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Potential Impacts

Subtopics:

Equity Goals and Multileveled Government

Should governments redistribute to people or places? If they should, which level of government should be responsible for such redistribution, and under what conditions? And how can governments attain these distributional goals while minimizing economic distortions?

These questions are priority policy areas in developed, developing and transition economies. For example, recent years have seen a substantial devolution in distributional responsibilities for welfare payments from the federal to the state governments in the United States. Economic integration and increased mobility in Europe raises questions about European national governments’ ability to effectively redistribute income within their national boundaries. Developing countries are often concerned with large variations in the relative revenues of subnational governments.

Assignment of Responsibility for Interpersonal Redistribution of Income

The Theory

The conventional wisdom, from classic sources in the literature (Oates, 1972, pp. 6-8; Musgrave, 1959, p.181) implies that redistribution has to be carried out by higher levels of government. Factor mobility (particularly labor) will make attempts by lower level jurisdictions to change the distribution of income self-defeating as the poor gravitate to areas of high redistribution, while the rich cluster in areas of low redistribution.

The Reality

The world does not fully correspond with this theoretical model, however. Many functions of subnational governments do, in practice, have significant distributional effects: regulatory policies such as land use and rent controls have profound distributional implications, for example. Some frequently subnational functions - most notably health and public education – also affect distribution.

Infrastructure services are another area where local government policies can have important redistributive effects – both progressive and regressive. Throughout the world, the core areas of responsibility of local governments consist of infrastructure services, and these responsibilities indicate the important role of this level of government in attaining efficiency goals. An implication of such efficiency goals is that the appropriate method of paying for these utility and infrastructure services is by cost recovery through user fees, so that the price charged for these services reflects their value to consumers. Departures from the user cost pricing principle are generally unsuitable as means of obtaining other goals of government, such as the distributional objectives of helping those with low incomes. For instance, subsidies for utility use always benefit most those who are better off, since utilization of these utility services rises with income. Algeria's 1988 expenditure survey showed, for instance, that the richest 10% of households spent four times as much on urban transport as the poorest 10%. Indeed, subsidies on fuels and urban transport in Algeria were actually chosen to illustrate the regressive effects of infrastructure subsidies in the Bank's 1994 World Development Report. More targeted and effective transfer instruments are available to help low-income groups.

Moreover, the Swiss example indicates that the formal assignment of distributional authority to a local government can work. Cantons have jurisdiction over health, education, and welfare services and have priority in levying taxes on personal income and wealth. In non-federal states such as Sweden, the Constitution formally gives local governments the right to levy income taxes. In fact, many attribute the relatively large size of local governments in the Scandinavian countries to their substantial responsibilities regarding distributional programs. In Denmark, for example, local governments account for over half of general government expenditures and about a third of GNP, while social security and welfare payments account for more than half of these large local government budgets. Local distributional functions are often substantially financed by local income tax rates which are "piggy backed" on (broadly redistributive) tax rates of the central government.

There is also plenty of evidence that subnational jurisdictions systematically incorporate their own particular distributional preferences into choices on spending decisions. Wildasin (1991)

Shows that monthly average benefits for Aid to Families with Dependent Children vary by a factor of five among U.S. states,notes that such differences have persisted over long time periods, and asserts that "decentralized redistribution is a fact of life that must be dealt with as a practical matter".

Reconciling Theory with Reality

Although debate on this subject continues, the traditional view that central governments have the major role to play in functions of income redistribution still predominates. Some of the most recent contributions to the literature recognize that local preferences for redistribution do matter. The traditional idea that the central government should control or at least coordinate redistribution remains, but there are some interesting differences from the traditional analysis. In particular, Wildasin (1991) argues that an optimal solution in multilevel systems of government is to provide grants which, because of differing subnational preferences for redistribution, are nonuniform by subnational jurisdiction, but lead to identical levels of transfer payments. Wildasin finds much behavior in multilevel systems of government which supports his analysis and policy prescription.

Factor mobility, the largest theoretical constraint on subnational redistribution activities, may not be as large a concern in reality. First, while empirical studies broadly indicate that interregional factor flows are influenced by the potential for monetary gain, such flows are usually relatively small. Second, barriers to mobility may be significant. For example, in many of the countries in transition, labor mobility is limited because of lack of housing. Since housing is often the responsibility of local governments in these countries, local redistributional policies (or the absence thereof) acquire added importance.

A Benefit of Subnational Redistribution

While the goal of reducing poverty is explicit in the objectives of the Bank and much other public policy, such redistributional policies rest on value judgments that are not shared by all. Those who place greater priority on goals of attaining individual freedoms and fear the arbitrary use of power by "Leviathan," such as Brennan and Buchanan (1980) or McLure (1986), see limits on the ability of predatory governments to carry out redistribution as important benefits of migration and federal structures of government.

Interregional Transfers: An Often Over-Looked Issue

Interregional redistribution has received less attention at the Bank and, in fact, many even contest the merits of redistribution between regions. A long-standing complaint in economic policy, for instance, is that redistribution to poor regions may interfere with natural adjustment mechanisms such as outmigration that will otherwise rectify regional imbalances. Nevertheless, this view needs to be modified to take into account the important variation in net fiscal benefits from the fiscal activities of subnational governments.

Variation in Net Fiscal Benefits

Variation in net fiscal benefits may arise for several reasons. Two of the most common are:

Fiscal activities of subnational governments whose residents have high per capita incomes, if such governments finance a given amount of public services with less tax effort (such as lower tax rates on income) than governments of poorer regions.
Possession of or access to natural resource revenues. The potential for income disparities from this source can be very striking in some client countries of the Bank. The Tyumen oblast in Russia, for example, accounts for two-thirds of Russia's oil but only 2 percent of its population.

Efficiency Arguments

The efficiency argument centers on the presumption of factor mobility. A classic example is if there is "fiscally induced migration" to share in these net fiscal benefits: for example, if people relocate next to provincial oil wells simply to be able to share in the jurisdiction’s ownership rights and clip coupons. If such fiscally induced migration is significant, it would be in the interests of jurisdictions where net fiscal benefits from subnational governments are substantial to make transfers to low income jurisdictions so as to limit the amount of such migration (and consequent rent dilution) that takes place. There would also be a net benefit to all in the nation because the very real costs of migration would be avoided.

There is some doubt as to the significance of such efficiency losses, however. In Canada, for instance, William Watson calculated in a 1986 article that there would have been a welfare gain of only $35 million from shifting billions of dollars around to equalize provincial government fiscal capacities (the latter being a proxy for net provincial benefits from subnational governments). As a consequence, the equitable case for redistribution of net fiscal benefits arising from subnational government activities probably deserves more weight than that arising from their efficiency costs.

Equity Arguments

The equity problem for a central government's tax and transfer system arises because of the "horizontal equity" goal of treating like citizens alike no matter where these citizens reside in the country. The problem is that central government attempts to attain interpersonal equity goals are implemented through tax and transfer systems which deal only with the market or taxable incomes of individuals, but the net fiscal benefits from subnational government activity may lead to substantial differences in the real or comprehensive incomes of citizens in different areas. It is difficult to think of practical ways in which a central government can deal with the fiscal benefits from subnational governments by adjusting its own personal taxes and transfers. It would be impractical and politically unacceptable to have different central government personal income tax rates in different subnational jurisdictions, for instance, and such a policy would also override legitimate subnational redistribution policies. The practical solution that has been advocated is to undertake intergovernmental transfers to "equalize" subnational per capita fiscal capacities so as to make it financially possible to achieve horizontal equity goals.

Extent of Equalization Programs

This reasoning may help to explain why programs to equalize subnational per capita fiscal capacities are common in developed, developing and transitional countries. Programs of equalizing state and provincial fiscal capacities may be more the rule than the exception in developed federal countries; they exist, for example, in Australia, Canada, Germany and Switzerland. Programs to reduce tax base disparities among local governments are also common in both unitary and federal countries. In developing countries, equalization is a factor in the general revenue sharing transfers to subnational governments that exist in such countries as Brazil, Chile, Colombia, India, Mexico, Morocco, Nigeria and Pakistan. Countries in transition have also realized that revenue sharing based on the origin of revenues (the derivation principle) results in a very unequal distribution of subnational government resources and several, from the largest in population (Russia) to the smallest (Estonia) of the former Soviet Union countries, but also including Hungary, Poland and other Baltic countries, have instituted programs to reduce disparities in the per capita revenues of subnational governments.

Transfers between Subnational Governments

It may be inappropriate to finance such equalization transfers by central government revenues, if the latter are raised from different sources than those received by subnational governments. The usual principles of tax assignment, whereby higher level governments tax more mobile resources and local governments tax more immobile resources (such as property), will automatically result in such differentiation of revenue sources by level of government. Another example is where subnational rather than national governments own natural resources which yield substantial revenues. This problem assumed serious proportions in Canada following oil price rises in the 1970's which increased revenues of oil-producing provinces. The Government of Canada was responsible for the equalization of provincial government fiscal capacities but did not have access to these oil revenues. In effect, redistribution of revenues to poorer provinces resulting from higher oil prices was being financed by transfers from federal taxation raised in the richer non-oil producing provinces.

The straightforward method of dealing with this problem is for direct redistribution to take place between subnational governments, where equalization to the desired standard of fiscal capacity is financed by "have" subnational governments contributing to a revenue pool which is then redistributed to "have not" subnational governments. One of the best known examples of such transfers occurs between the länder in the Federal Republic of Germany, and the Swiss version of equalization is similar. There are also examples of direct transfers between local governments being undertaken voluntarily, as in the case of the sharing of tax-bases between 201 municipalities in the Minneapolis-St. Paul area. Alternatively, some central governments require such equalization transfers to be undertaken between local governments, as in Sweden and Denmark. Nor are all examples of direct transfers limited to mature industrial countries: Chile has a system of direct transfers from rich to poor municipalities.

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Macroeconomic Impact of Decentralization

The design of decentralization can have a significant influence on how the restructuring of decision-making and responsibility affects a country’s macroeconomic conditions. Some countries, including Brazil and China, experienced macroeconomic problems when tax bases were decentralized without clearly assigning expenditures to the level of government that receives the revenues. Others, including Mexico and Argentina, ran into problems, because sub-national governments accrued unsustainable debts and had to be bailed out by the central government. Other decentralization efforts, in which governments solved their fiscal imbalances at the center by decentralizing expenditure responsibilities without the matching revenues, left essential services unperformed and, in some cases gave rise to unsustainable sub-national deficits.

The design of intergovernmental fiscal relations needs to take account of these possible negative effects. Most importantly, it must ensure a match between expenditure responsibilities and revenues at each level of government and create institutional mechanisms that will enforce a hard budget constraint between levels of government.

Sub-national Incentives

Compared to central governments, sub-national governments have less incentive to consider the macroeconomic impact of their policies. The macroeconomic impact of sub-national stabilization policies tends to leak away to other jurisdictions, giving macroeconomic stability public goods characteristics. Central governments are therefore usually assigned the task of maintaining stability, and should have the tools to go with it, such as control over monetary policy, and at least some control over fiscal conditions. The latter includes a share of revenues and expenditures sufficiently large and sufficiently flexible to influence aggregate demand in a country. However, whether intended or not, sub-national policies can influence stability: even balanced budget spending increases by sub-national governments can affect macroeconomic stability; and sub-national borrowing can become a major macroeconomic concern. On the other hand, macroeconomic shocks can hit different jurisdictions differently, making some sub-national influence on macroeconomic conditions actually desirable. Finally, centralizing all expenditure and revenues with a potential macroeconomic impact may have excessive efficiency costs.

Structuring Intergovernmental Fiscal Relations to Enhance Stability

Revenue Assignment and Tax Sharing

Sub-national governments should have a fairly stable tax base, for highly income elastic tax bases (such as VAT and progressive income taxes) can induce pro-cyclical government expenditures that aggravate macroeconomic imbalances. Central governments have tended to be more responsible in this respect. Moreover, taxes such as VAT and income tax lend themselves well for macroeconomic policy by increasing rates to cool down an over-heating economy.

Expenditure assignments

Although the discussion on this topic is limited, the public finance literature usually recommends assigning sufficiently stable expenditures to sub-national governments. For instance, many argue that social security is better assigned to the national level because of its pro-cyclical nature.

Incentives, however, may moderate this standard conclusion. For instance, while assigning unemployment compensation to central government may create an "automatic stabilizer" it also takes away the incentive for sub-national government to save on unemployment expenditures by, for instance, following a proactive employment policy. Thus the centralization of social security may actually increase macroeconomic imbalances. Making local government responsible for a part of these highly cyclical expenditures may actually lead to better results in terms of stability.

Grants

Macroeconomic considerations--but also tax administration and equity considerations--are likely to give central government the larger part of revenues, but not necessarily expenditures. Thus, a system of grants will be needed to fill the vertical imbalances. Although efficiency and equity consideration are likely to dominate the process of grants design, several features could be beneficial to macroeconomic stability.

Grants should be designed such that they fill ex ante the gap between sub-national revenues and expenditures. Ex post gap filling could give rise to excessive expenditures at local level, as central government will foot (part of) the bill.
The size of the grant pool should be fairly independent from macroeconomic conditions, to avoid the pro-cyclical spending patters noted above. Having a broad revenue base that feeds the grant pool is therefore to be preferred above single-tax based grants.

Central government needs some discretion to adjust the amount of grants transferred. Although this is often impossible for general grants mechanisms that are usually based in law, special purpose grants offer more flexibility. Their expenditure effects can even be leveraged, if the grants require sub-national matching.

Sub-national Borrowing

Sub-national borrowing can have a large effect on macroeconomic conditions in a country. Countries such as Brazil and Mexico saw their restrictive central fiscal policies in the early 1990s thwarted by sub-national deficits (either open or hidden) resulting in the end in a bailout by national government. However, intertemporal efficiency speaks strongly for allowing sub-national governments at least some access to borrowing. Countries have therefore taken a number of approaches in allowing sub-national borrowing:

Reliance on market discipline for limiting borrowing requires that several strict conditions are fulfilled, among which open capital markets, adequate information, responsiveness of the borrower to market signals, and strict no-bailout policy of central government. Even national governments may not meet these requirements, but especially the latter is particularly binding for sub-national governments. Except for some federal countries (the United States and Canada, for example), few countries solely rely on market discipline.

A number of countries (Germany, Switzerland, Spain, Korea) have relied on legally binding rules to restrict borrowing. Some have used the golden rule of allowing borrowing only for investment purposes. Others use rules that restrict borrowing to some indicator of debt servicing capacity.

Some countries directly control sub-national borrowing by setting overall limits, approving individual debenture issues, or by allowing borrowing only through a centrally controlled municipal bank. Local governments have ways to circumvent any of these regulations, by reclassifying expenditures from current to capital, running arrears, creating off-budget activities, and using state enterprises for borrowing, or providing guarantees on enterprise borrowing. Thus, any rule should have sufficient incentives and controls to enforce it.

Coordination mechanisms

In recognition of the sub-national influence on stability, several countries have designed intergovernmental macroeconomic coordination mechanisms. Germany, which probably has the most elaborate one, coordinates expenditure and borrowing plans within the context of the Stabilitaetsgesetz (stability law). The 5-year fiscal plan is discussed and coordinated with the states before submission to parliament. In Australia, the Loan Council now coordinates borrowing requirements of national and sub-national public sector, after previously serving as a forum to limit sub-national borrowing. In China, the annual planning and finance conference is used to discuss and coordinate the plans of each level of government. And many countries have informal coordination mechanisms, either through State or provincial representation in a house of parliament, or through special subcommittees of parliament. To what extent coordination without binding rules actually delivers better results is an open question.

Regulating Incentives by Design

In designing intergovernmental fiscal relations, the incentive effects on macroeconomic stability should be explicitly considered. Large vertical imbalances in favor of national governments are likely to lead to ex-post gap filling by national governments, bailouts of sub-national debt, or circumvention of national policies on taxes or debt. Large imbalances in favor of sub-national governments on the other hand could lead to large national debts, and to insufficient fiscal discipline at sub-national levels. Little tax autonomy of sub-national governments reduces the incentive to behave responsibly, because they cannot be required to increase taxes to restore balance on the budget. Thus, other things equal, a broad matching of expenditure and revenue responsibilities, together with explicit responsibility of each level of government to live within its means, and the autonomy to do so is desirable.

Rules for budget management for sub-national governments could address many of the detrimental macroeconomic effects of decentralization. As long as sub-national governments are held to responsible management--including limits on deficit spending--and provided the means and incentives to actually do so, the macro impact of their actions can be limited. Having harsh measures for central government to deal with fiscal irresponsibility could help (such as bankruptcy procedures for local governments in New Zealand, and transparent fiscal accounts that are regularly published and audited can add to discipline. Also, in the end, one of the best incentives for responsible behavior is likely to be the pressure from an electorate that would suffer from a fiscal crisis.

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Decentralization and Economic Growth

We know very little about the relationship between decentralization and growth. Empirical evidence for the way in which decentralization affects growth has been contradictory and is plagued by measurement, specification, and analytical problems. There is stronger evidence for a relationship in the other direction --from growth to decentralization-- but the interpretations of this correlation between high income and decentralization have varied.

In the absence of strong, unambiguous, empirical evidence, researchers have put forward the following three hypotheses concerning the relationship between decentralization and growth: In each of the hypotheses, growth has only a secondary relationship to decentralization and the nature of this connection -- growth enhancing, growth-impeding, or growth-requiring- depends on what one sees as the primary effects of decentralization. These primary effects, in turn, have much to do with the specific design of decentralization policy.

While the rest of the KMS node discusses the methods for reaching certain primary effects --ideally more efficient, responsive delivery of services-- this section provides an outline of the ways in which the commonly discussed primary effects of decentralization can shape decentralization’s effect on growth and desirability in less developed countries.

Three Alternative Hypotheses for How Decentralization can Indirectly Impact Growth

Hypothesis 1: Decentralization increases economic efficiency in public spending, therefore its dynamic effects should be growth-enhancing.

Hypothesis 2: Decentralization can lead to macroeconomic instability which can, in turn, inhibit growth.

Hypothesis 3: Developing countries have significantly different institutional and economic environments than developed countries and will not reap the benefits or suffer the consequences of decentralization in the same ways.

Conclusion: Design Matters

There is no clear, automatic, relationship between decentralization and growth. Direct empirical studies have not been satisfying and a return to the literature on decentralization’s primary effects may be a more useful way to think about the relationship between growth and decentralization. From this point of view, the design of decentralization becomes the key factor in determining whether policies will lead to the efficiency linked to higher growth, exacerbate the deficits and instability connected to lower growth, or simply become mired in institutional constraints.

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