Capital transfers to sub-national governments

[petagny]

I'm looking for some good practice guidance on approaches to making capital transfers to local governments. Does anyone have any good references or informative country experience?

Grateful for any pointers PFM Boarders might be able to give.

Petagny

[FitzFord]

Petagny,

As in so many aspects of decentralization (and inter-government capital transfers generally) the context is crucial. For example, what proportion of overall expenditures and revenues are assigned to the subnational governments? How closely does the assignment fit the funtions assigned? What particular services are these capital expenditures intended to finance? What is the potential revenue stream to be derived from the capital expenditures? What is the capital investment management capacity of the subnational governments (including procurement management)? What oversight role will the central government play? How effective is the central government [likely to be] at oversight? Even tentative answers to these questions will help to narrow the search for pertinent examples for your particular case.

Fitz.

[petagny]

Fitz,

Some good questions to start the analysis.

I don't really have the answers to all of them, but let's say a resource rich country with very large income disparities and a government keen to use conditional capital transfers to even out some of the economic and social inequalities. Central government capacities are relatively strong, but local government capacities vary with the economic and social wellbeing of the local government, i.e., it's the classic problem that capacities are weakest where the central government wants to direct more resources!

Central government is also ready to invest in building local government capacities, but is getting a bit fed up of sponsoring endless training in cost-benefit analysis and project planning and not really seeing much impact.

Central government is also keen to set up the right incentive environment and avoid situations where it funds investments that local government cannot afford to operate or maintain (or is at least not very good at planning to do so). Some sort of tiered matching grant system seems like it might address some of the issues.

This is a scenario I've encountered before. It's probably also familiar to you.

Best,

Petagny

[jorgemartinez]

Petagny,

You might want to take a look at a working paper I recently wrote with Ana Herrero-Alcalde (Universidad Nacional de Educación a Distancia) and  Encarnación Murillo-García (Universidad Rey Juan Carlos) on "the Challenge of Designing Capital Transfers: An Application to Spanish Regions".  The paper analyzes the main design issues for utilizing capital transfers with an equalization objective within a system of sub-national finance. Although there is a vast literature and ample policy practice with the design of equalization grants involving needs for recurrent expenditures and/or fiscal capacity associated with current revenues, there is a dearth in the fiscal federalism literature at both the theoretical design and actual practice levels on how to use capital transfers with an interregional equalization objective. The two main aims of this paper are first, at the conceptual level, to identify the singular characteristics of capital expenditures and capital financing sources that would allow quantifying capital expenditure needs and financing capacity across sub-national jurisdictions; and second, by incorporating those measures into a capital equalization transfer formula to apply the design framework at the regional level in Spain.   http://ideas.repec.org/p/ays/ispwps/paper1025.html

Jorge Martinez-Vazquez
Regents Professor of Economics and
Director of International Studies Program
Andrew Young School of Policy Studies
Georgia State University
http://aysps.gsu.edu/isp/index.html

[petagny]

Jorge,

Thanks so much. Your paper seems highly relevant. You are right about the relative dearth of material in this area.

Petagny.

[FitzFord]

Petagny,

I assume you will read Jorge's paper. It is clearly pertinent, even from a quick read. Among the points that I would emphasize is that a critical principle to take into account is that analysis of the size and terms of capital grants should take into account both current and future users. The practical implication is that the size and projected income of users, and the time that they become users, will influence the terms that will be necessary for financial viability. That, in turn, means that the central government must be prepared - willing and able - to provide ongoing subsidies for projects that have operating costs  beyond revenue expectations. This point is frequently overlooked, with unhappy consequences. The EU has a program of capital grants for some countries. It may be useful to review their rules and the resulting experience.

Japan has had a system of capital grants for some time. That also is worth looking at, although you will necessarily have to factor in Japan's special characteristics.

Fitz.

[petagny]

Fitz,

The paper is useful to me because it shows an approach to the design of a formula for capital equalisation transfers that builds in differences in needs for capital infrastructure as well as financing capacity, i.e., ease of access to capital markets. It therefore seems to be dealing with the issue that those local governments that have the large infrastructure deficits are often the one's least able to borrow. But how to balance needs and financing capacities?

The paper comes up with a formula that allocates capital equalisation transfers in 'direct proportion to estimated expenditure needs and each jurisdiction's relative deficit in initial stock of capital and in inverse proportion to the estimated financial capacity'. Inevitably there has to be a sharing arrangement whereby richer provinces must give up resources to poorer ones, but the interesting thing, at least in the Spanish case, is that the infrastructure deficit seems to be greater in the most economically dynamic and populated areas, so the required transfer is not necessarily as large as might have been expected.

The points you raise are important too and I shall be delving further into this paper.

I don't know anything about the Japanese system, but would like to know more if there are any useful references. Vietnam has allocation formulae ('norms') for transfering capital equalisation grants to provinces (and provinces are supposed to be designing similar formulae for transferring to districts and communes -  and some have). These formulae last for a 4-5 year stability period and are then redesigned/renegotiated. Decision 60/2010/QD-TTg dated 30/9/2010 sets out the allocation norms for the next 5 years. Unfortunately, I don't have a translation, but it looks rather complex, with sector specific components. All the same, the general view is that the norms have led to a more transparent and predictable funding mechanism. But there are still other funds with equalisation purposes where the centre exercises a lot more discretion in the transfer decision (and where lobbying is important). This seems less satisfactory.

Petagny

[petagny]

I've also tracked down the attached presentation by Jorge Martinez-Vazquez, which has some useful tips on the design of capital transfers, notably that there is no single best approach to design - context is everything. But in general it's best to avoid non-transparent, highly detailed and discretionary procedures. Matching requirements also carry many benefits in getting local governments to take ownership and maintain the infrastructure.

Some provisos associated with capital grants also seem important to bear in mind. Harry Kitchen's paper (attached) sets some out:

* Transfers can distort local decision-making. This can relate to matching funds, which have advantages and disadvantages: 'A matching transfer, by lowering the prices of some services, encourages municipalites to spend more on these services. This may mean that municipalities are spending in areas that may not be a priority for them.'

* Funding from senior governments can also lead to inefficient local revenue decisions. In particular, there is no incentive to use proper pricing policies for services provided where grants cover a large proportion of capital costs.

* Transfers may encourage people to stay in communities that simply cannot survive on their own. Should communities that cannot survive in the absence of disproportionate senior government funding exist at all?

* Transfers reduce accountability - where two or more levels of government fund the same service, accountability problems arise.

These are important issues, but seem to be most relevant to conditional capital grants rather than to more broadly based capital transfers (as the paper makes clear).

[FitzFord]

petagny,

I was able to find an old reference. It is likely that the system will have changed somewhat since then (most countries' in the study have  -  as is the norm!), but it does give a reasonably useful outline of the context, benefits, limitations and pitfalls of that particular approach. It is: MA, Jun 1997. "Intergovernmental Fiscal Transfer: A Comparison of Nine Countries (Cases of the United States, Canada, the United Kingdom, Australia, Germany, Japan, Korea, India, and Indonesia)", prepared for the Economic Development Institute, World Bank. Keep us up-to-date with your progress as the subject is inherently interesting and timely.

Fitz.