Issues in Program Design
|Contributor: World Bank
Author: Decentralization Thematic Team
Contact: Jennie Litvack
Macroeconomic Impact of Decentralization
Sub-national IncentivesCompared 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 SharingSub-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.
Sub-national BorrowingSub-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:
Coordination mechanismsIn 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 DesignIn 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.