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1.70 In many developing and transition countries, sub-national governments are given relatively little taxing power. The major source of local government revenue in these countries is intergovernmental transfers from the central level. In this case, local governments cannot set the tax rate or define the tax base for most of the major levies, therefore, they have little control over the total level of revenues available. However, intergovernmental transfer systems can be decentralized to varying degrees:

• By guaranteeing local government revenues an adequate flow of revenues,

• By providing local governments with some degree of certainty in the flow of revenue so that more efficient fiscal planning is allowed,

• By providing local governments with transfers that do not have "strings attached", i.e., by giving unconditional rather than conditional grants.

1.71 To evaluate the degree of centralization of the grant pool, one might think of two dimensions of a grant system: the method of determining the size of the total pool of distributable funds, and the method of allocating the funds amongst the eligible units.¹⁰

1.72 The size of the total grant pool might be determined in one of three ways: (a) as a share of a national tax, (b) on an ad hoc basis, and (c) on a basis of cost reimbursement. The former has the potential to be the most decentralized in that it can guarantee the local government some significant flow of revenue (assuming that the center does not change the rules for distribution). The other two forms of determining the distributable pool are more centralizing. The ad hoc method lets the central government determine how much will be allocated to local governments in any given year. The local governments, therefore, will not have an "entitlement", and the size of their budgets will be seen by local voters as beyond the control of locally elected officials. The cost reimbursement approach likewise will not be very centralizing, because it allows the central government to set standards for locally provided services, and to direct investment toward those services where national priorities are greatest.

1.73 The allocation of the total pool of transfers among local governments may also be more or less centralizing, depending on what method is used.

• If allocation is by a derivation method, decentralization is served. Local governments may retain a portion of what is collected within their boundaries and the funds are available to the local governments without conditions or earmarking. The amounts to be received can be predicted with more or less certainty.

• Allocation by formula is also consistent with fiscal decentralization. There is some degree of certainty in the share going to each local government, and if the total pool is allocated in a reasonably consistent way over time, there is some possibility for making a reliable forecast of revenues that will accrue to the local government.

• Allocation by a cost reimbursement method is centralizing because it lets the central government override local priorities, and it forces standards of service on to the local governments as a condition of receiving the funding.

• Allocation by an ad hoc method tends to be centralizing. The Central Government decides each year how much will be given to each local government, but the decision process is not systematic and the allocation method may change each year. This makes it difficult for the local governments to plan effectively for a given sized budget.

1.74 Formulae allocations can also be more or less centralizing. A formula is more decentralizing if it is transparent and if the local government fully understands how its share is determined.

1.75 Systems of intergovernmental transfers in transition countries tend to follow a pattern of derivation-based shared taxes and ad hoc grants. The former is more of a decentralized system of transfers, but the latter is more centralizing. Developing countries, however, often use grants where the pool is determined on an ad hoc or shared tax basis, and the allocations are usually formula or ad hoc. It is very difficult to describe a consistent pattern in developing countries.

Rules to Follow in Decentralizing Government Finance 

Fiscal Decentralization

Political Economy

Constitutional Framework

Government Relations

Expenditure Assignment

Revenue Assignment

Local Revenues

Government Grants

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Budgeting

Credit and Debt

Fiscal Risk

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