There are some limitations

Oct 04 - 10, 2004





The traditional approach of public finance economists to decentralization, known as "fiscal federalism", calls for a sub-national government structure with several tiers, with each tier delivering those services that provide benefits to those residing in the jurisdiction. This model identifies three roles for the public sector: macroeconomic stabilization, income redistribution, and resource allocation in the presence of market failure. The model assigns the stabilization role to the central government because it control monetary policy and has more scope to use fiscal policy than sub- national governments. The responsibilities for social services and direct income redistribution are typically shared across different tiers of government that have access to different sets of information and may have different objectives.

Global experience shows that this model while useful has some limitations. Tax bases vary substantially from region to region and city to city, but tax rate cannot. A provincial or local government with a relatively small tax base cannot compensate by imposing much higher tax rates without losing revenues and residents to jurisdictions with lower taxes. The costs of providing public services may also vary because of regional characteristics such as population density and geographical location. To correct for such variations, most decentralized fiscal systems include equalization grants. In Vietnam, the per capita tax revenue of low income provinces are only 9 percent of those of wealthier provinces, but expenditures are 59 percent as a result of transfers from the central government. In Australia, Canada and Germany grants guarantee a minimum level of per capita expenditures for essential services in all regions.

India is known as a decentralizing federation. Its federal constitution gives substantial fiscal and regulatory powers to its states. But, dissolvation power of the central government, centralized planning and domination of national political parties in sub national governments undercut the fiscal and regulatory powers of the sub-national governments. Sales tax in India is one of the major sharing components of its fiscal resources. It is a part of the Divisible Pool. However, in Indian fiscal mechanism the provincial governments collect it and 50 percent of the collection are transferred to the central government from provinces. This mechanism is inversed in Pakistan.

Fiscal decentralization reduces the central government's control over public resources. The government of the Philippines, for example, is required to share nearly half its internal tax revenue with sub-national governments, limiting its ability to adjust the budget in response to shocks.

The separation of taxing and spending powers allows sub-national governments to incur only a fraction of the political and financial costs of their expenditures, especially when most regional resources are funded out of a common national pool of tax revenues.

The question that which tier of government controls which resources is the crucial issue of decentralization. Experience provides two lessons in this area. First, sub-national governments need resources commensurate with their responsibilities. Second, sub-national authorities must operate under firm budget constraints, so that they do not spend or borrow excessively in the expectation of a central government bailout.



Certain forms of taxation are appropriate for financing local services with benefits that cannot be confined to individual consumers, such as local roads. Such taxes must fall on the residents of the jurisdiction and must be direct that is they must directly target individuals or personal properties. Good examples are the property tax and the personal tax. Indirect taxes such as the General Sales Tax (GST) or corporate income tax, which can be built into the price of the goods and passed on to consumers outside the taxing jurisdictions, are not generally appropriate as regional taxes. To compensate, most local governments in the world rely on various forms of business taxation. Jordan imposes a business license fee; Brazil has taxes on services, and some Indian states on the octroi.

For intermediate levels of government, the problem of matching taxes to the jurisdiction is even more complicated. Since transfers account for a large part of sub-national finances, their design is a critical factor in the success of decentralization. Transfers are needed to fund the services local governments provide on behalf of the central government, while local revenues should ideally cover local expenditures. And transfers are essential to ensure that decentralization does not occur at the expense of equity, particularly, if there are large income differences across the regions. Finally, government can use transfers to influence the sectoral pattern of local expenditures by transfers or disbursing of matching grants.

Although, transfers are almost always necessary, they should not be so large as to eliminate the need for local taxes. Local taxes ensure that sub-national governments face, at least to some degree, the political consequences of their spending decisions. And political necessity sometimes imposes the need for relying heavily on local taxes. Tax sharing was one of the more controversial issues in the Yugoslav Federation, where wealth differed greatly across ethnic groups and redistribution issues were mixed up with ethnic tensions. Similarly, the search for a good regional tax was of paramount importance in Ethiopia, where regions are defined on the basis of ethnic identity.

Transfers have three variables: The first variable is the amount to be distributed. This can be fixed as a percentage of national taxes, or it can be an ad hoc decision, sometimes to reimburse pre-approved expenditures. The second variable is the criteria for distributing transfers among jurisdictions. In Argentina, for example, a predetermined formula is used to allocate a fixed percentage of certain national taxes, whereas in Pakistan and India, the central governments periodically determine, on the basis of need, both the levels of transfers and the method of distribution. The third variable concerns the conditionality imposed on the use of transfers. Transfers can be assigned for specific uses or left unrestricted. Data on the global patterns of sharing in public expenditures and revenues by sub-national governments and the numbers of subnational tiers are shown in attached tables. Global experiences can be helpful to determine the fiscal nexus in Pakistan.

The paper was delivered in the meeting of discussion forum of the Institute of Business and Technology, Karachi