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Issues in Program Design

Contributor: World Bank
Author: Decentralization Thematic Team
Contact: Jennie Litvack

Revenue Assignment

Governments rely on a wide variety of tax instruments available for their revenue needs, such as direct, indirect, general, specific, business and individual taxes. The question addressed here is which types of taxes are most suitable for use by each level of government.

Principles of Tax Assignment

The assignment of taxes by jurisdiction depends partly on the mix of various taxes used in the country overall. In public finance theory, the issue of the ideal tax mix even in the unitary state has not been widely developed. Governments almost universally employ balanced tax systems which have the feature that different taxes apply to basically the same bases. For example, general sales taxes, payroll taxes, and income taxes have bases which overlap considerably. From the point of view of standard efficiency and equity, one should be able to make do with a single general tax base, yet no governments behave that way. The usual reason given for this is that administrative considerations play an important role. A mix of taxes keeps the rate on any tax low, thereby reducing the incentive to evade or avoid the tax. Furthermore, by using a mix of taxes, taxpayers who would otherwise be able to avoid taxation of one type are caught in the net of another, making the tax system fairer. The importance of the various taxes in the overall mix remains, however, a matter of judgment rather than something that can be deduced from the principles.

These same general considerations apply in the case of assigning taxes in a federal government system. Efficiency and equity arguments have to be tempered by administrative considerations, and the exact assignment depends upon informed judgment. We can, however, outline the economic principles that come into play in deciding which taxes to assign to lower levels of government. They are as follows:

Efficiency of the Internal Common Market

The internal common market will be functioning efficiently if all resources (labor, capital, goods, and services) are free to move from one region to another without impediments or distortions imposed by policy. Decentralized tax systems can interfere with the efficiency of the economic union in two ways. For one, the uncoordinated setting of taxes is likely to lead to distortions in markets for resources which are mobile across states, especially capital and tradable goods. This problem will be lessened considerably if state governments recognize that resources are mobile. However, if they do recognize that, they may engage in socially wasteful beggar-thy-neighbor policies to attract resources to their own states. If all jurisdictions engage in such policies, the end result will simply be inefficiently low taxes (or high subsidies) on mobile factors.

National Equity

The tax-transfer system in one of the main instruments for achieving redistributive equity. The argument for making equity a federal objective is simply that all persons ought to enter into society’s ‘social welfare function’ on an equal basis, and presumably the federal government is the only level that can ensure that residents in different regions are treated equitably. This may be tempered if states have different tastes for redistribution, or if centralized decisionmaking is not guided by normative criteria. To the extent that equity is viewed as being a federal policy objective, decentralized taxes can interfere with the achievement of those objectives. As with the efficiency case, uncoordinated state tax policies may unwittingly induce arbitrary differences in redistributive consequences for residents of different states. Also, given the mobility of labor and capital across the states, the states may engage in perverse redistributive policies using both taxes and transfers to attract high-income persons and repel low-income ones. Beggar-thy-neighbor redistributive policies are likely to be offsetting with respect to resource allocation, but will result in less redistribution than in their absence. (Of course, those who abhor redistribution through government will prefer decentralized policies for precisely the same reason.) This is obviously likely to be more of a problem for those taxes which are redistributive in nature, as well as for transfers.

Administrative Costs

The decentralization of revenue raising can also serve to increase the cots of collection and compliance, both for the public sector and for the private sector. There are fixed costs associated with collecting any tax which will have to be borne for each tax type that is used by the states. Taxpayers will also have to incur costs of compliance for all taxes levied. The possibilities for evasion and avoidance will increase with decentralization for some types of taxes. This will be true where the tax base is mobile, or where the tax base straddles more than one jurisdiction. In the latter case, there will need to be rules for allocating tax revenues among jurisdiction; in their absence, some tax bases may face either double taxation or not taxation at all. Auditing procedures may also be distorted for those tax bases which involve transactions across state boundaries.

Fiscal Need

To ensure accountability, revenue means should be matched as closely as possible to revenue needs. Thus tax instruments intended to further specific policy objectives should be assigned to the level of government having the responsibility for such a service. Thus progressive redistributive taxes, stabilization instruments, and resource rent taxes would be suitable for assignment to the national government; while tolls on intermunicipal roads are suitably assigned to state governments. In countries with a federal level VAT, it may be too cumbersome to have sub-national sales taxes. In such circumstances, the fiscal need criterion would suggest allowing subnational governments access to taxes which are traditionally regarded as more suitable for national administration, such as personal income taxes.

Reconciling the Difference: Making Subnational Governments Accountable, While Preserving Efficiency and Avoiding National Distortions.

The main problem with the tax assignment that emerges from the preceding prescriptions, as illustrated in the attached table, is that it generally does not provide sufficient revenues for lower-tier governments. In part for this reason, local and especially intermediate-level governments in many countries levy a variety of specific (excise) taxes on gambling, motor vehicles, and so on. Again, however, such levies seldom produce anything like the revenue needed to finance a significant part of major expenditures such as education and health that are often assigned to subnational governments.

Resolving the Problem

  • The first way is to supplement local revenues by intergovernmental fiscal transfers - without undesirably reducing local efforts to collect their own taxes. (see transfer section)
  • The second option is to permit subnational governments to levy their own broad-based taxes - as long as they burden local beneficiaries only. In principle, a retail sales tax or a tax on personal income would be possible. In practice, however, the only efficient, desirable broad-based subnational tax that seems feasible is likely to be a flat-rate surtax (often called "piggybacking") on a national personal income tax. Retail sales taxes are seldom feasible in the circumstances of developing or transitional countries.

Whether with respect to such a surtax, a local property tax, or local taxes in general, the critical elements required to ensure local accountability without efficiency costs are (1) to restrict local governments as much as possible from exporting taxes and (2) to permit them to set their own tax rates. For efficiency, it may be desirable to assess the base of a tax centrally and even to have it collected by the central government; but for accountability it is critical that the local authorities are responsible (perhaps within limits) for setting the tax rate.

The Transition Economies: Redefining Local Powers

A special situation exists in a few transitional countries, including those of NIS, China and Vietnam, where local governments have traditionally had a larger role in administering national tax bases. In these transition economies the central government may not have full control over its tax bases due to local administration of these. For example, in China and Russia , revenues were collected at the local level (via a tax contracting system in China and shared upwards. This created local level incentives to make better collection efforts for taxes fully retained at that level and less effort for taxes that were largely transferred upwards. Local governments in these countries preferred to receive transfers in kind or contributions from own enterprises rather than collect higher corporate taxes which had to be shared with higher levels. Revenue sharing on a tax by tax basis led to highly varied levels of efficiency in tax administration.

Further, in a country with conflict among levels of government, subnational administration of national taxes is not advisable since the subnational entity can refuse to submit national taxes if it becomes disgruntled (e.g.,Tatarstan in Russia).China has recently strengthened its central tax administration to collect revenues from central and shared taxes. Second, problems are also caused by overlapping, uncoordinated administration, especially for sales and excise taxes.

Conclusion: The Balance Between Enough and Too Much

Decentralization has the potential to reduce accountability by breaking the links between the levels of taxation and expenditure. Major expenditure responsibilities are being transferred to local governments in an effort to improve service delivery, but there are few high-revenue taxes which can be assigned to local governments without creating national economic distortions. Efficiency in tax administration suggests that local governments should levy taxes on immobile factors (e.g. property taxes) and fiscal need criteria suggest that they should also levy cost recovery user charges such as frontage taxes (tax per linear front foot of property), tolls on local roads and poll taxes. These tax revenues are unlikely to be sufficient in many localities, and thus, intergovernmental transfers are required to mitigate this imbalance. While taxation increases can create constituent pressure for good local performance, some grant designs can create central government pressure for local performance.