html

b675_Chapter-I.qxd

11/24/2008

5:52 PM

Page 6

6 ✦ Decentralization Policies in Asian Development

with a general purpose grant allocated by formula (Fengler and Hofman, 2008). Japan is moving away from conditional subsides to local taxes (Saito and Yunoue, 2008).
A third cost of fiscal decentralization is that it is not an inherently equalizing economic development policy. In fact, depending on how the system is designed, there may be little in it for poorer and rural provin...

Read more

Keywords

-12 /economics/6888.html 1 10 10.44 102 107 11 11/24/2008 12 128 13 13.01 13.24 13.78 14 15 155 16 16.59 17 173 18 18.71 18.75 183 19 19.13 1970s 1972 1980s 1990 1990s 1991 1992 1995 1997 1998 1999 2 20 2000 2000s 2001 2002 2003 2004 2005 2006 2007 2008 21 210 2122 22 226 23 236 24 25 26 26.12 28 295 3 30 316 32.27 32.41 325 33 33.78 345 35 37 3914 4 4.1 4.2 4.3 40 41 43 48 5 52 54 6 7 7.70 8 83 9 9.27 90 98 abil abl accept access accommod accompani accomplish accord account accur achiev across act action actual ad ad-hoc- adb add addit address adequ administ administr adopt advantag advisor advoc affair africa aftermath agenc agenda ago agre agreement agricultur ahead ahmad al align allianc alloc allow alm almost alon also alter altern although alway america american among amount amsterdam analysi analyst and/or anniversari annual anoth anticip appar appear approach approv area argu arguabl argument aris around arrang asia asian aspect asset assign assist assum aten atlanta attach attack attempt attent auster autonomi avail averag award away b b675_chapter-i.qxd back bahl bailout balanc bang bank base basi becom begin behavior behind believ benefit benefits1 best better big big-bang bird blejer blueprint boex borrow brace bring broad broaden brother/sister/father/son bruno budget budgetari built bulletin burden bureaucrat busi c cambodia cambridg canada canadian cannot capabl capac capit capita caribbean carri carrot case cash catalyt catch caus cautious cell center central centralist certain certainti challeng champion chanc chang chapter chara charg cheltenham china choos circumst citi citizen civil claim clariti clear climat close closer co co-exist code collect colombia column combin come comfort commerc commiss commit common compani compar comparison complet complic compon components.11 composit compound comprehens compromis con conceiv concentr concept concern concess conclud conclus condit confer conflict conform congress congressman congressmen connect consid consider consist constitu constitut constrain constraint construct consum consumpt contain context contribut control control.3 controversi coordin correct corrupt corruption.4 cost could count countri country-wid court cover coverag creat credit criteria critic crucial culmin current curv custom cut cyan d d.c dampen danger data date dc de de-concentr deal debat debt decad decades.5 decentr decentralization12 decid decis deconcentr defi deficit defin definit degre delinqu deliv deliveri demand democraci democrat demonstr denmark denomin depend deriv derivation-bas describ design design.8 detail determin develop deviat devolv differ differenti difficult dilling dimens diokno direct disagr disburs disciplin discourag discret discretionari discuss disincent dispar disrupt distribut district divert divis document domest done donor downward draft dramat draw drive driven dual due duplic duti e e.g earmark easi easier easili east econom economi economist ed edward effect effici effort either elast elect elector element elgar elig els embrac emerg empir employ employe enact encompass end end-of-year enemi enhanc enough enter enthusiasm enthusiast entitl entri equal equat equit equival erd erod escap eskeland especi estim et etc ethnic evalu even eventu everi everyon evid ex exact examin exampl excis exist expect expedi expenditur experi explain explan explicit explor export extent extern extrem eye f face fact failur fall famili favor featur feder fengler fervent fig final financ financi find fine fine-tun fire firm first fiscal fisman fit flaw flexibl flow fm focus follow forc forgotten form former formid formul formula formula-bas forthcom forward found four frame fratern freedom full fulli function fund fundament g gain game gap gatti gdp general generat georgia get give given go goal gone good govern government governor gradual grant grappl grassroot great greater greatest green gross ground groundswel group grow growth guarante guerra guid guidelin h hand haphazard happen harcourt hard harder harmless head heavi heavili held henc heterogen hide high higher hire his/her hoc hofman hold holland home homm hong hope horizont howev hung hypothesi i.e ignor ihori ikawa imbal imf immov impact implement impli implic implicit import impos improv inadequ incent inclin includ inclus incom inconclus increas increment incremental- incur india indic indig individu indonesia indonesian industri influenc inform infrastructur ingram inher initi innov inpr instabl institut instrument insur intent inter inter-american inter-government interamerican intercountri interest interfer intergovernment interior intern interst intervent introduc invers invest involv ira irresist irrig ism isp issu item j japan japanes journal jovanovich judg jurisdiction.7 k keep keeper key kind l lack lag land languag larg larger last late later latin latter law lay lead leadership learn least led legal legisl lengthi less lessen lesson let leteli level levi licens like limit lincoln line linn list literatur littl litvack litvak live lobbi lobbyist local locat london long long-liv look lose loss lost lot low lower lower-level ltd m macro macro-econom macroeconom made main major make makeup manag manasan mandat mani manila map market martinez martinez-vazquez martinezvazquez mass match matter may mayor mclure mean meaning measur member messag met method middl might mightili migrat million minassian ministri minor mistak mit mix mobil mobilization.9 mof monetari money monitor moreov move movement much must n na nation natur near necessarili need needi net neutral never nevertheless new non none normat norregaard north note notic notori nuanc nuisanc number numer oat object oblig observ occur oecd offer offici offload offset often oftentim one one-off one-third onehalf open open-end oper oppon opportun oppos opposit optim option order organ origin other otherwis outcom outlin outsid outstand outweigh over-assign over-borrow overal overrid oversight owen own-sourc owner oxford p packag page paid pakistan palat panella paper parenthesi parliament part partial particip particular pass paternalist path pattern pay payment payrol penal pension peopl per percent perhap permit perspect persuad phase philippin piec piecem place place.13 plan platform play pleskov plus pm point polici polit politician pool poor poorer popul popular posit possibl post potenti power pp practic pre pre-reform precis predict prefer prerequisit prescrib present presid presidenti press pressur presum previous price primari primarili princip prioriti probabl problem process product program progress prohibit project promis promot proper properti propos pros prospect protest provid provinc provinci provis prud pte public publish pull purpos push put qualifi qualiti question quick r rais rang rao rasyid rate rather re re-green reach realiti realiz reason receipt receiv recent recipi recogn record recours recurr redistribut reduc reduct refer reflect reform reformul regim region regional-loc regions/local regul regular reimburs reinforc relat relationship releas relev reli relianc religion reluct remain remark remedi replac report repres requir reschovski research resid resolv resourc respect respond respons restructur result rethink retrofit retun revenu revenue-rais review revis reward rhetor rich right risk rival road roadblock rodden role roll rose round rout routledg row roy rule rural russia saito salari sale sampl satisfactori scale scenario scientif second section sector see seem seen select separat sequenc serious servic set sethi sever share shift shih short shortfal show shown side signific silver similar simpl simultan site size skill slight slow slowli small smaller smoke social socialist soft soften solut sometim sooner sort sourc south spahn spain specif specifi spell spend spent spillov spot stabil stage stand standard start state statist status steep step stepwis sticki still stimul stori straightforward strategi strengthen strenuous strict strong stronger structur studi studies.6 sub sub-nat subject subnat subordin subsid subsidi substitut success suggest summari superior support suprem sustain sweden switzerland system t-minassian tabl taiwan take taken taliercio tantamount tanzi target tax tax-pay taxabl taxat taxation.2 taxonomi teacher technic tend tendenc ter ter-minassian term test thai thailand theori therefor thing think third though thought three threshold tie time timofeev together.10 tokyo tool topic total touch toward track tradit train transfer transit transpar trap treisman trend tri triniti true truli tune turn two type typic uk uncertainti uncommon uncondit unconstrain under under-repres under-tax underlin understood unfund uniform unit unitari univers unless unpaid unrealist unstabl unwilling upward urban us usaid use usual usui v vaillancourt valu vari variat varieti various vat vazquez version vertic via vietnam view violat virtual visibl volum vote vote-get voter vs vulner w wage wallac want washington way weak weaker wealth webb weight weist welfar well well-funct whether white wide wiest wife will willing within without work worker world worldwid would wrath written www.worldscibooks.com www.worldscibooks.com/economics/6888.html y y-h year year-end yearbook yet york yunou zero zuo