Fiscal Decentralization and AccountabilityJean-Paul Faguet

London School of Economics and Political Science & IPD

Outline1. Definition/concept of fiscal decentralization2. Intergovernmental (fiscal) relations3. How to assign public services to different levels of government4. Taxation at different levels of government5. Intergovernmental transfers6. Fiscal hierarchy vs. polycentrism7. Political decentralization accountable & responsive

government8. When and why does decentralization fail?9. Decentralization, conflict and political (in)stability

1. The Concept of Fiscal DecentralizationFinancial aspects of devolution to regional and local government.Also called “fiscal federalism”.

Two interrelated issues:

1. Who taxes and spends? Division of spending responsibilities and revenue sources between levels of government (national, regional, local etc).

2. What is taxed and spent on? Discretion given to regional and local governments to determine expenditures and revenues (both in aggregate and detail).

2. The Importance of Intergovernmental Relations

Decentralization does not eliminate central government responsibility, rather changes it:

Direct provision of public service Cost sharing, regulation, monitoring, etc.

“Decentralized” public services = overlapping responsibilities amongst 2+ levels of government.

Ex: Education – Local provision & regulation, Central finance, Central standards for pricing and provision.

Requires local and central governments to find a way to work together.

This is Intergovernmental Relations (IGR).

Key Educational Decisions and Responsibilities

GROUP DECISIONS ARG CHILE EL SAL MEX NIC Organization Level of decentralization R L S R S Choose textbooks S S S N S Determine teaching methods S S S S S Personnel Hire / fire school director R L S R S Recruit / hire teachers R L S R S Set or argument teacher pay R L N N S Planning Set performance exams N N N N N Resources Determine expenditures R N, L N R N, S Allocate personnel budget R L N R S Allocate non-personnel budget R L S R S N = national, R = regional, L = local, S = school.

Source: Winkler and Gershberg (1999).

Q.1 What levels take decisions in Afghanistan?

• Education?

• Health?

• Water & Sanitation?

• Agriculture?

Which public services should be devolved?• Geographically specific – low externalities/spillovers• Heterogeneous demand• Local information important for production (local info

expensive/hard to obtain)• Low economies of scale

Broad principle of government design:Encompassing principle: Assignment of governmental responsibility should encompass relevant externalities. National externalities and public goods are best dealt with by national governments, local externalities and public goods by local governments.

3. Assigning Services to Different Levels of Government

Oates’ (1972) Decentralization Theorem.Local government should be responsible for all forms of spending which do not inflict an externality on other jurisdictions. The level and type of such spending can be tailored to the desires of the local residents.

E.g.• trash collection• fire servicesArguably few externalities.

But: Actual political jurisdictions will never adequately encompass all the relevant externalities, and hence there will always be the need for intergovernmental cooperation

Decentralized Taxation Systems

Five basic guidelines for designing revenue systems.

1. Local taxes should be as neutral as possible Not distort economic behaviour.

2. Benefits and costs of local taxes should be clear to citizens.

3. Incidence of local taxes should be equitable.

4. Administration and compliance costs should be kept low No complex taxes to local governments.

5. Avoid mobile tax bases.

Four most common local taxes:

• Property: Easy to identify and assess. Linked to local prosperity and hence local policy. Provide LG accountability to taxpayers

• Income: Large source of LG revenues in Europe, but much less common in LDCs.

• Sales tax: e.g. VAT, Sales tax.• User charges: E.g. Housing rents, water and heating

charges, public transport fares.

Q.2 What taxes do LGs in Afghanistan levy?

• Property?

• Sales?

• Income?

• Royalties?

• User fees?

• Other?

5. Intergovernmental TransfersDifferent forms:1) Shares of national taxes distributed either

a) by formula (e.g. per capita), orb) by origin (i.e. to the local government where they are collected).

2) Grants/subventions which are eithera) targeted to support specific expenditures (e.g. education), orb) untargeted and used at discretion of LGs (e.g. block grants).

Targeted grants – for expenditures favoured by national government.

Tax sharing and block grants usually have two main purposes, vertical and horizontal equalisation.

Vertical equalisation: closing the gap between the cost of services devolved to local governments and their local revenues.

Horizontal equalisation: closing the gap between rich and poor districts’ revenues (per capita).

An effective transfer system should satisfy several criteria:

• Revenue adequacy: LGs should have sufficient resources to carry out devolved responsibilities.

• Local tax effort and expenditure control: Ensuring sufficient tax efforts by local authorities. Don’t encourage fiscal deficits.

• Equity: Transfers should increase with local fiscal needs and decrease with local fiscal capacity.

• Transparency and stability: Formula should be announced and localities should be able to forecast own revenues in order to prepare budgets. Formula should be stable, allowing long-term local planning.

Intergovernmental transfer systems in many countries, e.g. Latin America, are far from satisfying such criteria. There are often open channels for “moving money around” fiscal irresponsibility, uncertainty and instability.

6. Fiscal Hierarchy vs. PolycentrismSimple hierarchy

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7. Decentralization must be tied to political accountability if it is to enhance

accountability and responsiveness.

• Otherwise a country is likely to see modest improvements in public information in exchange for higher public overheads

But not necessarily any accountability improvements.

Q.3 When and Why Does Decentralization Fail?

• 80-100% of world’s countries are decentralizing over the past 25 years.

• But very little evidence of success, either specific (e.g. education, sewerage) or general.

• Why?

8. When and Why Does Decentralization Fail?

Why So Much Centralization?Why Does Decentralization Fail?

• Central Govt has power to make the rules of the game• CG is staffed by people who live in the capital, who benefit from public

goods available there.• Residents of c appropriate any surplus not allocated to the periphery

Residual authority Capital city is selfish• CG gains from convincing as many districts as possible to cooperate with

its plans.

This combination of incentives generates a game in which c offers districts the minimum necessary to ensure cooperation of the largest number. This maximizes its own allocation of resources.

Simple Solution – by analogy with the Ultimatum Game:• An economist gives Sam 100 x £1 coins, and instructs her to

offer Paul any amount between £0 and £100. If he accepts, each keeps their share. If he rejects the offer, the economist takes all £100 back. What amount will Sam offer?

Now apply this logic to Central-Local Government Relations.

Implications• In a context of strong central government and weak

countervailing powers brought about by a weak institutional framework, self-interested central government will systematically under-invest in the periphery.

Is this what most of the world’s developing countries look like?

Why So Much Centralization?Because it is in the interests of those who live in the capital. They

benefit directly from a highly centralized government with weak constitutional guarantees for lower-level districts. And they make the laws of the land.

Once central provision of a given service is established, the center’s incentive is to renege on initial promises and drive local allocations lower. Thus the center beggars the periphery, not once but continually.

Why Does Decentralization So Often Fail?B/c few reforms are seriously pursued. Those charged with

implementing reform – CG bureaucrats – have little interest in succeeding. They benefit from the residual power they hold, and do not want to see it, or resources, dispersed.

Instead, decentralization becomes one more policy promise on which the center reneges. And the old pattern of central accumulation continues.

9. Decentralization, Conflict & Political Instability

Decentralization decreased centrifugal forces in and helped integrate:• Bolivia – Story of reform… • Belgium• Spain • Switzerland• UK • India• Indonesia

Could decentralization help/have helped in:• Turkey• Serbia (Kosovo-Montenegro)• Czechoslovakia• Sudan ???• Afghanistan ???

Decentralization and Violence in Colombia• Colombian decentralization was designed to increase the responsiveness of

the state, and “drain the swamp” of public support for guerrillas & paramilitaries.

• Decentralization improved quality of, and access to, public services throughout Colombia.

Empirical evidence is contradictory

• Cohen (1997), Hechter (2000) and Saideman et al (2002) find that federal countries experience more protest but fewer violent rebellions. Can federalism redirect or moderate tensions that might lead to instability?

• Hug (2005) argues federalism is endogenous to ethnic conflict, and finds federal countries suffer more rebellions.

• Brancati (2005), Hegre and Sambanis (2005), and Treisman (2007) Results are mixed

Decentralization and School Enrollment

Index of Public and Private School Enrollment

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1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004Year

En

rollm

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t In

dex

Public Private Total

Health Insurance Coverage Rate by Region

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Andina Caribe Oriental Pacifica

But…Decentralization provided pots of money that guerrillas and para’s could capture. They did so, using these localities as bases of finance and operations.

Did D cause Bolivia’s political party system to collapse?Probably.• New class of politician arose in LGs – from local civil society &

private sector• New parties/movements arose nationally – MAS, many local

“partiditos”• Stable system of political party competition and alternation in

power collapsed.• Composition of Congress 50% new actors• Composition of Constitutional Convention 80% new actors

Group Exercise (15’)

Drawing on your experience -- Is fiscal decentralization likely to spur peacebuilding or aggravate tensions in Afghanistan?

Thank you