Prepared By: Candra Fajri Ananda

DECENTRALIZATION
 Decentralization : New Fiscal Paradigm
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 The central government ceases to control the

allocation of expenditure of regional governments
 It allocates blocks of resources - revenue sharing,
grants, borrowing authority - to local governments
and gives them the authority to decide on
expenditure priorities according to the needs of their
constituents
 It maintain an overall role in policy (service delivery
standards), inter- regional equity issues and overall
macro- economic and fiscal management
Why Decentralize?

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 Improve Efficiency
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 This is the basic for local government role

 Efficiency is improved because:
 Better match between services & preferences
 Accountability improves: links benefits- costs

 Mobilization of local revenues increases

 Participation by the beneficiaries encouraged

However!

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 Adverse Effect on Equity
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 Richer jurisdictions will provide better services

 Competitions – flight of investors and wealthy

 Externalities (spillovers) lead to under-provision of

services

Reducing inequity among jurisdictions provides important

reason for continued central government role
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AND
 Possible Negative Effect on Stabilization
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 Difficulties in shrinking the central government in

transition to decentralization
 Reduce ability by central government to contain
expenditures when fiscal pressures develop: nature
of block grant system
 Potential moral hazard in allowing local
governments to borrow
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Therefore
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• Need to pay attention to build a strong fiscal

framework to support decentralization and
to manage the tensions that are built into the
frame work

AND

• Understand that decentralization is a long

term process that requires adjustments as it
unfolds
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Fiscal Framework
 Architecture
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 Functional and expenditure assignments

 Revenue assignments
 Fiscal transfers
 Borrowing by sub-national governments
 Tensions
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 Expenditure assignments: typically 30-40 percent

of general governments expenditures
NEED TO BE MATCHED BY
 Own revenues. But, tax system leads to big gaps
between expenditures and revenues
WHICH RAINFORCES
 Reliance on fiscal transfers, difficult to design-
distortions in accountabilities
WHICH STRENGTHENS INCENTIVES
 For regional governments to borrow, possibly
undermining macro-economic stability
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Assignment of Functions
and
Expenditures
 Basic Principles
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o Economic theory: functions be assigned in

jurisdictions
 Where benefits costs are best internalized,
 Taking account of economies of scale and scope.
o Important principle since it links:
 benefits of their costs: basis of fiscal responsibility

And
 Beneficiaries to taxpayers: basis for accountability
While
 Limiting the fragmentation of management units- important
for efficiency
 Economic Theory Difficult to Apply
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 Benefits are difficult to quantify because of

externalities
 Decisions on functional assignments- made by
politicians and not economist
 Jurisdictions determined by electoral laws and not
by technocrats
 Management Approach - Subsidiarity
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 New public sector management theory basis for

subsidiary principle used by the European Union
 It says:
 Decentralize functions to the lowest level of
government
 UNLESS
 A strong case can be made for allocating those same
functions to a higher level of government

 In other words: “when in doubt, decentralize”

 Watch Out For!
Overlapping Jurisdictions
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 Inevitable: very difficult to set functional assignment

in “stone”, e.g., internet and cellphones are making
regulation of telecoms by national government
obsolete;
 Danger that much energy will be spent on “who does
what”, with very little getting done (Sri Lanka);
 Best approach is to set up legal framework in such a
way that it specifies how conflict will be solved out of
court;
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Tax Assignment
 Broad Principles
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 Principles underlying tax assignments

different than those used to determine
expenditure assignments;
 Key questions to be answered are:
 Who own the tax base?
 Who fixes the tax rates?

 Who collects the taxes?

 Broad principles guided by Considerations:
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 Efficiency of domestic market

 Equity
 Administrative costs
 Fiscal needs
 Efficiency of domestic market
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 The system is not interfere with free movement of

products and factors in the domestic economy;
 Avoid socially wasteful tax competition in
efficiently low taxes on mobile factors of
production;
 Efficiency of domestic market
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 The tax transfer system is main instrument for

redistributive equity
 Equity national concern because all people in a
country should have access to society’s “Social
welfare function”
 Decentralized taxes can interfere with this
objectives
 Administrative costs
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 Decentralization may increase cost of

collection and compliance:
 Fixed cost associated with the tax collection
 Compliance costs may be high for taxes collected
on mobile factors of production (person,
corporations, VAT)
 Tax auditing more difficult for tax bases that cut
across jurisdictions
 Administrative costs
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 To ensure accountability, revenue means should be

matched as closely as possible to expenditure needs;
 Tax instruments that further policy objectives should
be assigned to level of government responsible for
related service
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Grants
 Economic rationale
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 Grants are needed to:

 Correct vertical fiscal gaps
 Correct for fiscal inequity

 Correct fiscal inefficiency

 Compensate for benefit cost spillovers

 Improve fiscal harmonization

 Economic rationale (Continued)
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 Vertical fiscal gaps arise because of:

 Revenue expenditure imbalances

 Economic efficiency issues: avoidance of tax competition and

inter-jurisdictional tax distortions
 Fiscal inequity arises because of variations in wealth
public services may be unequal
 Fiscal inefficiency occurs because regional
differences in service provision affects business and
investor decisions
 Economic rationale (Continued)
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 Inter jurisdictional benefit-cost spillovers:

Benefit not fully captured by jurisdiction (e.g.,
primary education and health services, regional
roads) leading to under provision

 Fiscal harmonization problems arise out of unequal

provision of public services across jurisdictions
 Design: Basic Principle
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Every objective specified by a grantor must be

reflected in the grant design
 Grants Design: Better practice
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 Transparency
 Stability
 Simplicity
Borrowing
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 Decentralize Borrowing?
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 Examples of regional and municipal bankruptcies (Brazil,

Argentina, USA) are used to illustrate adverse effects on stability
of sub-national borrowing;
But
 Literature/experiences do not point to adverse linkage between
borrowing and ability of central government to stabilize the
economy;
Key Issues
 In-adequate design of fiscal framework and weakness in
regulation on borrowing foster moral hazard;
Solution
 Local government need to operate under a hard budget
constraint and central government needs to enforce it
Why Access to Financial Markets Important?
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 Capital expenditure are lumpy

 Financing capital expenditure through taxes is inefficient

 Future generations need to participate in investment

 Matching expenditures with tax flows: expenditures

and tax flows not always synchronized
 Fostering political accountability: market pricing of
capital provides independent mechanism to foster
accountability
 Regulating Sub-National Borrowing
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 Regulatory framework
 Transparency
 Pledging collateral of tax bases and grants
 Penalties
 Market decentralization
 Close loopholds
Concluding Remarks
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 Roy Bahl’s Golden Rule
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1. View Fiscal decentralization as comprehensive system

2. Finance follows function
3. Set into place strong central capacity to monitor outcomes
4. Allow for assymetry – urban versus rural communities
5. Strengthen local revenue raising powers
6. Ensure that central government abides by the rules it fixes
7. Keep the framework as simple as possible
8. Ensure consistence – grant design and decentralization objectives
9. Consider all three level of governments
10. Impose and stick to a hard budget constraints
11. Recognize and plan for transition
12. Find a strong champion