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Rule #1 Intergovernmental Fiscal Relations is a system, and all of the pieces must fit together. The system that any country designs must take into account, in some consistent way, the following:

• the assignment of taxing and spending powers and responsibilities,

• local government autonomy in setting tax rates, determining tax bases, and setting budgets,

• the degree to which local councils are popularly elected, and the degree to which local councils appoint and dismiss the chief local operating officers,

• whether the number and salaries of local government employees are determined by the local or the central government,

• whether, and how local governments will be able to borrow for capital purposes, and

• the structure of intergovernmental transfers.

If an intergovernmental system is designed without considering all of the pieces, it is not likely to accomplish the objectives that the government has set for it.

Rule #2 First, fix the assignment of expenditures, then assign revenues in amount that will correspond to the expenditure needs.

The order is important. If one begins on the revenue side, the vertical dimension of revenue sharing is never addressed and expenditure assignment becomes a process of "cutting the cloth" every time the tax system or the revenue sharing system is changed. This is bad public policy because there needs to be stability and continuity in the expenditure budgets of local governments. Recent cases of instability are the assignment and reassignment of capital expenditure responsibility, and social service responsibility, in transition countries.

Rule #3 Begin fiscal decentralization with a strong central ability to monitor.

Most developing and transition countries, no matter how vigorous their local government reform programs, will be very centralized for a long time to come. Macroeconomic considerations alone guarantee this result. The strengthening of local government finance will need to be led and regulated by a strong central government. Paradoxically, the first step in effective decentralization may be to develop a strong central ability to lead and monitor fiscal decentralization.

Rule #4 One system will not fit the urban and rural sectors.

Most developing and transition countries are characterized by wide disparities in income and wealth among their regions. While the larger and more urban places are able to absorb functions and finance, the more rural areas usually are not. The decentralization program must recognize these disparities in capacity by offering a two-track program for rural and urban areas. Many developing and industrialized countries do differentiate among the rural and urban area in terms of the degree of fiscal autonomy offered.

Rule #5 Accountability of local government officials requires significant local fiscal autonomy.

In order to capture the benefits of fiscal decentralization, there must be significant local autonomy given, and it must be given on both the taxing and expenditure side. If local governments do not have the power to set tax rates, then their officials cannot be held fully accountable by voters for the quality of public services delivered. It is also necessary for local councils to be elected, and for local chief officers to be appointed by the local council. Otherwise neither will be accountable to the local voting population, and the efficiency gains of decentralization will be lost.

Rule #6 The central government must honor its commitment to decentralization by following the rules it makes.

The success of fiscal decentralization programs depend on the ability of local governments to deliver what they promise to voters. If the central governments violate the compact (by not funding promised transfers, by making ad hoc last minute changes in transfer formulae, by abolishing local taxes, by assigning new expenditure responsibilities to local governments, etc.), local government officials can beg off from their accountability to the local electorate. The driving force behind successful decentralization will have been lost.

Rule #7 Keep it simple. Precision in tax administration and grant distribution is probably not possible in most cases.

Local governments need to stay away from complicated formulae for the distribution of transfers, largely because such formulae cannot be maintained with existing data, and cannot be implemented with existing staff. Likewise, special local tax provisions -- differential rates and exemptions to affect the allocation of resources -- should be shied away from because the local tax administration is unlikely to be able to enforce these effectively.

Rule #8 Grants and shared taxes must play an important role in almost any decentralized fiscal system in a developing or transition country.

It should be recognized that the age of VAT means that there is much less room for assignment of revenues to local governments. VAT is not suitable as a local government revenue source, or as a shared tax on a derivation basis. This suggests that grants allocated on a basis other than derivation will play an increasing role in the intergovernmental fiscal structures in many countries. The individual income tax has many characteristics that make it suitable as a local government tax. Other good prospects for local taxes are the property tax, taxes on motor vehicles, and user charges.

Rule #9 There is an intraprovince dimension to intergovernmental fiscal relations and this should be taken into account in planning the system.

If the central government worries only about the distribution of resources among the provinces, it may miss the more important issue of how resources are distributed among the rich and poor local governments within the province. Oftentimes, the disparities in income and wealth within a province are much greater than those among provinces.

Rule #10 Impose a hard budget constraint.

Local governments must realize that their expenditure level is limited by a combination of local taxes and a transparent system of intergovernmental transfers. The central government must guarantee an adequate "vertical" balance, but must not show a willingness to provide bail outs to over spenders.

Rule #11 Recognize that intergovernmental systems are always in transition, and plan for this.¹¹

Among the reasons for instability in systems of federalism are:

• Regional balances in economic power shift over time. As recently as 20 years ago when the United States federal system was going through a major overhaul, there was little thought given to the possibility that Florida and Texas would be the third and fourth largest states by 1990, and that grant formulas would have to reflect this new power.

• The oil and mineral rich provinces of Russia have realized a new economic power, and this has partly shaped the emerging federalism in that country.

• Ethnic differences take on more importance, either because of changing political power or because of civil unrest.

• Politicians change and bring new views and biases with them. For example, China’s economic reform begun in 1983 had profound implications for the system of fiscal relations between central and local governments, moving the balance of fiscal power towards the lower level. The recent 1994 reform shifted the balance back towards the center. Similarly, almost every new President in the United States in the past three decades has introduced a "new federalism".

What can a country do to protect itself against the disruptions caused by these circumstances? How can one protect the certainty needed by local governments to plan effectively for the expenditure of tax moneys? One possibility is to set up commissions, as in India and Australia, to periodically review the intergovernmental system. Another is to put in place a data system that will enable a careful tracking of the fiscal performance of sub-national governments, and the evaluation of the impact of changes in the federal system on these governments.

Topic 1: The Concept of Fiscal Decentralization

Fiscal Decentralization

Political Economy

Constitutional Framework

Government Relations

Expenditure Assignment

Revenue Assignment

Local Revenues

Government Grants

Infrastructure

Budgeting

Credit and Debt

Fiscal Risk

Accountability

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