Decentralization and MTEF By K. Migara O. De Silva Economist World Bank Institute August 20, 2004

Decentralization and MTEF Plan of the Presentation: Why MTEF? Concept & Objective Linking with Intergovernmental Fiscal Reforms –Establish policy priorities & planning through evidence- based and consultative budget formulation process –Discretionary powers to ministries and local governments –Establish hard budget constraints Benefits of MTEF and some challenges

Why MTEF: Concept & Objective MTEF provides the ‘linking framework’ which allows expenditures to be driven by policy priorities and disciplined by budget realities (constraints). MTEF is a potential solution in countries where policy making, planning, and budgeting are in disarray and not property linked with one another. For this reason, MTEF has recently become a central element of many of the public expenditure reform (PEM) programs. MTEF includes a ‘top-down’ resource envelop; a ‘bottom-up’ estimation of the current and medium-term costs of the existing policy; and matching these costs with resources available in the annual budget process. Top-down resource envelop includes fiscal targets and estimates of revenues & expenditures, government’s financial obligations, and costly, medium-term programs such as civil service reforms (CSRs).

Why MTEF: Concept & Objective Bottom-up estimation looks at sector policies and activities with an objective to optimizing intra-sectoral allocations. Stages of formulating a comprehensive MTEF include: –(a) developing a macro/fiscal framework which projects revenues & expenditure in the medium-term; –(b) developing sectoral programs with cost estimates of activities, their objectives, and outputs; –(c) defining a sector-resource allocation strategy based on medium-term sector budget ceilings; –(d) preparing sectoral budgets; and –(e) political approval.

Why MTEF: Concept & Objective Objectives of MTEF: –(1) greater macroeconomic balance which includes fiscal discipline attained through sound estimates of available resource envelop. These estimates are then used to make budgets that will fit within the envelop; –(2) improved inter & intra-sectoral resource allocation; –(3) greater budgetary predictability for line ministries; –(4) efficient use of public funds/resources; and –(5) linking the MTEF to PRSP. In sum, MTEF will include three pillars: (i) Projection of aggregate resource envelop, (ii) cost estimates of sectoral programs, and (iii) the political- administrative-institutional process which integrates the two

Linking MTEF with Intergovernmental Fiscal Reforms Fiscal decentralization provides greater opportunities for establishing policy priorities & planning through evidence-based and consultative budget formulation processes. When properly designed, it also improves efficient allocation of resources.  By virtue of their proximity and ready access to local population, sub-national units such as Dzonkhags have superior information on local services and thus are better placed to respond to local demand for services and problems of service delivery and to match expenditure responsibilities with available revenue resources.  Sub-national units could also raise local revenue and taxes more efficiently, finance local infrastructure, and effectively deal with the delivery of social services – such as education, health services – at the local level by developing monitoring mechanisms, performance benchmarks, private sector involvement, etc.  Therefore, it is critical to provide sub-national governments both incentives and sufficient authority to manage revenue & expenditure of their budget within a consistent and a comprehensive framework. They should also be able to predict with some certainty the amount of inter-governmental transfers (Bird, 2002, World Bank).  Strengthening political decentralization at local levels such as Geog and Dzonkhag is another critical ingredient for the success of intergovernmental reforms.

Linking MTEF with Intergovernmental Fiscal Reforms  It is also important to transfer responsibilities to local units which are best positioned to make the desired changes. Example: in Central America, decentralization of management responsibilities from central to provincial and local governments had little effect on primary education; but when these responsibilities were transferred directly to the schools, education performance improved (WDR, 1999/2000)  Quality of public services can also become worse when expenditure responsibilities are transferred to local government without introducing proper institutional mechanisms. Power may be simply transferred from national to local elites. Example: India’s caste system - local participation depends on caste and poor have little or no voice. (also see Table 2, 3, and 5 in the handout)  Two basic principles of revenue assignment: (I) Sub-national units should be allowed to finance locally-provided services (benefiting local residents) by using “Own-source” revenues; (2) Where possible, sub-national revenue should be collected only from local residents in relation to the benefits they receive from local services (see also: Table 1, 7 & 8 in the handout)  The basic requirement for an effective and efficient sub-national government is to be able to match expenditure responsibilities with resources; and revenue capacities with political accountability.

Linking MTEF with Intergovernmental Fiscal Reforms Establishing Hard Budget Constraints:  Macroeconomic instability is caused by the inability to impose hard budget constraints. However, imposing hard budget constraints require political will (see also Table 9 and Exhibit 1 in the hand out). Argentina provides an important case in point on why hard budget constraints are important. Before 1991, when Convertibility Plan was introduced, provinces were able to borrow large amounts from their own provincial banks which were later discounted to the central bank. In 1990, there were 20 provincial banks which provided more than 60% of the credit to provincial governments. Central Bank had to lend large amounts of new rediscounts to prevent the collapse of a number of these banks.  After 1991, with the introduction of the Convertibility Plan, the central bank was effectively transformed into a currency board – which required it to maintain 100% reserve requirement. In 1992, central bank’s charter was revised, restricting it to take any new domestic assets and prohibiting the guarantee of bank deposits. (Dillinger & Webb, World Bank, 1999). These institutional reforms imposed a hard budget constraint on provincial banks and helped the country avert macroeconomic crises in the 1990s.

Linking MTEF with Intergovernmental Fiscal Reforms  In Morocco, for instance, the government changed subsidy scheme for local government from one of budget-balancing, in which both capital and interest payment on loans increase transfer receipts, to a formulae-based equalization transfer which does not take into account the amount of borrowing done by local governments. Lenders were explicitly told that they should not count on financial bailouts (Richard Bird & Francois Vaillancourt, 1998)  There are instances where the central government bails out sub-national units when these units are too politically important to fail. In such situations, the central/provincial governments may keep the ‘door to the treasury’ under lock and key to avoid any possibility of financial profligacy. In Canada for instance, provinces severely restrict local government borrowing and under no circumstances the local governments are allowed to borrow as they wish (Bird, 2002, World Bank).  The main lesson to be derived from this discussion is that intergovernmental fiscal reforms should be carried out with the requisite institutional reforms and hard-budget constraints. For hard-budget constraints to be effective, there should be credible rules/procedures preventing bail-outs. In addition, there must be transparency - allowing full information to the creditors and residents, as well as full accountability.

Linking MTEF with Intergovernmental Fiscal Reforms  In the present context, institutions should provide proper incentives and reduce moral hazard. Sub- national borrowing is an important case in point. Since it is difficult to introduce formal bankruptcy procedures in the public sector, other institutional mechanisms may be introduced to limit sub- national borrowing. Politically important sub-national units may continue to borrow. Some constraints and procedures could be introduced such as:  Explicit prior approval; requirement for regular and full information of sub-national borrowing to the public; credible reviews and control systems; monitoring and evaluation (both ex-ante and ex-post); clear and simple bankruptcy procedures, etc.  Establishing explicit criteria for borrowing – such as the system of “traffic lights” in Colombia where sub-national governments could borrow when debt is below a certain threshold but require explicit prior approval when debt levels are higher (Dillinger & Webb, 1998); or “Maastricht criteria” for EU under which deficits and borrowing cannot exceed certain numerical limits (Bird, 2002). Similar mechanisms will limit recent foreign borrowing (Eurobonds) by some sub-national governments in Russia.  Organizational reforms with proper incentives which discourage inefficiency and corruption. Ex: recruitments based on merit; promotions based on performance and not on seniority  More ‘formal’ role for citizens. Example introducing ‘participatory budgeting’ where the public has a role to play at each crucial level of budget formulation. Example: St. Petersburg City Government where citizens involvement in the budget formulation has been effective.

Benefits of MTEF and Some Challenges Benefits: More realistic budget framework and better alignment with policy priorities such as PRSP Greater opportunities to fund highest priorities More accurate reporting requirements such as reporting expenditures Greater transparency and ownership due to the involvement of and consultation with line ministries, local/regional government units such as Dzonkhags. Setting up ‘Hard budget constraints’ and tighter sectoral ceilings Building ‘institutional’ (rules/procedures, etc.) and organizational (agency) capacities at all key levels of budget formation.

Benefits of MTEF and Some Challenges Some Challenges Creating an effective expenditure monitoring/tracking system at all levels of the government and especially at subnational governments. Implementation challenges due to lack of organizational and human resource capacity at all levels of government. Inability to prioritize sectoral/regional policies due to lack of political will. Lack of proper coordination within key policy-making & budgetary units in the government. Lack of ‘institutional capacity’ – i. e., lack of appropriate laws, rules, and regulatory and monitoring procedures in place.