Intergovernmental transfers are the dominant source of revenues for subnational governments in most developing countries. The design of these transfers is of critical importance for efficiency and equity of local service provision and fiscal health of subnational goverments.

Taxonomy of grants

For the purpose of economic analysis, grants can be broadly classified into two categories: non-matching and selective matching.

Nonmatching transfers:

Non-matching transfers may be either selective (conditional) or general (unconditional).

Selective non-matching transfers offer a given amount of funds without local matching, provided they are spent for a particular purpose. Such conditionality will ensure that the recipient government’s spending on the specified category will be at least equal to the amount of grant monies. If the recipient is already spending an amount equal to grant funds, some or all of the grant funds may be diverted to other uses. In theory, due to fungibility of funds, increase in expenditures on the specified category would only at the limit equal to grant funds; in practice it is possible that the lumpiness of investments in areas such as infrastructure may result in increases in expenditures exceeding grants.

If the non-matching grant is unconditional or general, no constraints are put on how it is spent and unlike conditional grants, no minimum expenditure in any area is expected. Since the grant can be spent on any combination of public goods or services or to provide tax relief to residents, general non-matching assistance does not modify relative prices and is the least stimulative of local spending.

In some empirical studies, it has been observed that the portion of these grants retained for greater local spending tends to exceed local government’s own revenue relative to residents’ income; that is grant money tends to stick where it first lands. This is referred to as the "flypaper effect." The implication is that for political, technical and bureaucratic reasons, grants to local governments tend to result in more local spending than if the same transfers were made directly to local residents.

Selective (Conditional) Matching Transfers:

We can identify five broad economic arguments for central-state transfers each of which is based on either efficiency or equity, and each of which may apply to varying degrees in actual federal economies.

Summary Table

i. The fiscal gap

An imbalance between the revenue-raising ability of subnational governments and their expenditure responsibilities (the "vertical imbalance") might arise for two reasons. First, there may be (often inappropriate) assignment of taxing and spending responsibilities such that expenditure needs of subnational governments exceed their revenue means. Second, many taxes are more efficiently collected at the central level responsibilities to avoid tax competition and interstate tax distortions, so transfers are necessary to enable local levels to carry out their expenditure responsibilities.

ii. Fiscal inequity

A country which values horizontal equity (i.e., the equal treatment of all citizens nationwide) will need to correct the fiscal inequity which naturally arises in a decentralized country. Subnational governments with their own expenditure and taxation responsibilities will be able to provide their residents different levels of services for the same fiscal effort owing to their differing fiscal capacities. If desired, these differences may be reduced or eliminated if the transfers to each jurisdiction depend upon its tax capacity relative to others, and upon the relative need for and cost of providing public services.

iii. Fiscal inefficiency

The argument for such transfers is reinforced by the fact that the same differentials which give rise to fiscal inequity also cause fiscal inefficiency.

iv. Interstate spillovers

This is the traditional argument for matching conditional grants. Normally, subnational governments will not have the proper incentive to provide the correct levels of services which yield spillover across jurisdictions. In theory, a system of matching grants based on the expenditures giving rise to the spillovers will provide the incentive to increase expenditures. In practice, the extent of the spillover will be difficult to measure so the correct matching rate to use will be somewhat arbitrary.

v. Fiscal harmonization

To the extent that the central government is interested in redistribution as a goal, there is a national interest in redistribution that occurs via the provision of public services by the subnational governments. Expenditure harmonization can be accomplished by the use of (non-matching) conditional grants, provided the conditions reflect national efficiency and equity concerns, and where there is a financial penalty associated with failure to comply with any of the conditions. In choosing such policies there will always be a trade-off between uniformity, which may encourage the free flow of goods and factors, and decentralization which may encourage innovation, efficiency and accountability.

As Bahl and Linn (1992) show and as discussed earlier, the most appropriate form of a transfer depends in large part upon its objective. (See Chart) Regardless of the particular design, however, experience demonstrates that good intergovernmental transfer programs have certain characteristics in common:

• Transfers are determined as objectively and openly as possible, ideally by some well-established formula. They are not subject to hidden political negotiation. The transfer system may be decided by the central government alone, by a quasi-independent expert body (e.g., a grants commission), or by some formal system of central-local committees.

• They are relatively stable from year to year to permit rational subnational budgeting but at the same time sufficiently flexible to ensure that national stabilization objectives are not thwarted by subnational finances. One system that appears to achieve this dual objective is to set the total level of transfers as a fixed proportion of total central revenues, subject to renegotiation periodically (say, every 3-5 years).

• The formula (or formulae, if there is more than one grant) are transparent, based on credible factors, and as simple as possible. Unduly complex formulae are most unlikely to prove either feasible or credible in developing countries because there are often serious disputes on fundamental issues such as regional population sizes.

• If several of the objectives discussed earlier are applicable - for example, some degree of equalization is desired while at the same time there are clear national policy objectives, e.g., with respect to the provision of minimal standards of education and perhaps variable degrees of national support for certain local infrastructure activities - it will generally assist both clarity and effectiveness if separate transfers are targeted at each objective.

Revenue Sharing

Many countries attempt to achieve various of the objectives ascribed above to transfers through systems variously described as "tax sharing" or "revenue sharing." While there are a wide variety of such systems, most of them - perhaps most markedly in the transitional countries - suffer from several common problems. First, if they are partial, that is, do not apply to all national taxes but only to a subset of such taxes, they may bias national tax policy. Second, if - as is often the case - they share the revenues from origin-based (production) taxes to the jurisdictions from which the revenues are collected, they break the desirable link between benefits and costs at the local level and hence reduce accountability and the efficiency of decentralization. Third, since in such systems tax rates are invariably set by the central government, and in addition since the sharing rate is often applied uniformly throughout the country, once again the accountability link is broken and subnational governments have no incentive to ensure that the amount and pattern of their spending is efficient. In addition, if, as in some of the transitional countries, such taxes are collected by local governments and then supposedly shared with national governments - and in this case perhaps especially if the sharing rates are higher (more flows upwards) for richer areas - either an undesirable disincentive for collection effort is created or, more usually, the temptation to "cook the books" is likely to be overwhelming.

Practical guidance on the design of these transfers is summarized in the following:

Criteria for the design of intergovernmental fiscal arrangements

• Autonomy
  Subnational governments should have complete independence and flexibility in setting priorities, and should not be constrained by the categorical structure of programs and uncertainty associated with decisionmaking at the center. Tax base sharing—allowing subnational governments to introduce their own tax rates on central bases, formula-based revenue sharing, or block grants—is consistent with this objective.
  
• Revenue adequacy
  Subnational governments should have adequate revenues to discharge designated responsibilities.
• Equity
  Allocated funds should vary directly with fiscal need factors and inversely with the taxable capacity of each province.
• Predictability
  The grant mechanism should ensure predictability of subnational governments’ shares by publishing five-year projections of funding availability.
• Efficiency
  The grant design should be neutral with respect to subnational government choices of resource allocation to different sectors or different types of activity. The current system of transfers in countries such as Indonesia and Sri Lanka to finance lower level public sector wages contravenes this criterion.
  
• Simplicity
  The subnational government’s allocation should be based on objective factors over which individual units have little control. The formula should be easy to comprehend so that "grantmanship" is not rewarded, as appears to occur with plan assistance in India and Pakistan.
• Incentive
  The proposed design should provide incentives for sound fiscal management and discourage inefficient practices. There should be no specific transfers to finance the deficits of subnational governments.
• Safeguard of grantor’s objectives
  The grant design should ensure that certain well-defined objectives of the grantor are properly adhered to by the grant recipients. This is accomplished by proper monitoring, joint progress reviews, and providing technical assistance, or by designing a selective matching transfer program.

The various criteria specified above could be in conflict with each other and therefore a grantor may have to assign priorities to various factors in comparing policy alternatives.