Challenges of Budget Management in Decentralization Budget Management and Financial Accountability Course Dana Weist Lead Public Sector Specialist, PRMPS dweist@worldbank.org 2 March 2004

Decentralization: A World-Wide Phenomenon Underway in over 85 countries Political and economic rationales Varieties Deconcentration Delegation Devolution

Decentralization Trends Subnational Expenditure Shares Subnational Tax Shares Developing Countries 1970s 13.0% (48) 10.4% (43) 1980s 13.2% (43) 7.7% (35) 1990s 13.8% (54) 9.3% (28) Transition Countries 26.1% (23) 16.6% (14) OECD Countries 33.8% (22) 18.7% (22) 32.3% (23) 32.4% (23) 19.1% (23) Source: International Monetary Fund. Government Finance Statistics Year Book , various years, Country Tables

Differences Across Regions Subnational Share of Expenditures Subnational Share of Revenues Note: Simple average of most recent observations in available countries. Numbers in parenthesis indicate number of countries represented. Source: International Monetary Fund. Government Finance Statistics Year Book 1998, Country Tables.

Positive or Negative Outcomes? If designed well, decentralization can Move decision making closer to people (subsidiarity principle) Enhance efficiency and responsiveness of service delivery Improve economic growth Potentially alleviate poverty But, design is complicated, since it spans political, fiscal, and administrative policies and institutions

Key PE Questions Who is doing what? How is it being financed?

Macroeconomic Stability Key factor is “hard budget constraint” Creates incentives for subnational fiscal discipline Limits risk of central government Can be “softened” through several channels (intergovernmental fiscal system, financial system, SOEs, borrowing, etc.) One often hears about the potential (and sometimes realized) risk of macroeconomic stability in decentralized countries. The critical factor influencing subnational fiscal behavior and central government liabilities is the presence of “hard budget constraints”. A hard budget cosntraint exists when the central government can and does refuse to provide additional resource to a sub-national government beyond a pre-agreed resource envelope. The problem often in decentralized countries is that despite local governments being”autonomous”, they will tend to overspend, under tax or overborrow if they believe that the central governent will provide additional resources to them (or “bail them out”) If central governments do bail out local governments, their discipline is compromised, national fiscal deficits can grow and this can ultiamtely be destabilizing. A budget constraint can be softened by a number of channels:

Equity Extent of fiscal equalization Ways and means for targeting poor places and poor people Add comment that experience with local solidarity will depend, amongst other things, on social capital and homogeniety of local populations.

Four Pillars of Intergovernmental Fiscal System Expenditures Revenues Intergovernmental transfers Subnational borrowing/debt

Expenditure Issues Objective: significant and clear expenditure responsibility and autonomy Subsidiarity principle: provide services at lowest level of government compatible with "benefit area" associated with those services Distinction between production and provision Do local services respond to local needs? Do citizens have meaningful opportunities for voice? Do officials face incentives to respond? Assign expenditures first, then assign revenues that match expenditure needs

Local Revenue Issues Own resources typically inadequate to carry out assigned functions Revenues not adequately responsive to changing needs Striking variations in size and capacity – one size doesn’t fit all Local revenue mobilization strengthens accountability -- link taxes with benefits derived from local government services Simplest and most effective form of tax autonomy: discretion to set tax rates

Rationales for Intergovernmental Transfers Vertical imbalances Horizontal imbalances Inter-jurisdictional spillovers (externalities) Enhancing national objectives at the subnational level Paying for national programs implemented by subnational governments

A “Good” Transfer System Transfers should be transparent and predictable (formula-based) Equalization transfers should include A measure of “need” A measure of “capacity” Adequate sub-national revenue autonomy Stable but flexible financing Avoid a proliferation of conditional grants

Local Borrowing Benefits Risks Finance long-lived assets efficiently and equitably Overcome liquidity problems of lumpy investments “Pay-as-you-use” financing Improve selection of investments Risks “Soft” budget constraint Macro-instability

Borrowing Risks Can Be Managed Strengthen intergovernmental fiscal system Apply administrative controls Implement rule-based framework Establish market-based system Impose other controls

Decentralization Challenges Balance responsibilities with resources, capacity and accountability Subsidiarity Finance follows function Responsibility with capacity (learn by doing) Accountability through political channels, own source revenues, participation and transparency Create incentives for implementation to match formal arrangements

Operational Implications of Decentralization Many more potential clients Weaker client capacity Limited knowledge of Bank processes and requirements Weak capacity in project preparation and procurement Local accountability may be weak and potential for local corruption may be high Shorter time frame for local officials Need for Improved data Streamlined Bank processes? Experimentation and new solutions?

Public Expenditure Management Lens Clarity in expenditure assignment? Adequacy of resources? Formula-based transfer system? Hard budget constraint? Budgeting and reporting systems Uniformity vs. flexibility Carrots vs. sticks