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A Practitioner’s Guide to Intergovernmental Fiscal Transfers Anwar Shah, World Bank ashah@worldbank. org Budgeting A Practitioner’s Guide to Intergovernmental Fiscal Transfers Anwar Shah, World Bank [email protected] org Budgeting and Public Financial Accountability Workshop, Pretoria, South Africa June 18 -22, 2007

Perceptions on intergovernmental finance are generally negative • Federal/Central View: Giving money and power Perceptions on intergovernmental finance are generally negative • Federal/Central View: Giving money and power to sub-national governments is like giving whiskey and car keys to teenagers. • Provincial and Local View: We need more grant monies to demonstrate that “money does not buy anything”. • Citizens: The magical art of passing money from one government to another and seeing it vanish in thin air.

Intergovernmental Fiscal Transfers edited by Robin Boadway and Anwar Shah, World Bank INFOSHOP Book Intergovernmental Fiscal Transfers edited by Robin Boadway and Anwar Shah, World Bank INFOSHOP Book Launch Event April 18, 2007

Ironically these perceptions are well grounded in reality • Primary focus on dividing the Ironically these perceptions are well grounded in reality • Primary focus on dividing the spoils • Passing the buck transfers – revenue sharing with multiple factors (Brazil, Argentina, India, Philippines and more) • Asking for more trouble grants – deficit grants (China, Hungary, India, and more) • Pork barrel transfers or political bribes (Brazil, India, Pakistan, USA e. g. $200 m bridge to nowhere in Alaska ) • Command control transfers (most countries) • Overall: Intergovernmental finance is the dominant source of revenue but creates perverse incentives for fiscal management and accountability.

No need to despair …. As properly designed fiscal transfers can be part of No need to despair …. As properly designed fiscal transfers can be part of the solution rather than part of the problem.

How to do it ? • Realigning incentives (grant design) with grant objectives • How to do it ? • Realigning incentives (grant design) with grant objectives • Ensuring local autonomy and flexibility while providing incentives for accountability • External, Competitive Results Based Focus • Reinforcing accountability for service delivery to citizens • Reducing transaction costs for redress • Institutional arrangements that overcome the commitment problem

Considerations in the Design of Fiscal Transfers u Consistency of design with a single Considerations in the Design of Fiscal Transfers u Consistency of design with a single objective u Simple and transparent allocation criteria u Create incentives for competitive service delivery and support citizen-centered governance u Provide incentives for fiscal prudence u Ensure flexibility in use but accountability for results u Stable and predictable u Equitable ( entitlements vary inversely with fiscal capacity and directly with fiscal needs) u One size does not fit all – urban vs. rural, large vs. small u Sunset clauses to ensure periodic review and assessment

Instruments of intergovernmental finance • Unconditional vs conditional transfers – Unconditional: preserving local autonomy 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

Conditional transfers with conditions on spending impair recipient’s autonomy without furthering grantor’s objectives Conditional transfers with conditions on spending impair recipient’s autonomy without furthering grantor’s objectives

Traditional versus Output-based grants -1 Criterion Traditional grant Output-based grant Objective Spending levels Design Traditional versus Output-based grants -1 Criterion Traditional grant Output-based grant Objective Spending levels Design complex Quality and access to public services Simple and transparent Eligibility Government conditions inputs Provides through government outputs Allocation Project proposal Service population

Traditional versus Output-based grants -2 Criterion Traditional grant Compliance Inspections and audits Penalties Output-based Traditional versus Output-based grants -2 Criterion Traditional grant Compliance Inspections and audits Penalties Output-based grant Client feedback. Comparison with base year Audit observations Public censure, voice and exit Managerial flexibility LG Autonomy None Absolute Little High Transparency Little High

Traditional versus Output-based grants -3 Criterion Traditional grant Output-based grant Focus Internal External Accountability Traditional versus Output-based grants -3 Criterion Traditional grant Output-based grant Focus Internal External Accountability Top down input based Bottom up , results based

Output-based transfers: Results Chain Application in Education Program objectives Improve quantity, quality, and access Output-based transfers: Results Chain Application in Education Program objectives Improve quantity, quality, and access to education services Outputs Achievement scores, graduation rates, drop-out rates Inputs Intermediate inputs Educational spending by age, sex, urban/rural; spending by level; teachers, staff, facilities, tools, books Outcomes Literacy rates, supply of skilled professionals Enrollments, studentteacher ratio, class size Impact Informed citizenry, civic engagement, enhanced international competitiveness Reach Winners and losers from government programs

Long Route to Accountability Inputs Control Grants National Government Citizens as Clients State Government Long Route to Accountability Inputs Control Grants National Government Citizens as Clients State Government Local Government Providers

Short Route to Accountability Output-Based Grants National Government Citizens as governors State Government Local Short Route to Accountability Output-Based Grants National Government Citizens as governors State Government Local Government Competitive Provision Govt Non Govt

Objective Grant Design Better Practices to Avoid Fiscal Gap Reassign, tax base sharing Canada Objective Grant Design Better Practices to Avoid Fiscal Gap Reassign, tax base sharing Canada Deficit & wage grants (China), tax by tax sharing (China, India pre-2006) Regional fiscal disparities Fiscal capacity equalization (FCE) FCE with an explicit standard as in Canada, Germany, Denmark General revenue sharing with multiple factors (Brazil, India), Fiscal eq. with a fixed pool as in Australia, China Setting national minimum standard Output-based transfers nonmatching, conditions on service standards and access Ex-Indo. roads and primary education; Education (Chile, Brazil, Colombia) Health transfers (Brazil, Canada) Conditions on inputs/ spending (most countries, USA “bridge to nowhere”) Capital grant with matching inverse to FC School construction (Indonesia), Highway matching (USA) Capital grant with no matching and no upkeep Open-ended matching Canada social Ad hoc grants assistance (pre-2004) Influencing local priorities

Transfers to deal with fiscal gap u Fiscal Gap: Structural imbalance as a result Transfers to deal with fiscal gap u 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.

Transfers to set national minimum standards u Rationale: u National economic union or internal Transfers to set national minimum standards u Rationale: u National economic union or internal common market u Redistributive role of the public sector and the national government u Design: conditional non-matching block transfers with conditions on standards of service and access. u Better practices: Indonesia roads and primary education grants; Brazil health transfers, Colombia and Chile education transfers; Canada health and postsecondary education transfers. u Practices to avoid: Conditional transfers with conditions on spending; ad hoc grants.

An example : A performance oriented education grant to set national minimum standards and An example : A performance oriented education grant to set national minimum standards and encourage competition and innovation and citizen empowerment • Allocation basis among local governments: school age children (ages 6 -17) • Distribution to providers: equal per pupil to both government and private schools • Conditions: Universal access to all, private school admissions on merit regardless of parents’ income, improvements in school achievement scores, graduation and drop out rates, no condition on spending • Penalties: public censure, reduction of grant funds • Incentives for cost efficiency: retention of savings

International practices in transfers to reduce regional fiscal disparities u Design: General non-matching fiscal International practices in transfers to reduce regional fiscal disparities u Design: General non-matching fiscal capacity equalization transfers. u Better practices: Fiscal equalization programs (sources of data: CGC, Morris, Finance Canada, Dafflon, Lotz, Shah, Spahn & Werner) u Paternal: Australia (fiscal capacity plus fiscal needs) and Canada (fiscal capacity only) u Solidarity, Fraternal or Robin Hood: Germany (fiscal capacity) u Mixed: Switzerland, Sweden, Denmark u Practices to avoid: General revenue sharing with multiple factors e. g. practices in Brazil and India

Equalization programs are concerned with inter-jurisdictional equity (horizontal fiscal equity) not with interpersonal equity Equalization programs are concerned with inter-jurisdictional equity (horizontal fiscal equity) not with interpersonal equity (vertical equity) • Australia: capacity to provide services at the same standard with same revenue effort and same operational efficiency • Canada: “reasonably comparable levels of public services at reasonably comparable levels of taxation across provinces” • Germany: “to equalize the differences in financial capacity of states” • Switzerland: “to provide minimum acceptable levels of certain public services without much heavier tax burdens in some cantons than others”.

Fiscal Equalization Program Australia Canada Germany Switzerland Legal Status Federal Law Constitution Paternal or Fiscal Equalization Program Australia Canada Germany Switzerland Legal Status Federal Law Constitution Paternal or Solidarity Paternal Solidarity Mixed Total Pool determination Ad hoc Formula Ad hoc Allocation Formula Yes, RTS Yes, major macro tax bases Fiscal capacity Yes, RTS equalization Constitution Yes, Actual Revenues

Fiscal Equalization Program Australia Canada Germany Switzerland Fiscal Need Equalization Yes No No (only Fiscal Equalization Program Australia Canada Germany Switzerland Fiscal Need Equalization Yes No No (only pop some size and density) Program Complexity High Low Medium Political Consensus No? Yes (? ) Yes Who recommends Independent agency Intergov. Solidarity Committees pact II Federal Government Sunset clause no Yes (5 years) no no Dispute resolution Supreme court Supreme Court Constitution al court Supreme court

Germany – Fiscal Equalization in 3 stages • Stage 1: Equal per capita distribution Germany – Fiscal Equalization in 3 stages • Stage 1: Equal per capita distribution of 75% of States’ share of VAT revenues (47. 8% of total) to all 16 states and remaining 25% as supplement to financially weak states. • Stage 2: Formal Fiscal Equalization Program through Solidarity Pact II – Rich state contribute to the pool through a progressive tax (45 – 72. 5% rate) and poor states receive progressive subsidy from the pool. • Stage 3: Federal Supplementary grants

Denmark: Equalization models and standards Equalization Counties type Fiscal capacity Fiscal Needs Metropolitan Local Denmark: Equalization models and standards Equalization Counties type Fiscal capacity Fiscal Needs Metropolitan Local areas Govts. 85% Robin 90% Robin 50% Hood central grant 85% Robin 60% Robin 35% Robin Hood

Alternate Institutional Arrangements for ET • • • Central government agency Intergovernmental Forums Intergovernmental Alternate Institutional Arrangements for ET • • • Central government agency Intergovernmental Forums Intergovernmental cum civil society forums Sub-national government forums Independent agency model – reporting to executive – permanent or periodic • Independent agency model reporting to legislature

Fiscal Transfers: Negative Lessons or Practices to Avoid • • General revenue sharing with Fiscal Transfers: Negative Lessons or 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 One size does not fit all

Fiscal Transfers: Positive Lessons or Practices to Strive For • • K. I. S. Fiscal Transfers: Positive Lessons or 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

Fiscal Equalization Grants: Some Lessons from International Experiences • Equalization formula must determine both Fiscal Equalization Grants: Some Lessons from International Experiences • Equalization formula must determine both the pool and allocations. • 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. • Output based transfers offers a promising alternative for fiscal need compensation. Enhance results based accountability. • Equalization transfers must not be looked at in isolation of the broader fiscal system especially conditional transfers. • 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 require serious thoughts as independent grants commission typically recommend more complex formulae.

From Dividing the Spoils to Creating An Enabling Environment for Responsive and Accountable Local 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