Intergovernmental Transfers in Federations

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 STUDIES IN FISCAL FEDERALISM AND STATE–LOCAL FINANCE

Series Editor: Jorge Martinez-Vazquez, Regents Professor of Economics and Director,

International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State
University, USA

This important series is designed to make a significant contribution to the development of

the principles and practices of state–local finance. It includes both theoretical and empirical
work. International in scope, it addresses issues of current and future concern in both East
and West and in developed and developing countries.
The main purpose of the series is to create a forum for the publication of high-quality
work and to show how economic analysis can make a contribution to understanding the role
of local finance in fiscal federalism in the twenty-first century.
Titles in the series include:

The Political Economy of Inter-Regional Fiscal Flows

Measurement, Determinants and Effects on Country Stability
Edited by Núria Bosch, Marta Espasa and Albert Solé-Ollé
Decentralization in Developing Countries
Global Perspectives on the Obstacles to Fiscal Devolution
Edited by Jorge Martinez-Vazquez and François Vaillancourt
The Challenge of Local Government Sizes
Theoretical Perspectives, International Experience and Policy Reform
Edited by Santiago Lago-Peñas and Jorge Martinez-Vazquez
State and Local Financial Instruments
Policy Changes and Management
Craig L. Johnson, Martin J. Luby and Tima T. Moldogaziev
Taxation and Development: The Weakest Link?
Essays in Honor of Roy Bahl
Edited by Richard M. Bird and Jorge Martinez-Vazquez
Multi-level Finance and the Euro Crisis
Causes and Effects
Edited by Ehtisham Ahmad, Massimo Bordignon and Giorgio Brosio
Fiscal Decentralization and Budget Control
Laura von Daniels
The Future of Federalism
Intergovernmental Financial Relations in an Age of Austerity
Edited by Richard Eccleston and Richard Krever
Fiscal Decentralization and Local Finance in Developing Countries
Development from Below
Roy Bahl and Richard M. Bird
Federalism in China and Russia
Story of Success and Story of Failure?
Alexander Libman and Michael Rochlitz
Local Accountability and National Coordination in Fiscal Federalism
A Fine Balance
Charles R. Hankla, Jorge Martinez-Vazquez and Raúl Alberto Ponce Rodríguez
Intergovernmental Transfers in Federations
Edited by Serdar Yilmaz and Farah Zahir

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 Intergovernmental
Transfers in
Federations

Edited by

Serdar Yilmaz
Lead Public Sector Specialist, Governance Global Practice,
World Bank

Farah Zahir
Senior Economist, Governance Global Practice, World Bank

STUDIES IN FISCAL FEDERALISM AND STATE–LOCAL

FINANCE

Cheltenham, UK • Northampton, MA, USA

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 © Serdar Yilmaz and Farah Zahir 2020

All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system or transmitted in any form or by any means, electronic,
mechanical or photocopying, recording, or otherwise without the prior
permission of the publisher.

Published by
Edward Elgar Publishing Limited
The Lypiatts
15 Lansdown Road
Cheltenham
Glos GL50 2JA
UK

Edward Elgar Publishing, Inc.

William Pratt House
9 Dewey Court
Northampton
Massachusetts 01060
USA

A catalogue record for this book

is available from the British Library

Library of Congress Control Number: 2019951902

This book is available electronically in the

Economics subject collection
DOI 10.4337/9781789900859

ISBN 978 1 78990 084 2 (cased)

ISBN 978 1 78990 085 9 (eBook)

Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

02

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 Contents
List of contributorsvii
Foreword by Richard Birdxiii
Acknowledgementsxv

1 Introduction to the volume 1

Serdar Yilmaz and Farah Zahir

PART I CONCEPTUAL ISSUES

2 
The architecture of intergovernmental transfers: principles and
practice in low- and middle-income countries 7
Roy W. Bahl Jr
3 
Issues in intergovernmental fiscal transfers: public finance and
political economy considerations 21
Serdar Yilmaz and Farah Zahir
4 
The practice of fiscal equalization: a political economy
clarification41
Bernard Dafflon and François Vaillancourt

INTERGOVERNMENTAL TRANSFERS IN
PART II 
MATURE FEDERATIONS

5 
The German model of addressing vertical and horizontal fiscal
imbalances64
Paul B. Spahn
6 The United States grant system 86
Howard A. Chernick
7 
Federal finance arrangements in Canada: the challenges of
fiscal imbalance and natural resource rents 109
Marcelin Joanis and François Vaillancourt
8 Revenue and expenditure needs equalization: the Swiss answer 134
Bernard Dafflon

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 vi Intergovernmental transfers in federations

9 Intergovernmental fiscal relations in Australia 163

Bob Searle
10 
The economic impacts of horizontal fiscal equalization as
practised in Australia 185
Jonathan Coppel

PART III 
INTERGOVERNMENTAL TRANSFERS IN
EVOLVING FEDERATIONS

Intergovernmental fiscal transfers and performance grants in

11 
Brazil204
Deborah L. Wetzel and Lorena Viñuela
Intergovernmental fiscal transfer system in Argentina:
12 
historical evolution, current performance and reform options
to promote efficiency, equity and transparency 224
Marco Larizza and Julian Folgar
Evolving role of the Finance Commissions in India in the
13 
last 25 years 248
Farah Zahir
14 
Emerging trends in fiscal transfer systems in selected
federations: implications for India 275
Jorge Martinez-Vazquez

INTERGOVERNMENTAL TRANSFERS IN
PART IV 
UNITARY FEDERATIONS

Intergovernmental fiscal transfers in Kenya: the evolution of

15 
revenue sharing under new devolution in a quasi-federal
system296
Jamie Boex and Paul Smoke
Reforming vertical programmes: the case of South African
16 
local government323
David Savage

Index345

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 Contributors
Roy W. Bahl Jr is Regents Professor and Dean Emeritus at Georgia State
University, USA and Professor Extraordinarius at the University of
Pretoria, South Africa. From 1968 through 1971, Dr Bahl was an econo-
mist with the Fiscal Affairs Department of the International Monetary
Fund. Then, he was the Maxwell Professor of Political Economy at
Syracuse University, USA, where he directed the Metropolitan and
Regional Research Center and the Metropolitan Studies Program.
He serves as a consultant to various World Bank departments, the
International Monetary Fund, the Asian Development Bank, the Lincoln
Institute of Land Policy and to the United Nations.
Jamie Boex is a Senior Fellow at the Duke Center for International
Development (DCID), USA and has extensive experience in public sector
finance, fiscal decentralization, intergovernmental (fiscal) relations and
local governance reforms in developing and transition countries around
the world. Working with organizations such as the World Bank, United
Nations Development Programme (UNDP), United States Agency for
International Development (USAID) and numerous bilateral development
agencies and research organizations, Jamie has contributed to policy
reforms in over twenty countries around the world.
Howard A. Chernick is Professor Emeritus at the Department of
Economics, Hunter College, the City University of New York, USA and
a board member of the Institute for Taxation and Economic Policy. In
2015 he was awarded a Fulbright specialist grant for study in Paris. He
has published in the areas of fiscal federalism, urban public finance and
anti-poverty policy. Selected writings include the articles ‘Fiscal Effects
of Block Grants for the Needy: An Interpretation of the Evidence’ (1998)
and ‘The Impact of the Great Recession and the Housing Crisis on the
Financing of America’s Largest Cities’ (2011) and, as editor, Resilient
City: The Economic Impact of 9/11 (Russell Sage, 2005).
Jonathan Coppel is a Commissioner with the Australian Productivity
Commission. Prior to his appointment, Jonathan was Head of the OECD
G20 Sherpa office. In Australia he has held senior management posi-
tions at the Reserve Bank and started his career at the Commonwealth

vii

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 viii Intergovernmental transfers in federations

Treasury. Jonathan has taught at the World Trade Institute’s Mile Masters
Programme in International Law and Economics and the Paris, Sciences
Po Institute. He has a Master’s in economics and management from
Columbia University, New York, a Bachelor’s in economics (Honours)
from the Australian National University and is a graduate of the Australian
Institute of Company Directors.
Bernard Dafflon was the Chief Economist at the Ministry of Local
Affairs in Fribourg, Germany (1977–91) and full-time Professor of Public
Economics at the University of Fribourg (1991–2013). He has worked as
an international consultant on decentralization policies and reforms in a
number of developed and developing countries. He is an expert on fiscal
federalism, local public finance and environmental policies.
Julian Folgar is an economist at the World Bank Group. Julian works on
various analytical projects including macro-fiscal areas, fiscal federalism
and debt sustainability. He received his undergraduate degree in econom-
ics from the Buenos Aires University (UBA), Argentina, and is about
to complete his Master’s degree in economics at UBA. He worked as a
consultant in macro-fiscal policy in the private sector, for the Congress
of Argentina, and for various international organizations (International
Labour Organization (ILO) and United Nations Economic Commission
for Latin America and Caribbean (CEPAL)). He also teaches public sector
economics at the UBA.
Marcelin Joanis holds a PhD in economics from the University of Toronto
and is currently a Full Professor of Economics at Polytechnique Montréal
and the Vice-President for Research of the Center for Interuniversity
Research and Analysis on Organizations (CIRANO), Canada. He also
serves as the Director of the Research Group on Globalization and
Management of Technology (GMT) at Polytechnique Montréal. A spe-
cialist in public economics, political economy and fiscal federalism, he
has published articles in, among others, Fiscal Studies, the Journal
of Development Economics, Public Choice, Economics and Politics and
Applied Economics, as well as several edited volumes and book chapters.
He has also worked as an economist at Finance Canada and Quebec’s
Commission on fiscal imbalance and as a Professor of Economics at the
Université de Sherbrooke.
Marco Larizza is a Senior Public Sector Specialist in the Governance
Global Practice at the World Bank. He is a contributing author of the
World Development Report 2017 ‘Governance and the Law’. His most
recent work focuses on transparency and anti-corruption initiatives in
Latin America and the Caribbean. Marco served as Visiting Fellow at the

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 Contributors ­ix

Center for Latin American Studies, Georgetown University, USA and

the Centre for Democracy and Conflict Resolution, University of Essex,
UK. He has published journal articles, book chapters and policy reports
on comparative democratization, human rights, the political economy
of decentralization and public service reforms. He received his PhD and
MA in political science from the University of Essex, UK and his MA in
development economics from the University of Bologna, Italy.
Jorge Martinez-Vazquez is Regents Professor of Economics and Director
of the Cluster of Public Finance Centers at the Andrew Young School,
Georgia State University, USA. He has published over twenty books and
numerous articles in academic journals, such as Econometrica and the
Journal of Political Economy. He has advised federal and state agencies in
the US and over ninety countries and is the recipient of numerous prizes
and awards.
David Savage is a specialist in local service delivery, intergovernmental
relations and urban public finance. He has served as a Commissioner on
the Financial and Fiscal Commission, worked for the World Bank in South
Asia and the South African National Treasury on urban development,
service delivery and institutional restructuring issues and is most recently
the former Program Manager of the Cities Support Program in the South
African National Treasury. He holds Master’s degrees in public adminis-
tration from the London School of Economics and in Urban and Regional
Planning from the University of Cape Town.
Bob Searle worked at the Commonwealth Grants Commission (CGC) in
Australia for 30 years, the last ten as the CEO. Since leaving the CGC, he
has worked as a consultant on decentralization and intergovernmental
financial relations, mainly for the World Bank. Bob has assisted in devel-
oping the fiscal transfer system in several post-conflict African countries
and has also worked in Central and South-East Asia and the Pacific.
Paul Smoke is Professor of Public Finance and Planning and Director
of International Programs at the New York University Robert F. Wagner
Graduate School of Public Service, USA. His policy and research interests
include the political economy of public sector reform, especially decentral-
ization, intergovernmental fiscal relations and service delivery, as well as
urban and regional development planning. He has published in numerous
journals and has authored or edited several books on decentralization
and local governance. Professor Smoke teaches courses on public finance,
development planning, governance and development assistance. He has
worked in many countries, especially in Africa and Asia, and with a wide
range of development partners.

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 x Intergovernmental transfers in federations

Paul B. Spahn is Professor Emeritus of Goethe University, Frankfurt

am Main, Germany. After retirement in 2005, he served as Macro
Fiscal Advisor to the Minister of Finance and Treasury of Bosnia and
Herzegovina, became the founding Executive Director of the House of
Finance in Frankfurt and was Commissioner to the Government of Wales.
A former Vice-President of the University of Frankfurt, Professor Spahn
has held several visiting professorships across the world, has published
widely in scholarly and policy-oriented journals and has provided expert
advice to more than seventy government and parliamentary organizations
worldwide.
François Vaillancourt is a Fellow at CIRANO and an Emeritus Professor
(economics), Université de Montréal, Canada. He has published exten-
sively in three areas of public policy: intergovernmental financial relations
(IGFR), economics of language and language policy and compliance costs
and complexity of taxation. He has been a Fulbright Scholar and a visitor
in universities in Australia, Belgium, France, UK and USA. He has done
extensive consulting work on language economics issues and on IGFR,
the latter for governments in Canada and for international organizations
(African Development Bank (AFD), International Monetary Fund (IMF),
OECD, UNDP, World Bank).
Lorena Viñuela is a Senior Public Sector Specialist with the Governance
Practice in the Eastern Europe and Central Asia ECA region. She worked
previously with the Latin America and Caribbean Region and Public
Sector Anchor Unit. Her work focuses on public financial management,
intergovernmental fiscal relations and service delivery in multi-level govern-
ments. Prior to joining the World Bank, she worked at the Inter-American
Development Bank’s Research Department and for EuropeAid’s AL-Invest
Program. She has published several articles, books and book chapters on
decentralization, political economy, public investment management and
natural resource wealth management.
Deborah L. Wetzel is currently the Director of Regional Integration for
the Africa and Middle East North Africa Regions of the World Bank. She
has previously been Senior Director for the Governance Global Practice,
Director of Strategy and Operations for the Middle East North Africa
Region, Country Director for Brazil and Chief of Staff to the President at
the World Bank. Over the years she has worked and written on intergov-
ernmental finance issues in a range of countries including Brazil, Hungary,
Russia and Ukraine, among others.
Serdar Yilmaz is a Lead Public Sector Specialist at the World Bank. He
has broad experience in the related areas of fiscal decentralization, public

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 Contributors ­xi

expenditure management, subnational governance, and governmental

accountability. Throughout his twenty-year tenure at the World Bank, he
has provided technical assistance and contributed to policy reforms in low-
and middle-income countries in Africa, Eastern Europe and Central Asia,
the Middle East and East Asia regions. In addition to his task management
responsibilities, Serdar makes original contributions to the literature.
Farah Zahir is currently a Senior Economist in the Governance Global
Practice, South Asia Region, at the World Bank. She is a seasoned macro-
economist and public policy specialist and a prolific writer on fiscal policy
and macroeconomic management and fiscal decentralization. Her core
areas of expertise have been fiscal policy and growth, statistics and fiscal
federalism. Farah has led several large and complex lending operations of
the Bank in India on decentralization and statistics. She has been a member
of various high-level Government of India committees on decentralization
and service delivery, and has worked in several countries besides India.

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YILMAZ_9781789900842_t.indd 12 16/12/2019 10:44
 Foreword
Politicians, officials, scholars, students and citizens in many countries have
been exposed to a litany of apparently opposing abstract labels in recent
years: globalization versus nationalism, capitalism versus socialism, equity
versus growth, private versus public, free market versus state control,
centralization versus decentralization, and so on. These broad and vague
concepts are often discussed not only as though they represent a clear
choice between polar opposites, but also as if everyone knows exactly
what they mean and understands them in exactly the same way. Because
none of these assumptions is valid, all too often public discourse about the
critical policy questions obscured by such labelling degenerates into little
more than name calling. This book contributes to improving one of these
debates, that on centralization versus decentralization, by casting the light
of reasoned discussion on the often-contentious issue of intergovernmen-
tal transfers. In doing so, it demonstrates clearly why – as with many policy
issues – the best solution is almost always context-specific and seldom
simply or easily generalized: the problems hidden behind such labels as
decentralization may be universal in scope, but the solution for any par-
ticular country usually needs to be carefully tailored to fit each situation.
There are few, if any, simple ‘one-size-fits-all’ designs for public policy in
any area. To understand intergovernmental fiscal transfers in any country,
for example, one must first understand the complex and often changing
institutions and conditions that shape taxation, spending, and intergov-
ernmental fiscal relations more generally. Because each country has its own
history, political setting and economic conditions, every transfer system is
different and transfer reform is always and everywhere an exercise in the
art of political economy, requiring both familiarity with the considerable
technical complexities required to design efficient and effective transfers
and sensitivity to the realities of the relevant political, institutional and
economic context. Whether novice or expert, all who attempt to navigate
these difficult waters – whether trying to develop a better system or simply
to understand why there are so often conflicting views about the design and
effects of intergovernmental transfers – can learn much from this book.
In addition to the ten countries specifically singled out for study in this
volume, the impressive set of authors included here draw on their prior

xiii

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 xiv Intergovernmental transfers in federations

experience in an even wider set of countries as well as on the growing theo-

retical and empirical literature focusing on the intergovernmental fiscal
issues which underlie, shape and are in turn shaped by transfer systems.
As this book (and the literature cited) shows, there is seldom any clearly
‘best’ way to design and implement intergovernmental transfers. The basic
problems – vertical and horizontal imbalances, regional disparities in
resources and capacity, poverty and inequality, coping with cyclical and
other instabilities, balancing growth and equity, delivering basic public ser-
vices effectively and equitably, damping down separatist tendencies – may
exist to some extent in every country. But both the importance attached
to each of these issues and the extent to which any feasible transfer may
alter outcomes usually depends so much on specifically local factors that
it is difficult to identify any simple scheme that will fit all seasons in all
countries.
Successful transfer reforms are thus likely to continue to be tailor-made
rather than simply cut-and-paste jobs based on someone’s book of best
practices. There are, of course, best practices that can be learned about
how to approach reforming intergovernmental fiscal relations and the
efficacy of different solutions in different circumstances. Would-be reform-
ers, like students trying simply to understand what is going on, will find
here both some master classes on questions that should be – but seldom
are – asked and a number of careful examinations of how and why this
or that approach seems to have worked to at least some extent in some
circumstances, while failing in others. There is much more to be learned,
but, as this book shows, we have already learned much.

Richard Bird
June 2019

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 Acknowledgements
The editors gratefully acknowledge the assistance of the following people,
who reviewed the manuscript:

James Alm, Professor and Chair, Department of Economics, Tulane

University, USA.
Richard M. Bird, Professor Emeritus of Economic Analysis and Policy,
University of Toronto, Canada.
Giorgio Brosio, Professor of Public Economics, University of Turin, Italy.
William Dillinger, Former Lead Public Sector Specialist, World Bank.
Robert D. Ebel, Former Lead Economist, World Bank.
William F. Fox, Randy and Jenny Boyd Distinguished Professor, University
of Tennessee, Knoxville, USA.
Guy Gilbert, Professor, École normale supérieure Paris-Saclay, France.
Andrew Reschovsky, Professor Emeritus of Public Affairs and Applied
Economics, University of Wisconsin–Madison, USA.
Alain Schönenberger, Professor, Université de Neuchâtel, Switzerland.
Enid Slack, Director of the Institute on Municipal Finance and
Governance, University of Toronto, Canada.
D.K. Srivastava, Chief Policy Advisor, Ernst and Young.
Trevor Tombe, Associate Professor, University of Calgary, Canada.
Mehmet Serkan Tosun, Barbara Smith Campbell Distinguished Professor
of Nevada Tax Policy, University of Nevada, Reno, USA.
Timothy Stephen Williamson, Senior Public Sector Specialist, World
Bank.

xv

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YILMAZ_9781789900842_t.indd 16 16/12/2019 10:44
 1. Introduction to the volume
Serdar Yilmaz and Farah Zahir

1.1 BACKGROUND

This book intends to contribute to the definition of the frontiers of

research in vertical and horizontal imbalances (VFI) in federations. It
also looks ahead for opportunities and challenges and subsequent needs
for future research and development. Whereas the second section of the
volume includes theoretical and methodological contributions, much of
the book is devoted to case studies that illustrate important policy or
methodological lessons.
The most important lesson to be learned from the book is that there is
no single or best way of addressing vertical and horizontal imbalances.
That is because each country is different and policy objectives of intergov-
ernmental transfers are different. More importantly, transfer system design
in a country is a response to specific conditions that exist at that particular
time in history.
The book is divided into four sections. After this brief introduction, the
second section covers conceptual issues of principles of VFI and public
finance and political economy considerations in addressing them. Then,
the next three sections analyse how different federations address VFI.

1.2 CONCEPTUAL ISSUES

Much of the earlier literature on fiscal federalism revolved around studying

departures from a model fiscal system whereby intergovernmental trans-
fers played a benevolent role. However, in the 21st century, the federations
seem to be recalibrating their fiscal architecture to address the needs of
pluralistic communities and their large populace. More recently, the system
of intergovernmental transfers is more actively used for restoring a balance
in sharing of resources between the states (and local governments) and the
national government for improving development outcomes. The chapters
in the second section of the book delve into the various theoretical aspects

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 2 Intergovernmental transfers in federations

of VFI and political economy considerations in designing a transfer

system in addressing them. The second chapter by Bahl offers explanations
‘for why countries set up their grant systems in so many different ways,
and to offer a set of principles that might enable low- and middle-income
countries to do a better job with achieving the objectives they have set for
their transfer systems’. The third chapter by Yilmaz and Zahir surveys the
first-generation theory of fiscal federalism and the second-generation ‘to
summarize the theoretical conceptualization of intergovernmental transfer
design . . . to present a case for the importance of political economy
considerations in designing and analysing intergovernmental transfers
systems’. The fourth chapter by Dafflon and Vaillancourt puts forward a
fascinating reading of how the theory of fiscal equalization is an elusive
goal for practitioners.

1.3 MATURE FEDERATIONS

A federation is a political union of partially or fully self-governing prov-

inces, states or regions under a central/federal government. In a mature
federation, the self-governing status of the constituent units, as well as
the division of power between them and the central/federal government,
is typically constitutionally entrenched and may not be altered by a
unilateral decision of either party. The second section of the book focuses
on five mature federations: Germany, United States, Canada, Switzerland
and Australia. In this group of federations, sovereign power is formally
divided between the federal government (centre) and the constituents
of the federation (second tier) which retain some degree of control over
its internal affairs. In mature federations, concurring sovereignties exist
between the centre and constituent units of the federation, with full taxing
and expenditure powers for each tier.
In Germany, each of three levels of government is autonomous in their
expenditure and revenue responsibilities. Chapter 5 analyses the German
equalization system which is characterized as one of the most generous
ones in the world. The pending 2020 reforms in the intergovernmental
transfer system have brought much anxiety among the stakeholders.
According to Spahn, it is ‘unlikely that the setup of the German financial
constitution will change dramatically given that the majority of states,
that exert strong legislative voting powers through the second chamber of
parliament, are still at the receiving end of the scheme’.
The US, on the other hand, has a chaotic intergovernmental system
with the judiciary playing a major role. In the US, Medicaid is the most
important federal grant to states. Since its enactment, the Affordable Care

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 Introduction to the volume ­3

Act has been subject to several lawsuits. In Chapter 6, Chernick presents

the intergovernmental grant system in the US which has a very high degree
of conditionality. According to him, ‘[o]f the 1,714 authorized grant
programs as of 2012, the vast majority are relatively narrow categorical
grants, authorized for specific purposes’.
Unlike the US, in Canada the federal-provincial relationship is less
confrontational. The federal government has the responsibility for stand-
ard sovereign functions, such as defence, foreign relations and monetary
policy, and provinces are responsible for delivery of social services, such as
health, education and welfare as well as infrastructure services. In Chapter
7, Joanis and Vaillancourt present the key aspects of fiscal federalism in
this one of the oldest federations in the world. The chapter focuses on
a contentious issue of how to incorporate provincial natural resource
revenues into the equalization programme.
In the next chapter, Dafflon shows the constitutional and institutional
complexities of VFI in Switzerland. Chapter 8 lays out the complex public
finance arrangements to achieve national equalization through both
revenue and expenditure equalization in the Swiss federation.
The last two chapters in this section are devoted to Australia. The
six states in Australia, the original six British colonies, came together
to form the Commonwealth, much like the US. Therefore, states have
strong constitutional protection. However, the assignment of expenditure
responsibilities and revenue capacities presents a large vertical imbalance
question. In Chapter 9, Searle presents the complex architecture of
Australian intergovernmental grant system and its institutional backbone.
In the next chapter, Coppel examines the economic impacts of horizontal
fiscal equalization (HFE) in Australia. He argues that HFE is functioning
reasonably well, achieving a high degree of fiscal equality. However, he
highlights the need for tax reforms, particularly for efficient taxation and
extraction of mineral and energy resources. As the extraction activities
are not evenly distributed across the country, the design of grants has
distortionary effects on state level policies, much like Canada. He argues
that ‘[i]f Western Australia raised royalties on iron ore, it would lose close
to 90 per cent of the additional revenues to other states’.

1.4 EVOLVING FEDERATIONS

The third section of the book is devoted to evolving federations: Brazil,

Argentina and India. In this group of federations, the balance of power
between the centre and the constituent unit is evolving over time. As it
stands today, the political and economic powers are concentrated in the

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 4 Intergovernmental transfers in federations

centre. In these countries, the centre has the constitutional authority to

circumvent the powers of a constituent unit government. Furthermore, the
centre has the constitutional authority to suspend a constituent govern-
ment or create new constituent units. India, for example, got its newest
29th state in Telangana in 2014. In Brazil, which has experienced both the
federal and the unitary state in its history, the latest state, Tocantins, was
created in 1988 for mainly administrative reasons.
Chapter 11 provides an overview of Brazil’s system of intergovernmental
transfers and reviews three performance-based transfer programmes. Wetzel
and Viñuela provide a critical review of the Bolsa Familia programme, that
provides grants to both states and municipalities for administering one of
the largest social protection programmes and performance-based transfers
in Ceara and Rio de Janeiro states.
Argentina is an evolving federation with territorial heterogeneity. In
Chapter 12, Larizza and Folgar describe the inequalities across provinces
as huge. In their words, Argentina has ‘areas as rich as developed nations,
and provinces as poor as low middle-income countries’. At the heart of the
Argentinian intergovernmental system are an automatic revenue-sharing
scheme (‘coparticipación’) and discretionary transfers to address these
inequalities. The conclusion of the chapter is that the system needs reform-
ing ‘to simplify its design and align it with international best practices
to better achieve three fundamental objectives: closing the vertical gap,
closing the horizontal gaps and promoting sectoral objectives’.
Chapter 13 reviews the evolving role of the Finance Commission in the
world’s largest federation, India. Zahir ‘traces the history of the Finance
Commissions in India over last two and a half decades in shaping the inter-
governmental transfer system in India’. According to her, the Finance
Commissions, a constitutional body established every five years to make
recommendations to the government on intergovernmental transfers,
shape and recalibrate ‘the Indian federalism from time to time . . . in
providing continuity that has been critical to the unity of the country’.
According to Martinez-Vazquez, India has ‘an elaborate and complex
system of resource transfers to the states’. In Chapter 14, he provides
reform options for India’s transfer system by drawing from international
experience with the design and implementation of transfers systems.

1.5 UNITARY FEDERATIONS

The last section of the book covers unitary federations: Kenya and
South Africa. In a federation sovereignty is shared between the centre
and the constituent units of the federation, whereas in a unitary country

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 Introduction to the volume ­5

sovereignty rests with the central government. However, in unitary states

autonomous self-governing regions may exist by the sufferance of the
central government. We call these countries unitary federations. While
federations are created by an agreement (Constitution) between the centre
and a number of independent/autonomous regions, unitary federations
are often created through a process of devolution, where the centre agrees
to grant autonomy to regions that were previously entirely subordinate.
In Chapter 15, Boex and Smoke describe how Kenya, a unitary state,
established a highly devolved system with the 2010 Constitution. They
argue that ‘Kenya’s path towards devolution has in some ways been a
“political” success’. However, they caution that transforming devolution
into development outcomes requires ensuring ‘the development and use
of an appropriate intergovernmental fiscal framework’. They seem to have
faith in the Commission of Revenue Allocation to do just that.
Chapter 16 reviews the trajectory of intergovernmental fiscal reforms
in South Africa since the end of the apartheid era. Savage character-
izes the country as a ‘unitary state with federal characteristics’. The
Constitution establishes three interdependent and interrelated spheres of
government. As far as the transfer system is concerned, Savage argues that
the recent reforms have created momentum in establishing a functioning
performance-based transfer system.

1.6 CONCLUDING THOUGHTS

The best transfer system is the one that achieves the policy objectives set
beforehand. The measurement of VFI is a scientific exercise; however,
addressing them is a political choice. This book presents resource materials
for researchers, practitioners, policymakers and students willing to under-
stand the choices made by different countries against the overarching prin-
ciples of needs, equity and efficiency for sharing of resources. The various
chapters capture empirical, theoretical and methodological contributions,
as well as case studies that illustrate important policy or methodological
lessons for future work.

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 PART I

Conceptual Issues

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 2. 
The architecture of
intergovernmental transfers:
principles and practice in low- and
middle-income countries
Roy W. Bahl Jr

2.1 INTRODUCTION

There is an economic science to the design of intergovernmental transfers,

thanks to the effort spent by scholars in questioning the impacts of
transfers on market efficiency (Yilmaz and Zahir, Chapter 3). But there is
also an art. Practitioners have spent considerable effort trying to develop
efficient, equitable and politically acceptable intergovernmental transfer
structures from what is often a poor database. And there is a political
economy dimension, where elected officials, bureaucrats and civil society
have worked hard to turn the final design of transfers to their self-interest.
While much has been learned from all of this (Bahl and Bird, 2018), a
‘model’ design for intergovernmental transfers has not emerged.
The goals in this chapter are to explain why countries end up structuring
their grant systems in so many different ways, and to offer a set of princi-
ples that might help with improving the practice. We draw on reviews of
the practice and more specifically on the experiences in countries described
in the chapters in this book.1
This chapter begins with a discussion of the normative guidelines for
structuring transfers, comments on the reasons for so much variation in
the practice and describes the architecture of intergovernmental transfers.
We then turn to a general evaluation of the most commonly used vertical
and horizontal revenue sharing regimes, and to the important question
of equalization. The focus is on the practice in low- and middle-income
countries, and on what might be taken from the development of transfer
systems in industrial countries. A concluding section offers a retake on the
principles of good design of intergovernmental transfer systems.

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 8 Intergovernmental transfers in federations

2.2 
NORMATIVE GUIDELINES AND THE
ARCHITECTURE OF INTERGOVERNMENTAL
TRANSFERS

The primary missions of an intergovernmental transfer system include

covering some portion of the vertical fiscal imbalance and limiting fiscal
disparities to some acceptable level. But these objectives can also be
addressed with expenditure and revenue assignments, and changes in the
structure of governance. Under each intergovernmental fiscal arrange-
ment, transfers play a different role and are structured differently to
accommodate that role. Universal norms are not easily found.
The fiscal culture also matters in the choice that governments make
about their intergovernmental fiscal structures. Almost every country
faces reform options that are just not starters. China finances almost all
subnational government (SNG) expenditures with transfers and does not
have a strong equalization programme (Bahl et al., 2014). Neither does the
German system depend on SNG taxing autonomy, but its transfer system
features significant equalization (Spahn, Chapter 5). Both countries are
willing to accept the absence of incentives to mobilize local revenues,
and with a weak model of accountability by elected local officials. On the
commitment to a national minimum service level, there is more solidarity
in Australia and Germany than in other industrialized countries reviewed
here (Dafflon and Vaillancourt, Chapter 4). The US is committed to pre-
serving subnational fiscal autonomy and competitive federalism. It does
not use untied federal grants for fiscal equalization (Chernick, Chapter 6).
In this context of variation in the practice, the architecture of every
intergovernmental transfer regime answers three questions, that is, (a) how
the divisible pool for total grants is decided, (b) how this pool of funds
is distributed across eligible subnational governments, and (c) how much
autonomy SNGs will be given in making expenditure decisions. The more
common methods of determining the divisible pool (the vertical share) are
described in the columns of Table 2.1, and the methods of distributing this
divisible pool (horizontal sharing) are presented in the rows.2

2.3 VERTICAL SHARING

Most countries determine the vertical share by one or both of two

methods: a defined sharing of central government tax revenues, and/or a
discretionary allocation in the annual central government budget.

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 The architecture of intergovernmental transfers ­9

Table 2.1 The architecture of intergovernmental transfers

Vertical sharing
Specified share of national Annual budgetary
Horizontal sharing or state government tax decision
Origin of collection A n.a.
(derivation)
Formula B E
Cost reimbursement C F
(matching)
Ad hoc D G

Notes:
For definitions of forms A–G, see text.
n.a. 5 not applicable.

Sources: Adapted from Bahl and Linn (1992) and Bahl and Bird (2018, p. 290).

The Size of the Vertical Share

In theory, the vertical fiscal imbalance is the difference between (a) the
amount that SNGs can raise from own-revenue sources if they exert a
‘normal’ revenue effort and (b) the amount they must spend to provide
a ‘minimum’ level of the government services that have been assigned to
them (Bahl and Bird, 2018, pp. 282–5). The gap for all subnational govern-
ment in the country is:

GAP 5 a (E i 2Ri ) (2.1)

| |
i
where
|
Ri 5 the revenue raised from own sources at normal effort by local govern-
ment i
|
Ei 5 the amount of expenditure needed to provide a minimum level of
assigned services in local government i.
The targeted vertical share (VS) – the share of central taxes allocated to
subnational transfers – is then:
α (GAP)
VS 5 (2.2)
CR
where α is the affordability parameter, that is, the per cent of the financing
gap that the central government commits to cover with the transfer system,
and CR is the total amount of revenues raised by the central government
from current sources.

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 10 Intergovernmental transfers in federations

Few low- and middle-income countries explicitly use such a model in

deciding on their vertical shares, or even attempt to define exactly what
they mean by ‘normal tax effort’ or ‘minimum service provision’. Most
decisions on vertical shares are constrained by present levels of SNG
expenditures with adjustments relying on a few crude indicators combined
with intuition about expenditure needs, and a good sense of the political
economy and the slack in the central government budget. Countries tend
not to move too far from current levels of SNG expenditures in changing
their vertical shares. Interestingly, the Indian Finance Commission awards
have increased the vertical share by only about four percentage points of
total taxes over the past 15 years (Zahir, Chapter 13).
Some industrial countries have developed approaches to determining
the vertical share that are similar to the theoretical model described above.
The vertical share for Canada’s equalization grant is determined as a sum
of provincial entitlements (Joanis and Vaillancourt, Chapter 7). However,
in Australia, there apparently has been little interest in restructuring inter-
governmental transfers to address the underlying issues regarding vertical
fiscal imbalance (Searle, Chapter 9).

Shared Taxes

The shared tax approach is used in many low- and middle-income coun-
tries, but the specific practice varies widely in terms of which taxes are
shared and the size of the sharing rate. Indonesia shares 26 per cent of
all taxes with SNGs, the Philippines 40 per cent, Pakistan 57 per cent and
Mexico 20 per cent. In other countries, the sharing rate varies by tax. For
example, China shares 40 per cent of income taxes and 50 per cent of value
added taxes with provincial governments. Only 15 per cent of Kenya’s
revenues are mandated to be shared with SNGs.
The practice is similarly varied in the industrial countries. Australia
shares goods and services tax (GST) collections with SNGs, Germany
and Switzerland share 50 and 13 per cent of income taxes, respectively,
with states (lander and cantons) and Japan uses a complicated system of
revenue sharing with different sharing rates for several taxes. It is difficult
to find a ‘common’ practice (Kim et al., 2010).
The advantages of this approach in low- and middle-income countries
depend on whose glasses one is looking through, and on the specifics
of the tax sharing programme that is in place. SNGs as a class can ben-
efit from the shared tax approach, because it could give them access to a
broad-based and income-elastic tax base which their central government
or their constitution oftentimes denies them. The tax sharing approach
is transparent, usually stable enough over time to allow fiscal planning by

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 The architecture of intergovernmental transfers ­11

SNGs and can involve less ‘gaming’ of Congress to give them a larger share
than is the case for a discretionary allocation made by government in the
annual budget. To gain these benefits, however, SNGs must accept some of
the drawbacks to tax sharing, including vulnerability to changes in central
government tax policy. And, unless tax sharing rules are enshrined in the
constitution, they can be lowered by the central government.
There also are drawbacks to vertical sharing from the point of view
of the central government. In particular, budget management and fiscal
policy are made more difficult because SNGs are guaranteed a revenue
entitlement.

The Discretionary Budget Approach

The other possibility for determining the vertical share is with discre-
tionary allocations made as part of the budget process. Under this
approach, the central government and/or the Congress can determine
that a particular expenditure programme, or all SNG expenditures, will
be funded by an intergovernmental transfer for the coming fiscal year
(or for multiple years). The discretionary budget approach is part of the
vertical sharing regime in most low- and middle-income countries. In
Kenya, for example, the vertical share for the major intergovernmental
transfer programme (‘equitable shares’) is determined as part of the
annual Division of Revenue Act. It is subject to a lower limit of 15 per
cent of total national revenues, and may be changed annually (Boex and
Smoke, Chapter 15). South Africa takes a similar approach in regulat-
ing transfers to subnational governments through the national budget
process.
A major advantage of the discretionary budget approach is that it allows
specific central programmes to be terminated when they are no longer
needed or are no longer meeting their objectives. Sometimes a sunset law is
imposed, requiring a thorough review of the programme as a requirement
for renewal.
Vertical shares that are established as discretionary budget allocations
raise a number of issues. Three are particularly important to note. First,
grant programmes tend to be owned, often by a line ministry, and so
they may have a champion with enough political clout to keep them
in play, even if their effectiveness is questionable. Or, if the champion
does not have significant influence, a grant programme might find itself
endangered, even if it is meeting its objectives. This raises the unfortunate
prospect of viable programmes being discontinued midstream for political
or administrative reasons (Shah, 2013). The South African system guards
against this problem by managing intergovernmental transfers with a

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 12 Intergovernmental transfers in federations

three-year rolling cycle medium-term expenditure framework (MTEF)

(Savage, Chapter 16).
A second issue is that grant programmes funded in this way can prolifer-
ate in numbers and can lead to significant administrative and compliance
costs. The US conditional grants system includes 1714 separately author-
ized programmes, equivalent in amount to about 17 per cent of all federal
spending (Chernick, Chapter 6). Third, the discretionary approach usually
supports grants that carry conditions about how the money will be spent
and diverts local budgets from the outcomes that voter-consumers at the
local level might have preferred. Searle (Chapter 9) argues that this has led
to a steady reduction over time in the autonomy of state governments.
When the vertical share for any major intergovernmental grant pro-
gramme in the country is revisited annually by an elected Congress, it is at
risk of being heavily influenced by political factors, as may now be the case
in Kenya (Boex and Smoke, Chapter 15).

Mixed Models

Because countries are trying to do so many different things with their inter-
governmental transfer system, they often use both of these approaches to
vertical sharing. The tax sharing approach seems more suited for general
purpose aid for SNGs in decentralized countries, because it gives recipients
a more or less guaranteed base and tends toward untied grants. The annual
budget approach seems especially suited for conditional grants or special
purpose assistance, because these programmes can be more short-lived and
lend themselves better to earmarking for individual programmes.
Still, the practice varies widely as the following few examples illustrate.

●● India directs intergovernmental transfers to the states with vertical

shares based on recommendations made by the Finance Commission,
which convenes every fifth year. Parallel to this is a set of ‘centrally
sponsored schemes’, which are multiyear programmes where the
funding is decided every year at the time the budget is made (Zahir,
Chapter 13; Martinez-Vazquez, Chapter 14; Mathur, 2012).
●● China finances provincial and local government budgets with shared
income and value added tax collections. But it also funds numer-
ous conditional grant schemes with annual allocations, though the
revenue importance of these has been trending downward (Bahl et
al., 2014).
●● The vertical share in Kenya is determined annually by Congress, but
subject to a constraint that it must be at least 15 per cent of national
government revenues (Boex and Smoke, Chapter 15).

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 The architecture of intergovernmental transfers ­13

●● The vertical share for Canada’s Health transfer programme is funded

through a budget allocation that is indexed to a three-year moving
average of GDP. The funding for the Social Transfer programme
was last set in 2009 and is indexed at 3 per cent per year. The vertical
share for equalization grants is determined, bottom up, by provincial
entitlements (Joanis and Vaillancourt, Chapter 7).
●● At the canton level in Switzerland, the share of revenues received as
intergovernmental transfers is 6 per cent from shared federal taxes, 4
per cent from federal equalization, 13 per cent from federal subsidies
and specific grants-in-aid, and 7 per cent are contributions of com-
munes for shared competencies (Dafflon, Chapter 8).
●● Under Argentina’s co-participation programme, total transfers to
subnational governments are equivalent to about 70 per cent and
are allocated as shared taxes. The remaining 30 per cent are a set of
transfers authorized by special laws (Larizza and Folgar, Chapter 12).
●● Australia’s transfer system is about equally divided between discre-
tionary conditional grants and unconditional grants. The growth in
untied grants is pegged to national consumption tax revenues, and
the growth in conditional grants is pegged to general price increases.

2.4 HORIZONTAL SHARING

Horizontal sharing, the second dimension of the architecture of an

intergovernmental transfer, is the method by which the central government
divides the vertical share among the eligible subnational government units.
In practice, countries seem to have followed one or more of four approaches
to horizontal sharing: derivation, formula, cost ­reimbursement, and ad hoc
distributions.

Derivation

The derivation approach (Type A in Table 2.1) distributes a shared national

tax among SNGs according to where the tax is collected. For example, in
China, 50 per cent of domestic value added tax (VAT) collections and 40
per cent of income tax collections in each province are kept by the prov-
ince where it was collected. The appeal to this approach is that it returns
national government tax collections to urban areas where the investment
may yield greater returns, and it finances intergovernmental transfers with
more efficient central government taxes.
The most contentious feature of derivation-based sharing is that
regions with a stronger economic base will receive more transfer revenue

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 14 Intergovernmental transfers in federations

than poorer ones. This reinforces the disparities in the quality of public
services and infrastructure that already are better in many regions with a
stronger economic base. Paradoxically, countries that use the derivation
approach often adopt an equalization transfer to offset the advantages
given to the rich provinces. For example, Germany shares 50 per cent
of income taxes on a derivation basis, but mostly erases the advantage
of higher income states with a sharing of the VAT and a horizontal
sharing regime among the states that is equalizing (Spahn, Chapter 5).
Switzerland shares 13 per cent of federal income tax collections with
cantons on a derivation basis, but also has a significant equalization
programme (Dafflon, Chapter 8).

Formula Grants

The formula approach (Types B and E in Table 2.1) is probably the most
widely used method of horizontal sharing in low- and middle-income
countries. An appealing feature of a formula grant is that it offers the pos-
sibility of building equalization features into the distribution of transfers.
The richer subnational governments might be less enthusiastic about the
formula approach since they are home to most of the tax base and may
receive less of the transfer pie.
A formula can offer transparency, simplicity and objectivity. But these
advantages are not always achieved. Particularly in low- and middle-income
countries, data are limited and finding a transfer formula that will do the
job is often a stretch. The goal of simplicity is also hard to hold to, in part
because well-intentioned ‘social engineers’ often lobby to insert additional
variables into the formula to achieve some particular effect. Horizontal
transfer formulae can become complicated to a point where support for
them can be eroded. Coppel sees the Australian system as ‘fiendishly com-
plicated’ (Chapter 10), the Argentinean system has long been referred to as
a ‘labyrinth’ (Larizza and Folgar, Chapter 12) and fully understanding the
Swiss approach is no easy matter. Most horizontal distribution formulae
use indicators that reflect fiscal capacity and expenditure needs. The obvi-
ous proxy for fiscal capacity is a broad measure of the potential tax base
such as regional or local GDP, or better yet, bases of SNG taxes, but many
developing countries do not have good measures of either.
The expenditure needs focus is also common. Many countries have
landed on the goal of giving the formula ‘common sense elements’ that
the general population can identify with, for example, the higher cost of
providing public services in more remote Indonesian provinces, or the
special needs of Indian rural local governments with heavy concentrations
of poverty, or simply the belief that population size is a good indicator

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 The architecture of intergovernmental transfers ­15

of expenditure needs. In the end, the variable used to take account of the
needs-resources gap is rough justice at best.
While there are common elements to the formulae in low- and middle-
income countries, the approaches taken vary a great deal. Brazil’s intergov-
ernmental transfers are structured with different sharing rates for each tax,
and extensive earmarking. The long-term trend has been to move toward
a formula-based distribution of transfers (Wetzel and Viñuela, Chapter
11). Mexico’s unconditional transfers are distributed under eight different
heads, each with a different formula; and Ethiopia’s includes 14 indicators
of expenditure needs and fiscal capacity. Over 90 per cent of South Africa’s
transfers to provincial governments are allocated on a basis of population
size, health care needs and education sector needs (Savage, Chapter 16).
In the first six years of the operation of Kenya’s equitable shares grant,
Congress has prepared two horizontal distribution formulae. More than 80
per cent of the revenues are distributed according to population size, equal
shares and poverty (Boex and Smoke, Chapter 15).
There is also variation in the approach taken in the industrial countries
in this sample. Canada’s health and social transfers are allocated across
provinces on an equal per capita basis (Joanis and Vaillancourt, Chapter
7). The VAT transfer is distributed across states in Germany on a per
capita basis (Spahn, Chapter 5). The horizontal sharing formulae for the
equalization grants in Switzerland and Australia are structured to close
the gap between resources and needs. The Swiss revenue capacity equaliza-
tion fund is distributed by a representative tax approach, and the two
­expenditure equalization components by formula (Dafflon, Chapter 8).

Cost Reimbursement and Matching Grants

Cost reimbursement grants (Types C and F in Table 2.1) usually are

earmarked for a particular function. The practice with respect to cost reim-
bursement grants is varied, both in terms of the objectives sought and the
structure of the grants. In Nepal a conditional grant funds the salaries of
central government employees that were transferred to the newly formed
local governments. Another justification is to compensate for an activity
that the centre fears the subnational government cannot afford, or for
which the central government feels some degree of responsibility, for exam-
ple, medical assistance to low-income families in the US, or compensation
for the abolition of a local tax. The cost reimbursement approach may
also be used to support programmes of the line ministries, for example,
­matching grants for India’s rural development schemes.

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 16 Intergovernmental transfers in federations

Ad hoc Transfers

Finally, some intergovernmental transfers are distributed on an ad hoc basis

by the legislature or by the central government (Types D and G in Table
2.1). Ad hoc grant programmes exist in most countries and are roundly
criticized for their lack of transparency and susceptibility to corruption.
But they survive because they are a way for the central g­ overnment or the
Congress to build their support base.
One version of ad hoc grants would have subnational governments
compete for funding from a special pool of funds, with the higher-level
government choosing those projects to be funded. Ad hoc grants may also
take the form of emergency (off-budget) year-end bailouts for regions in
trouble, or special support to troubled regions. Some countries, like India,
have given legislators an allocation to be spent at their own discretion. The
discretionary grants used in the Argentine transfer system, which could be
used as conditional transfers to attack specific sectoral objectives, in practice
are used as a tool of political bargaining (Larizza and Folgar, Chapter 12).

2.5 EQUALIZATION

It would be rare to find an intergovernmental transfer system in a low- or

middle-income country that does not include equalization as a prominent
goal for its intergovernmental transfer system. Yet, research in this area
suggests that many low-income countries do not do a very good job with
narrowing fiscal disparities or favouring poor regions with their distribu-
tion of transfers.3
Many explanations might be offered for this policy failure. Central
governments and parliaments do not begin the design of an equalization
programme with a precise statement of the ultimate objective, usually avoid
the guaranteed minimum service level question, work with inadequate data
and rarely monitor outcomes. In the end, a rough justice approach is taken,
with an equalization variable included in the grant distribution formula to
reflect the general level of economic and service level well-being of local
populations.
Dafflon and Vaillancourt (Chapter 4) argue that the approach has
been flawed and call for a ‘second generation’ approach that better inte-
grates expenditure needs and revenue capacity factors into the horizontal
equalization approach. Martinez-Vazquez (Chapter 14) makes a similar
argument with reference to equalization transfers in India.
In fact, the approach to equalization taken by the countries in this volume
show a good deal of variation. The South African equitable shares grant is

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 The architecture of intergovernmental transfers ­17

distributed among local governments according to a formula that provides

enough funding for provision of basic services to poor households (Savage,
Chapter 16). During the first five years of the devolution in Kenya, the
horizontal allocation formula distributed considerably greater resources to
the undeveloped and less (densely) populated counties (Boex and Smoke,
Chapter 15). On the other hand, the co-participation transfers in Argentina
do not show a significant impact on regional re-distribution (Larizza and
Folgar, Chapter 12). While the education and health transfers in Brazil favour
lower income states, the minimum supported levels are low, and wide dispari-
ties among the states continue to exist (Wetzel and Viñuela, Chapter 11).
The experience with equalization in the industrial countries studied here
brings some good lessons, though the transferability is limited because the
context is so different than in low- and middle-income countries. Industrial
countries tend to have a clearer policy to define what they want from their
equalization system, and they have a longer experience with intergovern-
mental transfer regimes. The existing level of fiscal disparities tends to be
less, better data are available with which to develop creative formulae, and
the fiscal culture is more likely to accept a complicated regime of intergov-
ernmental fiscal transfers. But, like the lower income countries, they must
balance the gains from equalization with political considerations.
Most of these countries attempt equalization on both the revenue capac-
ity and expenditure needs dimensions of the budget. Though Canada is
committed to equalization, and its basic approach to fiscal capacity
equalization is consistent with good international practice, its efforts in
this direction have weakened in recent years (Joanis and Vaillancourt,
Chapter 7).
Swiss cantons receive about 30 per cent of revenues from intergovern-
mental transfers, but equalization transfers account for only about 4 per
cent (Dafflon, Chapter 8). The system of equalization transfers adopted in
Switzerland in 2008 includes three separate components: revenue capacity
equalization, expenditure needs equalization, and a transition fund to
accommodate those burdened by the shift to the new system.
The intergovernmental transfer system in Germany is structured to
achieve horizontal fiscal balance. The national VAT is distributed among
the states according to population, and state government revenues are
reallocated among the states according to fiscal capacity (Spahn, Chapter
5). In Australia, the distribution of untied grants to the states is managed
by the Commonwealth Grants Commission (CGC). In 2010, the equaliza-
tion objective was redefined to say that state governments should receive
funding such that, after allowing for material factors affecting revenues
and expenditures, each would have the fiscal capacity to provide services
and the associated infrastructure at the same standard, if each made the

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 18 Intergovernmental transfers in federations

same effort to raise revenue from its own sources and operated at the same
level of efficiency (Searle, Chapter 9).
The US is the outlier in this group in that it has no general purpose
equalization grants. The approach to equalization is to subsidize SNG
provision of merit goods, using matching or block grants. Overall grant
distributions have moved toward favouring rich states because of their
higher Medicaid expenditures (Chernick, Chapter 6).
Evaluations of the impacts of the intergovernmental transfer system are
more common in industrial countries, in fact it is legally required in the
Swiss system (Dafflon, Chapter 8). There is a system in place to manage
and evaluate horizontal fiscal equalization in Australia, though it now may
involve the national treasury as well as the CGC.
The fiscal capacities of German and Australian states are significantly
levelled by vertical and horizontal transfers (Spahn, Chapter 5, and
Coppel, Chapter 10). Australia is the only OECD country that takes the
objective of fully eliminating disparities in fiscal capacity (Coppel, Chapter
10). In the Swiss system, seven cantons with taxable capacity above the
national average contribute to the equalization pool, and post-distribution,
all cantons are levelled at 85 per cent of the national average (Dafflon,
Chapter 8). The extent to which the expenditure needs formulae contribute
to equalization are less clear.

2.6 
CONCLUSIONS: GUIDELINES FOR
STRUCTURING HORIZONTAL AND VERTICAL
SHARING

No single ‘model’ regime for intergovernmental transfers has emerged

from the practice in low- and middle-income countries. This is partly
because these governments have shaped their intergovernmental fiscal
systems in different ways, partly because they do not have the data to
develop a proper approach, and partly because they do not have the
political mandate to make the sweeping and sensitive changes that might
be necessary. But even within this wide variation in the practice, there are
some more or less universal principles that can help guide the practice.
These are outlined below.

1. 
The place to begin in designing (or reforming) an intergovernmental
transfer regime is with a policy outlining the objectives that the gov-
ernment wants to achieve. ‘How much vertical fiscal balance and how
much equalization is desired, what incentives will be imbedded in the
system, and how much autonomy will be released to the SNGs’ are the

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 The architecture of intergovernmental transfers ­19

kinds of questions that will be answered by government with its policy

and its laws.
2. 
The intergovernmental transfer system should be designed, or
reformed, in a context of the overall system of intergovernmental
finance. Expenditure and revenue assignment, and capital finance, all
will impact the choices made for the best design of the grant regime.
3. 
The maintenance of the intergovernmental transfer regime is as
important as the design of its architecture. Governments could greatly
benefit from an intensive review of the system, carried out periodically
by an apolitical, professionally staffed research cell. Governments
should redouble their efforts to provide a database that can support
the work of the evaluation unit.
There is no one best way to structure the vertical share of intergov-
4. 
ernmental transfers. In fact, some valuable diversity comes from
using both the shared tax and the discretionary budget approach. Tax
sharing is well suited to support general expenditure programmes for
subnational governments in that it can provide access to a broad and
income-elastic tax base, and it tends not to carry spending conditions.
The annual budgetary approach to vertical sharing fits conditional
grants and special purpose transfers because of their special condi-
tionalities and monitoring requirements. While they can be structured
as multiyear programmes, they should be structured to face a sunset at
which time their continuation would depend on a full evaluation.
The right choice for horizontal distributions depends on the objectives
5. 
the government has set down for its grants system. The derivation
approach puts the funds back to the richer places where presumably
the greatest return can be received from the transfer, but it favours rich
subnational governments to such an extent that a significant equal-
izing transfer programme is necessary to undo the equity damage.
Many low- and middle-income countries pair a shared tax approach
to vertical sharing with a formula approach to horizontal sharing.
Formula systems for horizontal sharing should follow the objectives
6. 
laid out in government policy. They should be monitored regularly
and changed as better data become available or when the formula
becomes compromised by political considerations.
Intended and unintended incentives are present in almost all inter-
7. 
governmental transfer systems and should be reviewed periodically to
understand their effectiveness and impact.
The equalization component of intergovernmental transfers should be
8. 
subjected to comprehensive, regular review. The benchmark for evalu-
ation should be the government’s policy statement about the goals of
equalization.

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 20 Intergovernmental transfers in federations

NOTES

1. This chapter draws heavily from Bahl and Bird (2018), Chapter 7, where there is a more
in-depth and comprehensive discussion of this topic, and where more extensive referenc-
ing is provided.
2. This taxonomy of intergovernmental transfers was first developed in Bahl and Linn
(1992) and was enhanced and upgraded in Bahl and Bird (2018, p. 290).
3. For reviews on this, see Bahl and Bird (2018) and Mathur (2012). For a more positive view
about the effectiveness of second-best solutions, see Boex and Martinez-Vazquez (2007).

REFERENCES

Bahl, Roy and Richard Bird (2018) Fiscal Decentralization and Local Finance
in Developing Countries: Development from Below (Cheltenham, UK and
Northampton, MA, USA: Edward Elgar Publishing).
Bahl, Roy and Johannes Linn (1992) Urban Public Finance in Developing Countries
(New York: Oxford University Press).
Bahl, Roy, Chor-Ching Goh and Baoyun Qiao (2014) Reforming the Public Finance
System to Fit a More Urbanized China (Beijing: China Financial and Economic
Publishing House).
Boex, Jameson and Jorge Martinez-Vazquez (2007) ‘Designing Intergovernmental
Equalization Transfers with Imperfect Data: Concepts, Practices and Lessons’ in
Jorge Martinez-Vazquez and Bob Searle (eds), Fiscal Equalization: Challenges
in the Design of Intergovernmental Transfers (New York: Springer), pp. 291–344.
Kim, Junghun, Jørgen Lotz and Niels Jorgen Mau (eds) (2010) General Grants
versus Earmarked Grants Theory and Practice: The Copenhagen Workshop 2009
(Albertslund: Korea Institute of Public Finance and Danish Ministry of Interior
and Health).
Mathur, Om Prakash (2012) ‘Intergovernmental Transfers in Local Government
Finance: Decentralization and Strengthening of Local Authorities’, Report
submitted to UN-Habitat, Nairobi.
Shah, Anwar (2013) ‘Grant Financing of Metropolitan Areas: A Review of
Principles and Worldwide Practices’ in Roy Bahl, Johannes Linn and Deborah
Wetzel (eds), Financing Metropolitan Governments in Developing Countries
(Cambridge, MA: Lincoln Institute of Land Policy), pp. 213–42.

YILMAZ_9781789900842_t.indd 20 16/12/2019 10:44

 3. 
Issues in intergovernmental fiscal
transfers: public finance and
political economy considerations
Serdar Yilmaz and Farah Zahir

3.1 INTRODUCTION

Intergovernmental transfers1 are an essential component of intergovern-

mental fiscal arrangements.2 They play a prominent role in subnational
finances in both federal and unitary countries.3 Thus, the design of an
intergovernmental transfer system is of great importance for efficiency and
equity of local public service provision and the fiscal health of subnational
governments. Intergovernmental transfers, including grants, shared taxes,
revenue sharing, subsidies and subventions, are used to pursue a variety of
public policy objectives in different countries.
The design of the intergovernmental transfers in many countries is
influenced by the traditional public finance theories which emphasize
their role in correcting vertical and horizontal imbalances. This so-called
first-generation theory (FGT) of fiscal federalism has an efficiency-
centred view of policy. The FGT refers to a normative theory in which
the main elements are well established (Oates 1972; Gramlich 1977).
Intergovernmental transfers are viewed as economic policy tools to
correct imperfections. However, the first-generation theory assumed
that decision makers are benevolent actors who would intervene to
provide public goods efficiently (Weingast 2014; Oates 2005; Inman and
Rubinfeld 1997). A second generation of thinking (SGT) in the fiscal
federalism literature recognizes that public officials have divergent inter-
ests and they are not necessarily benevolent actors who seek to maximize
public interests (Weingast 2009; 2014). The SGT focuses on the political
economy implications of transfers and pays attention to the institutional
and political incentives that induce or constrain the behaviour of officials
as they interact within and across the tiers of government. The second-
generation literature sees intergovernmental transfers as a potentially
tempting target for rent-seeking politics. The SGT is particularly mindful

21

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 22 Intergovernmental transfers in federations

about the potential distortionary effect of intergovernmental transfers on

the internal economic union of a country.
The FGT and SGT complement each other. According to Weingast
(2009: 290), the FGT ‘studies the optimal design of fiscal institutions in
the context of welfare maximization with respect to incentives of political
officials. [SGT] extends and adapts [FGT] lessons to the context of incen-
tives and self-interested political officials’. In terms of intergovernmental
transfers, the SGT builds on the normative lessons of the FGT and focuses
on the incentive structure of the transfers to foster local economic devel-
opment. It highlights the importance of local revenue generation which
enhances accountability of local politicians to their citizens and ‘the incen-
tives to provide market-enhancing public goods’ (Weingast 2009: 290). In
terms of the design properties of a transfer system, the SGT strongly sug-
gests the use of step functions ‘to provide subnational governments with
higher marginal incentives to foster local economic prosperity’ (Weingast
2009: 290).
The main purpose of this chapter is to survey the FGT and SGT litera-
ture to summarize the theoretical conceptualization of intergovernmental
transfer design and empirical analyses in specific country contexts. It aims
to present a case for the importance of political economy considerations
in designing and analysing intergovernmental transfer systems. After this
brief introduction, we begin this chapter by describing the evolution in
thinking about fiscal federalism. We then discuss the purposes of intergov-
ernmental transfers with an emphasis on incentives. Finally, we conclude
with some broad lessons about designing intergovernmental fiscal systems
for effective service delivery.

3.2 
THE EVOLUTION OF THEORY IN FISCAL
FEDERALISM

The traditional public finance theory prescribes expenditure and revenue

assignments between levels of government and the design of transfer sys-
tems and subnational debt on the grounds of efficiency, equity and mac-
roeconomic stability. These prescriptions are expressed as the four pillars
of an intergovernmental system in a country – expenditure assignment,
revenue assignment, intergovernmental transfers/grants and subnational
debt/borrowing (Bird 2000). For efficiency reasons, lower tier governments
should provide public goods and services that benefit local consumers,
and which their residents prefer, given that the tastes for goods are
local-specific, and local authorities may have more accurate information
about what their citizens want (Tiebout 1961). Higher tier governments

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 Issues in intergovernmental fiscal transfers ­23

should provide goods that are non-excludable, meaning those goods that
a non-paying individual cannot be prevented from enjoying – for example,
national defence. In terms of revenues, efficiency considerations suggest
that the most buoyant sources of taxes, that is, those based on income, can
be collected at the centre more easily and at lower economic costs than at
subnational level. And intergovernmental transfers are a prescription to
remedy the resulting vertical and horizontal imbalances after the assign-
ment of service delivery responsibilities and taxing powers to the levels of
government. In cases where the provision of local goods generates exter-
nalities, the centre handles the issue by providing subsidies or transfers to
internalize the benefits (Oates 1972). And, for reasons of intergenerational
equity, subnational governments should use borrowing for infrastructure
investments.
It is important to realize that these four components of an intergovern-
mental system are highly interdependent, and transfers are just one com-
ponent of the system. Therefore, the design of a transfer system cannot be
separated from the design and evolution of the broader intergovernmental
fiscal system. Of course, each of these components of the system must be
very well linked to broader fiscal policy and service delivery objectives.
The design of an intergovernmental system has come under intense ques-
tioning by the SGT. While accepting the basic premises of the traditional
public finance analysis in designing an intergovernmental system, the SGT
puts strong emphasis on giving own source revenue powers to subnational
governments.4 It underlines the importance of horizontal competition
between subnational governments for economic efficiency and argues for
refrainment of the central level from interfering in subnational taxing and
spending decisions. It regards central fiscal interventions as distortion-
ary policy instruments that inhibit the development of a competitive
and efficient intergovernmental system. According to the SGT analysis,
central interventions create incentive compatibility problems by inducing
subnational spending, amassing unsustainable deficits, and perpetuating
their dependence on the centre for more support (McKinnon and Nechyba
1997).5 In addition, the SGT literature warns about the dangers of soft
budget constraint,6 highlighting disincentives created by transfers for
subnational governments to pay attention to their expenditures and make
prudent fiscal decisions. The literature also warns about the so-called
common pool problem (Rodden 2003; Oates 2005; Rodden and Wibbels
2002) – the potential adverse incentives created by transfers.7 If the design
of a transfer system symbolizes fiscal dentistry,8 subnational governments
will have incentives for opportunistically shifting their overspending costs
and excessive borrowings to the centre. In that sense, transfers create a
moral hazard by insuring fiscally reckless behaviour. In fact, the literature

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 24 Intergovernmental transfers in federations

presents the Argentine and Brazilian fiscal crises of the 1980s and 1990s
as examples of fiscal recklessness (Rodden 2012). The SGT prescribes
market-based and rule-based institutional mechanisms that would create
hard budget constraint (Ter-Minassian 1997). Market-based institutional
mechanisms involve the establishment of an efficient market together
with an intergovernmental system in which subnational governments have
autonomous taxing and expenditure powers. Rule-based institutional
mechanisms are laws that prohibit deficits, severely limit borrowings,
provide for credible no-bailout and minimal intergovernmental transfers,
and allow for subnational bankruptcy (Burret and Feld 2014; McKinnon
and Nechyba 1997; Oates 2005; Skeel 2011; Ter-Minassian 1997).

3.3 
THE PURPOSES OF INTERGOVERNMENTAL
TRANSFERS

Traditional public finance theories suggest that intergovernmental trans-

fers can serve a useful purpose in aligning subnational incentives to
national public welfare, while the SGT literature highlights the potential
detrimental impact on economic performance through rent-seeking. The
rent-seeking arguments stem from Brennan and Buchanan’s (1980) work
where they argue that governments are net surplus maximizers (Leviathan
thesis).9 In this line of thinking, intergovernmental transfers create
dependency and discourage subnational governments for competition.
Thereby, transfers create an environment for rent-seeking for bureaucrats’
own benefit. The empirical literature provides some evidence to support
this argument.10
The traditional public finance theory and literature focus mostly on
static effects of intergovernmental transfers dealing with the question of
designing a system to achieve a minimum standard of service delivery
across subnational jurisdictions – horizontal equity. Whereas the SGT
puts emphasis on growth effects of fiscal federalism design, particularly
the impact of intergovernmental transfers on revenue mobilization at the
subnational level. The most critical aspect of an intergovernmental transfer
system is not the issue of who gives them or who gets them but its effect on
the efficiency of public service provision as well as achieving fiscal equity
and macroeconomic stability (Bird and Smart 2001). The large spread of
literature on intergovernmental transfers presents theoretical arguments
on how to achieve these objectives. In this section, we organize the discus-
sions around four major objectives of intergovernmental transfers. We
discuss public finance and political economy considerations in achieving
these objectives:

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 Issues in intergovernmental fiscal transfers ­25

1. 
Closing the vertical gap, in other words to improve revenue adequacy;
2. 
Addressing horizontal fiscal inequalities – interjurisdictional
redistribution;
3. Financing spatial spillovers;
4. Meeting national goals, objectives and priorities.

3.3.1 Closing the Vertical Gap

Revenue and expenditure assignments give rise to vertical and horizontal

fiscal imbalances within a nation’s intergovernmental finances. Vertical fiscal
imbalance is the disparity between revenue sources and expenditure needs
of the aggregate of subnational governments. Vertical fiscal imbalance exists
when there is no broad correspondence between the expenditure responsibili-
ties assigned to each level of government and the fiscal resources available to
them to carry out those responsibilities at some prescribed minimum level.
For the most part, tax collection is the responsibility of central government
as it collects taxes at a lower cost than the subnational governments.
The most common source of vertical imbalance is the lack of own
revenue sources at the subnational level. Intergovernmental transfers are
typically designed to redress this vertical imbalance. However, it is very
important to properly estimate the vertical gap as ‘increased transfers
might muddle rather than clarify the link between taxes and benefits, which
increases the likelihood of fiscal illusion’ (Rodden 2003: 706). There are at
least two other ways to close the vertical imbalance gap, such as increas-
ing the ­revenue-raising ability of subnational governments (raising own
revenues) and/or reducing the expenditure responsibilities of subnational
governments (reducing subnational expenditures). Addressing the vertical
gap problem through only transferring more resources to subnational gov-
ernments can easily have adverse incentive effects on subnational behav-
iour. Increasing revenue autonomy of subnational governments, rather
than increasing transfer revenues, will also help strengthening Wicksellian
connection of the cost of service delivery and revenues to finance them.11
However, subnational taxation comes at a cost as well. Subnational
taxation can easily lead to tax competition or tax exporting, which creates
inefficiencies. In addition, subnational governments can easily use their
taxation power in order to affect the composition of their population.
The FGT takes subnational governments’ revenues as given and tries to
formulate a transfer model to increase revenues for expenditures. Efficiency
considerations highlighted in the FGT suggest that the central government
is best positioned to collect more taxes at a lower cost and then transfer
the resources to subnational governments to close at least a portion of the
vertical gap. On the other hand, the SGT emphasizes own source revenue

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 26 Intergovernmental transfers in federations

generation by subnational governments as a way to strengthen account-

ability linkages to citizens, to provide market-enhancing local public goods
and services and minimize corruption (Rodden 2003; Singh and Srinivasan
2006; Carega and Weingast 2003). The SGT literature suggests that subna-
tional governments need to keep a big chunk of own revenues. Otherwise,
the increase in the retention rate of the centre will have an adverse impact
on the revenue-raising efforts of subnational governments. In order to
show these adverse impacts, Carega and Weingast (2003) calculate the
retention rate in Mexico. The low retention rate of 23.3 per cent coincided
with the poor performance of the Mexican economy in 1995. In contrast,
the retention rate in China during the high growth period of 1981–92 was
89 per cent (Jin et al. 2005).
The SGT examines the effects of transfers on incentives for revenue-
raising and responsible spending. The concerns in the SGT literature stem
from negative incentives created by transfers on subnational revenue mobi-
lization.12 According to Weingast (2009: 284), the SGT logic suggests that
the design of transfer should ‘lower the tax burden on the economy and
limit tax competition and following the [SGT] fiscal incentive approach,
transfer systems should reward subnational governments that foster local
economic growth’. The SGT literature suggests that federations can
simultaneously achieve ‘horizontal equalization, preventing tax competi-
tion, and ensure high marginal incentives – by designing transfer by
non-linear functions’ (Weingast 2009: 284). The policy recommendation to
provide incentives to subnational governments in closing the vertical gap
is to design a transfer system with a step function which allows wealthier
subnational jurisdictions to keep a proportion of revenues above a certain
level (Weingast 2009).
Vertical imbalance persists in almost all countries for three reasons
(Bahl and Bird 2018): first, central governments are unwilling to devolve
more revenue-raising powers to subnational governments, like in China
or Egypt. Second, subnational governments have very limited capacity
to finance even a minimum level of services without support from the
centre, like Nepal. Third, some of the subnational expenditures generate
spillovers.
A generic representation of the vertical gap measure in mathematical
notation is

VG i 5 c a (tjs Bji ) d 2 c a (cks Eki ) d (3.1)

R z

j51 k51

where VGi is the vertical gap in subnational government i. The first bracket
is revenue-raising ability of subnational government i. In the first bracket,

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 Issues in intergovernmental fiscal transfers ­27

Bij is the tax base for revenue item j in i and tsj is the standard tax rate for
item j. The total number of revenue items is R (j 5 1 . . . R). The second
bracket represents the total costs of expenditure responsibilities of the
subnational government i. In the second bracket Eik denotes expenditure
item k in i and csk is the standard cost of expenditure item k. The total
number of expenditure items is Z (k 5 1 . . . Z).
Therefore, the total vertical gap in country A is equal to the sum vertical
gap across subnational governments:

VG A 5 a VG i(3.2)
n

i51

where VGA is the sum vertical gap in all subnational governments in country
A. In other words, the vertical gap amount is ‘total pool of funds to be
allocated to subnational governments . . .’ (Bahl and Wallace 2007: 205).
However, this notation of vertical gap in designing an intergovernmental
transfer system ‘is more easily conceptualized than it is measured . . .’ (Bahl
and Wallace 2007: 206). There are two major assumptions in this notation:
(i) subnational governments exert a normal level effort to collect revenues;
and (ii) subnational governments provide an acceptable level of services. It
is always difficult to define these concepts. If transfer revenues are directly
linked to the actual amount of revenues collected, subnational governments
have incentives to underperform in the collection. It is quite difficult to meas-
ure whether subnational governments make an acceptable level of effort to
exploit revenue bases available to them. More importantly, when subnational
governments become dependent on transfers, their incentive to exploit their
own revenue base weakens (Weingast 2009). On the expenditure side, the
definition of acceptable is subject to interpretation – acceptable to whom?
It is impossible to come up with an individual utility function to estimate an
aggregate level at the subnational level. As Bahl and Bird (2018: 284) suggest
‘since the public generally has little idea of the real tax price of local public
goods in any case, the demand for local government services is always likely to
outweigh the capacity (or willingness) at any level to finance them’.
There is only a handful of countries trying to estimate the vertical gap
according to the notation presented.13 Even then, these countries are
partially successful at using this approach. In many federations, the appli-
cation of the vertical gap measure concentrates only on the revenue side
which makes the total elimination of vertical imbalance a challenging task.
In Canada, for example, the system focuses only on the revenue-raising
ability of subnational governments.
Total elimination of vertical imbalance is an impossible task since some
degree of mismatch between expenditure needs and revenue capacity is

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 28 Intergovernmental transfers in federations

unavoidable. The difficulty of elimination of vertical imbalance is related

to its estimation, which requires detailed information about local govern-
ments’ expenditure needs and revenue-raising capacity and effort. The
lack of reliable information related to both the expenditures and revenues
of subnational governments are the most important technical constraints
in designing an effective intergovernmental transfer system to close the
vertical gap. In addition, central governments need information about
local preferences to estimate the optimal amount of Pigouvian subsidies to
address interjurisdictional spillovers (Oates 2005).
Even if there is an abundance of data and information, it is still a
challenging task to include politically accepted expenditure norms and a
fair estimate of the revenue capacity of subnational units in estimating
vertical imbalance (Alm and Martinez-Vazquez 2002). The fairness of the
allocation is widely questioned by subnational governments in the systems
that use the formula-based method. In some cases, the central government
takes away part or all of surplus revenues, giving the subnational govern-
ments no incentives to optimize their own revenues. Even supposing the
decision makers find a way to overcome the issues raised above to estimate
the optimal amount for closing the vertical gap, there are at least two other
issues they need to attend to going forward. First, the dynamic nature of
intergovernmental finance requires keeping an eye on revenue adequacy
and buoyancy. Second, the affordability of the vertical gap financing.

Revenue adequacy and buoyancy

In designing a transfer system to close the vertical gap, it is important to
secure revenue adequacy to generate sufficient resources for subnational
governments, and to reduce distortions in the allocation of resources
and increase fairness. Revenue adequacy refers to availability of revenues
to cover the cost of service delivery. A transfer system provides revenue
adequacy when it ensures that subnational governments have enough
resources to cover expenditure needs. The assessment of revenue adequacy
needs to be conducted to understand changes in intergovernmental
finances. A good example is the abolition of octroi in India. When the
Indian federal government decided to abolish octroi, it had a negative
impact on the vertical gap as octroi was a source of state revenues. In
order to compensate for the loss in revenue adequacy, the government has
decided to allocate a percentage of goods and sales tax revenues to states.
However, the estimation of vertical gap should be a dynamic process
providing ability to subnational governments to continue with the provi-
sion of services. In order to guarantee a certain quality and quantity of
subnational services, revenues should grow as much as the expenditure
needs. Buoyancy of the transfer system refers to the growth of the

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 Issues in intergovernmental fiscal transfers ­29

t­ransferred resources with the expenditure needs of subnational govern-

ments. The term buoyancy must be defined in a relative sense: revenues are
buoyant when they grow at the rate necessary to allow local governments
to finance their services over time. Thus, a system has appropriate buoy-
ancy if revenue growth is at the same rate as expenditure growth. Revenue
growth should be at the same rate as the desired expenditure growth.
Alternatively, buoyancy can be measured by the growth in revenues rela-
tive to the growth in GDP. Thus, a buoyancy coefficient of one indicates
that revenues grow at the same rates as GDP, a coefficient of less than
one is evidence of revenues growing more slowly than the economy, and
a coefficient of greater than one shows that revenues are growing faster
than the economy. Regardless of the measurement method, low buoyancy
means that a revenue system that is adequate today will be inadequate in
the future, since revenue growth will not keep pace with expenditure needs.
The buoyancy of revenue systems comes from a combination of growth
in tax base, such as through improvements in tax administration, and rate
increase.

Affordability
In designing a transfer system to close the vertical gap, it is important to
recognize budget constraints and macroeconomic stability at the centre.
The intergovernmental transfer programmes that try to address expendi-
ture needs should particularly pay attention to budget constraints at the
central level. These programmes must also estimate the extent to which
expenditure needs can be covered by available resources (Bahl and Wallace
2007). Closing the vertical gap will ultimately be a bargain over what
subnational governments need and what the central government can afford
(Bahl and Wallace 2007). In Australia (Chapter 9), Searle notes, the size of
the Commonwealth’s wallet seems to have by far the greatest influence on
what is done and how it is done.

3.3.2 Addressing Horizontal Fiscal Inequalities

The second objective of intergovernmental transfers is to minimize hori-

zontal imbalance. According to Dafflon and Vaillancourt (in this volume,
Chapter 4), there are five possible origins of horizontal fiscal inequalities:
three outside the control of subnational governments and two in the fiscal
preferences of subnational jurisdictions. They identify the three possible
origins outside of subnational governments as the capacity to raise (tax)
revenues, the expenditure needs, and the net residual which is expressed
as ‘needs minus capacity’. The other two are related to local preferences
for expenditures and taxes, therefore, they need not be compensated by

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 30 Intergovernmental transfers in federations

any kind of equalization or transfer payment (Dafflon and Vaillancourt

Chapter 4).
Subnational provision of services and subnational taxation invariably
make it impossible to provide a comparable level of public services at a
comparable level of taxation in all jurisdictions. In all countries, subna-
tional jurisdictions have dissimilar needs and the cost of public service
provision differs across them. Jurisdictions with more elderly, for example,
will allocate resources to healthcare services, and jurisdictions with more
school-age children to education. In addition, the cost of per unit service
provision might differ across jurisdictions due to geography, wage dif-
ferentials and other factors. On the revenue side, differences in tax bases
across jurisdictions generally require different rates to generate same level
per capita revenue. These forces are the main reason for net fiscal benefits
– the net benefits accrue to identical households in different jurisdictions.
Net fiscal benefits are the source of potential inefficiency and inequality.
Individuals would move to jurisdictions where they maximize net fiscal
benefits. Therefore, there would be inefficient allocation of labour across
jurisdictions due to the fiscally induced migration. However, if individuals
with identical income do not migrate despite differences in net fiscal ben-
efits, there will be horizontal inequality: individuals with identical income
will be treated differently in different jurisdictions (Boadway 2007).
Intergovernmental grants can be an effective instrument to avoid fiscally
induced migration and to minimize horizontal inequalities arising from
differences in fiscal capacity across subnational jurisdictions.14 They help
to achieve efficiency in labour allocation and horizontal equity by provid-
ing additional resources to subnational governments for comparable levels
of public services at comparable tax rates. In countries like Germany,
interjurisdictional redistribution is the main purpose of the equalization
transfer system. For instance, Spahn in Chapter 5 concludes,

In Germany (like in Canada) the focus of equalization is on taxable capacity

only, with little or no concern for specific burdens. As the tax law is uniform
throughout Germany (except for some limited discretion of municipalities to
vary their tax rates), there is no need to standardize taxable capacity among
regions (as in Canada), because effective tax collections can be considered to
reflect the regional variations of tax potentials.15

At first glance, addressing fiscal inequalities seems an easy task. Once the
extent of fiscal inequalities is measured, a decision needs to be made in
terms of how much of the interregional inequality needs to be eliminated.
Then an equalization formula should be designed to address the issue.
However, measuring fiscal capacity is not an easy task. To begin with, there
is a controversy surrounding its measure. The application of the fiscal

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 Issues in intergovernmental fiscal transfers ­31

capacity measure in some countries, such as Canada, concentrates only on

the revenue side (see details in Chapter 7, Joanis and Vaillancourt). The
treatment of the fiscal capacity concept solely as the revenue-raising ability
of subnational governments can be observed in the academic world as well
(Martinez-Vazquez and Boex 1997a; 1997b).
On the expenditure side, the overriding concern in designing an equali-
zation transfer system is to ensure that subnational governments provide
similar bundles of necessary public services to all citizens at comparable
tax rates. Dafflon (Chapter 8) argues:

In the Swiss context, expenditure needs equalization is exclusively vertical. The

theoretical argument is that horizontal equalization exists where beneficiaries
of services in low-costs-low-needs jurisdictions accept a tax-price supplement
(that is, more expensive public services) in order to subsidize public services in
high-costs-high-needs jurisdictions. This would distort the relative tax prices
of subnational public services and result in allocative inefficiency and wrong
incentives in deciding service levels.

Australia is the only OECD country that seeks to fully eliminate disparities
in fiscal capacity for both revenue and expenditure between sub‑national
governments (Coppel, Chapter 10). It enables all states to provide the
average national level of services and mostly adjusts for material structural
disadvantages that are out of states’ control. The principle of fiscal
equalization is strongly supported. To achieve this goal, most governments
design equalization transfer systems focusing on either equalization of
the capacity of local governments to provide certain levels of services or
equalization of the performance of local governments. Bird and Smart
(2001) criticize the performance approach on the grounds that central
governments’ policy preferences are dominant and ‘there is clearly no
agreement on either the desirability or the effects of general intergovern-
mental transfers intended to achieve this goal’. They also point out the fact
that, if capacity issue is given little consideration, performance approach
awards local governments that do not try to raise their own revenues. If
fiscal capacity is measured accurately, which is not an easy task due to the
reasons mentioned earlier, intergovernmental transfers would create very
little incentives for local governments’ revenue-raising restraint.
Although the FGT sees equalization transfers as a necessary tool to
prevent relatively rich regions attracting more investments at the expense
of poorer regions, the SGT literature argues against full equalization.
According to the SGT literature, full equalization discourages subnational
governments from pursuing policies to promote economic development
to expand the tax base as it takes away the revenue gains from economic
growth (Weingast 2009). Weingast recommends bringing all subnational

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 32 Intergovernmental transfers in federations

fiscal capacity to a certain level rather than full equalization by using step
functions; so that subnational governments have ‘marginal incentives
to foster local economic prosperity’ by retaining a certain percentage of
revenue derived from their own tax base (Weingast 2009: 290).

3.3.3 Spatial Spillovers

A third objective of intergovernmental transfers is to correct for interjuris-

dictional spillovers. Some local government services’ benefits (or costs)
extend beyond the borders of the locality. In case of positive spillovers,
local governments may be unwilling to provide an efficient level of certain
services if they believe that people who reside outside their locality will
enjoy many of the resulting benefits.16
Bird and Smart (2002) highlight three potential complications in deter-
mining the size of spillovers: (i) the matching rate for the central government
might decline if externalities decline with the increase in expenditures; (ii)
the rate might also vary across jurisdictions if there is a higher local price
elasticity of demand for the spillover generating service in some areas; and
(iii) if local fiscal capacities are not fully equalized a uniform matching rate
would discriminate against poorer subnational jurisdictions.
Because of these complications empirical studies on the outcome of
matching grants to address spillovers find mixed results. In the US context,
Inman (1988) suggests that the intergovernmental grant programmes do a
very poor job of making subnational governments internalize spillovers.
Similarly, Chernick (2000) finds that the fiscal incentive packages provided
by the federal government to states to induce social welfare spending have
limited impact.
In the developing world, designing a matching grant programme is even
more challenging because of the lack of information. Designing a sector
specific matching grant programme requires a clear specification of the
level of service to be provided in addition to fairly accurate and up-to-date
per unit cost of service provision.

3.3.4 National Goals, Objectives, and Priorities

Intergovernmental transfers can be an important instrument for national

governments to achieve broader national goals, objectives and priorities.
Here we discuss the issue of macroeconomic priorities.

Macroeconomic stabilization by risk sharing

From a national perspective intergovernmental transfers fulfil a risk-
sharing or stabilization function (von Hagen 2007). When different regions

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 Issues in intergovernmental fiscal transfers ­33

are subject to different economic shocks, intergovernmental transfers

can serve as an insurance to provide financial resources for addressing
adverse impacts of economic downturn. Zahir (Chapter 13) notes that
disentangling the redistribution, stabilization, and risk-sharing roles of
fiscal transfers is complicated in India as centre-state fiscal transfers are
believed to affect all roles simultaneously. Regional risk sharing through
intergovernmental transfers stabilizes regional business cycles (von Hagen
2007).17 To the extent that economic shocks have an adverse impact on
personal incomes and household consumption, subnational governments
are exposed to risks as their tax revenues will be impacted.18 According to
von Hagen (2007: 108), ‘[c]hanneling income from prosperous regions to
regions in distress can help attenuate asymmetries in the cyclical fluctua-
tions of regions within a country, producing more even economic develop-
ment across regions’.
Von Hagen (2007) argues that intergovernmental transfers, especially
equalization transfers, may also act as a stabilization factor when economic
shocks are lasting. Transfers can be instrumental in facilitating fiscal
adjustments, including regional wage and price adjustments, to a region’s
specific asymmetric shocks. Transfer systems can facilitate adjustment by
providing relief to reduce the fiscal pain. In addition, transfers can act as
a built-in stabilizer by augmenting aggregate demand in economic shock
affected regions.19
Political economy considerations, however, suggest that risk-sharing
arrangements give incentives to subnational governments in devising risk
avoidance strategies. Perrson and Tabellini (1996) show that subnational
governments have little incentive to raise local taxes in order to finance
programmes to alleviate the negative impact of economic shocks else-
where. Similarly, Baretti, Huber and Lichtblau (2002) suggest that, if
regional insurance transfer payments are tied to tax revenues collected by
subnational governments, it will lead to reduced tax effort.

3.4 CONCLUSION

Traditional public finance considerations are the raison d’être for inter-
governmental transfers. However, this chapter has argued that considering
political economy issues in designing intergovernmental transfers is equally
important to promote equal access to services for all citizens. Evidence
from the literature suggests that imperfections in political markets have
huge bearing on intergovernmental resource allocations. Boex and Smoke
note, in Chapter 15, Kenya’s path towards devolution has in some ways
been a ‘political’ success. The basic elements of the county government

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 34 Intergovernmental transfers in federations

systems have been defined and are being implemented. The extent to which
devolution has led to improved service delivery and governance outcomes,
however, is far less self-evident. Zahir (Chapter 13) further reiterates the
point that the attempt to use states as ‘laboratories for experimenting with
what programs work best’ had both political and economic ramifications
in India. In the last two decades in India there has been a general trend
towards coalition governments with a number of states and local repre-
sentatives now participating in politics at the centre. In addition, the 73rd
and the 74th Constitutional Amendments in 1992 had incentivized grass-
roots level politicians to rise above the petty politics of local and state level
and occupy a space at the centre. Poor regions tend to have less informed
citizens on public policies and they are less likely to participate in political
process. Given this evidence, it is important to come up with institutional
arrangements that secure broad-based representation in the sharing of
intergovernmental resources. For instance, Chernick in Chapter 6 points
out that the US grants system distributes large amounts of fiscal resources
to incentivize states and their localities to provide services to the poor and
enhance their capital stocks. While there is some modest fiscal equaliza-
tion, interstate and intrastate differences in spending for redistribution and
education, both between and within states, remain substantial.
The SGT literature suggests several remedies to address the political
economy imperfections in designing an intergovernmental system. First, it
suggests using market economy institutions to address some of the adverse
selection issues. For example, creating efficient credit markets will improve
subnational governments’ fiscal performance as credit market ratings have
a bearing on the cost of borrowing. Similarly, creating efficient land mar-
kets is an important disciplining factor on subnational finances through
local property values. Second, it suggests strengthening fiscal institutions
which have a bearing on subnational fiscal behaviour. The existence of a
stable and clear system of taxation, for example, creates the Wicksellian
connection between revenues and the cost of local services. Third, the SGT
literature suggests using constitutional or legislative restrictions to provide
constraints on fiscally irresponsible behaviour (see details, for example,
in Wetzel and Viñuela, Chapter 11; Larizza and Folgar, Chapter 12). For
instance, the existence of balanced-budget requirements and limitations on
borrowing as well as the existence of public bankruptcy laws can promote
fiscally prudent decision-making.
Finally, an analysis of intergovernmental transfer design must also
recognize the importance of institutional arrangements for managing the
system. There are two different institutional arrangements to minimize the
political influence: formula-based transfers and establishing independent
agencies to decide on the distribution of transfer resources. The evidence

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 Issues in intergovernmental fiscal transfers ­35

from literature is mixed. In the South African intergovernmental fiscal

framework (Savage, Chapter 16) the primary transfer to subnational
government is the unconditional, constitutional entitlement known as
the ‘equitable share’. This is distributed to provinces and municipalities
through the Provincial Equitable Share (PES) and the Local Government
Equitable Share (LGES), both of which are formula-based allocations
that are distributed without conditions. Worthington and Dollery (1998)
present evidence from Australia which suggests that formula-based trans-
fers are less prone to political influence as opposed to transfers which
are not subject to strict formulae.20 Similarly in India, Khemani (2003)
finds evidence that political agents play a big role in the distribution of
general purpose federal transfers, whereas the distribution of transfers by
independent Finance Commission is less subject to political interference.21

NOTES

1. The term ‘transfers’ is often used to refer to a number of different kinds of public
finance arrangements, including grants, subsidies, tax sharing and cost-reimbursement.
In this chapter, we use all these terms interchangeably to refer to transfers of funds from
central government to subnational governments.
2. The direction of a transfer mechanism can encompass all levels of government, such as
central to provincial, provincial/state to local, directly central to local or even national to
supra national (like the EU).
3. We use the term ‘subnational’ to encompass all governments below the central level.
4. On the issue of own revenues, the FGT is concerned about tax distortions and ineffi-
ciencies introduced by decentralized revenue-raising. In addition, the FGT is also appre-
hensive about potential tax competition among subnational governments. Whereas
the SGT perceives tax competition as beneficial by reining in excessive spending by
subnational governments. Tax competition is a particularly relevant issue in federations
where subnational governments use broad-base taxes that overlap with federal taxes
because of harmonization of tax bases.
5. A case in point is the changes in borrowing by Spain’s Autonomous Communities (AC)
in 2015. When they got into financial distress during the recent Spanish financial crisis,
due to a high level of borrowing, the central government’s Autonomous Financing
Fund (FFA in Spanish) came to their rescue. For more on the issue, please see Caixa
Bank (2018).
6. The concept of soft budget constraint was initially coined by Kornai (1980; 1986) to
highlight perpetual bailing out of public enterprises with state funds. Loss-making
public enterprises were able to count on financial assistance from state coffers, an
expectation that defined the behaviour of their top management. Later, the concept was
applied to subnational governments (Kornai et al. 2003).
7. Rodden (2003: 697) describes the potential negative impact of transfer revenues as
‘breaking the link between taxes and benefits, mere expenditure decentralization might
turn the public sector’s resources into a common pool that competing local governments
will attempt to overfish’.
8. Bird (1993) defines fiscal dentistry as gap-filling, suggesting that subnational govern-
ments with larger deficits receive larger transfers.
9. Brennan and Buchanan have developed a body of theory where they present govern-
ment as a revenue-maximizing Leviathan, which can be constrained by a constitution.

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 36 Intergovernmental transfers in federations

This constitution places definite limits upon the tax base. They believe that a tax
constitution is required to restrict governments which have propensity to tax and spend.
10. Grossman (1994), for example, argues that the per capita amount of intergovernmental
transfers in the US is correlated with party similarity, size of state bureaucracy and size
of state Democratic Party majority, suggesting that the transfer decisions are politically
driven. Sorensen (2003) finds that lobbying activities of local governments have an
impact on the amount of intergovernmental transfers in Norway. Borck and Owings
(2003) show that in California proximity to the state capital is an important factor in
determining the amount of transfer resources going to counties. Feld and Schaltegger
(2005) find that in Switzerland fiscal referendums lead to lower levels of intergovern-
mental transfers suggesting that voters serve as a hard budget constraint. Sole-Olle and
Sorribas-Navarro (2008) show that partisan alignment has a sizeable positive effect
on the amount of transfer revenues coming to municipalities in Spain. Sorens (2016)
presents evidence from the United States that subnational spending financed by federal
dollars leads to higher subnational and overall government debt and spending.
11. Theoretical considerations suggest that transfer revenues exert an incentive effect
on the tax effort of subnational governments. Buettner (2006) tests these theoretical
predictions using a large panel data of German municipalities and his empirical findings
suggest that the volume of transfer revenues reduces tax effort.
12. Evidence from empirical studies provides a convincing case of the disincentive effects
of intergovernmental transfers on local tax effort in different countries. For the German
equalization transfers, Buttner (1999) and Baretti et al. (2002) report a similar negative
effect on local revenues. In the context of India, Naganathan and Sivagnanam (2000),
Rajaraman and Vasishtha (2000) and Panda (2009) present similar evidence. In the case
of China, Liu and Zhao (2011) provide considerable evidence of disincentive effects of
transfers on local tax revenue generation. For Ghana, Mogues and Benin (2012) find
that transfers have a depressing effect on local revenues. In an empirical analysis, Bravo
(2010) finds negative effects of intergovernmental grants on local revenues in Chilean
municipalities. Similarly, Canavire-Bacarreza and Espinoza (2010) show that conditional
transfers negatively affect property tax collection in the State of Sinaloa in Mexico.
13. In the 1980s, the United States Advisory Commission on Intergovernmental Fiscal
Relations developed a methodology to incorporate the expenditure side of public
finances into the vertical gap concept (ACIR 1986; 1990a; 1990b). However, this
methodology was never applied to the estimation of actual federal transfers to states.
14. However, it is important to avoid eliminating differences in net fiscal benefits arising
from regional choices in the mix of public services (Boadway 2007). According to Sing
and Srinivasan (2006: 8), the concept of equalization is ‘eminently sensible if there is a
social consensus on what should be included in the set of services to be provided by the
government and at what level’.
15. A uniform state tax regime is, of course, immune against horizontal tax competition
among states in a legal sense. However, there could be incentives for the states to relax
their tax administration in an effort to attract and foster economic activities in their
jurisdiction. Such incentives are to be expected if the shortfall of revenue from lenient
tax administration is fully compensated through equalizing grants, which is true for a
number of states in Germany. Although there has been suspicion of leniency in some
instances, it is, of course, difficult to prove in practice. The redistribution effects follow-
ing the primary allocation of taxes will also induce lenient states (strategical reasons,
administrative inertia, weaker tax compliance where authorities are seen to be lenient)
to go on with their practice since they may make up 92 per cent of the difference through
equalization.
16. Tertiary education and transportation service provision are two good horizontal
spending externality examples. In both cases interjurisdictional spillovers could easily
generate disincentives for subnational governments to invest in the sector.
17. If the design of the transfer operates as an insurance mechanism over the business
cycle, then transfer revenues can reduce the procyclicality of subnational government

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 Issues in intergovernmental fiscal transfers ­37

resources. However, if transfers are subject to typical political pressures to increase

spending when in a boom, transfers can exacerbate the procyclicality of expenditures.
18. On the expenditure side, subnational governments might have to bear additional
expenses for programmes on soup kitchens, shelters and food banks to take care of
needy citizens during economic turmoil.
19. von Hagen (2007: 113) suggest that ‘[t]axing the prospering region and giving the
proceeds to the region in distress restores aggregate demand there and reduces aggregate
demand in the taxed region’.
20. In Australia, intergovernmental transfers are recommended by an independent
Commonwealth Grants Commission to the federal government.
21. There is a growing recognition of the relevance of political agency models in explain-
ing incumbent behaviour. Besley and Burgess (2002) use this approach to study how
politicians respond to shocks in India under the spotlight of the media. They observe
that state governments where the difference in the seats held by the two major parties is
smallest also appear to have more responsive governments. India’s sluggish performance
from independence through the early 1990s reflects its centralized federal system, where
the central government made most of the important policy decisions (compromising
subnational autonomy) and imposed some restrictions on the movement of goods
across states (prevented a common market). Democracy provides an obvious value to
citizens when it allows them to make choices over competing visions about policy and to
throwing out bad local officials. Yet the tragic brilliance mechanism – the threat by the
centre of withholding substantial revenue or policy benefits from localities that support
the opposition – perverts elections by preventing citizens from exercising freedom of
expression and choice (Weingast 2007).

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 4. 
The practice of fiscal equalization: a
political economy clarification*
Bernard Dafflon and François Vaillancourt

4.1 
INTRODUCTION: THE RATIONALE FOR
EQUALIZATION1

Most federal and decentralized States experience fiscal imbalance, verti-

cal and horizontal, and have found it necessary to correct both. In a
decentralized setting, vertical imbalance results from the fact that, in most
cases, major buoyant taxes such as personal or corporate income taxes or
consumption taxes are tax fields that belong to the federal or central gov-
ernment, while costly labour intensive functions, such as health, education
and social services have usually been assigned to sub-national governments
(SNGs thereafter; they can be regional or local) for reasons of proximity
and preferences (Watts, 2008, p. 103). Vertical imbalance can be solved by
re-assigning taxation and functions, or, with those unchanged, through
financial transfers from the centre to the SNGs.
The origin of horizontal imbalance is different. First, federal or decen-
tralized countries do not have perfectly homogenous regions; indeed, their
more or less decentralized arrangements are put in place because of this
lack of homogeneity. Thus, sub-national financial capacities depend on
both the revenue bases legally accessible to SNGs and the territorial distri-
bution of those bases. Needs vary according to the particular preferences
of the SNG residents; but they also depend on geographic, demographic
and socio-economic factors. They are further determined by legal (but not
only) requirements as to the type of mandatory public services that SNGs
must provide. And unit costs of publicly provided goods and services can
vary between SNGs due to factors such as weather or topography. Second,
no matter how carefully functions and revenues are decentralized at a point
in time (say when writing or amending the Constitution) with the objective
of matching expenditures and taxation, their paths differ over time causing
disparities in decentralized budgets of SNG units.
Equalization is the usual answer to horizontal imbalance. It refers to
attempts made at the reduction of fiscal differences among SNGs by

41

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 42 Intergovernmental transfers in federations

­ onetary transfers. Two initial questions arise with respect to implement-

m
ing equalization schemes. (i) What sort of ‘solidarity’ among SNGs is
accepted and acceptable and who decides on this? More solidarity would
clearly mark a trend towards standardization in the delivery of core local
public services, instead of leaving SNGs provide local-specific services,
assuming the consequences in terms of tax levels, under the constraint of
the potential mobility of users/taxpayers. In the case of federal countries,
examples of substantial solidarity between SNGs are Australia and
Germany, of less solidarity Canada and Switzerland and of little solidarity
the United States. (ii) Where to draw the line between local preferences
and mandatory local public services? As Boex and Martinez-Vazquez
(2007, p. 293) put it: ‘Without a clear demarcation line separating specific
standards of services from an overall envelope of expenditures, percep-
tions of what may be a need can easily escalate to completely unaffordable
expenditure levels’.
For practitioners, the theory of fiscal equalization is elusive. There is
no core programme; it is mainly derived from the theory of grants-in-aid.
There are several ways to consider SNGs’ ‘capacity’ or ‘needs’; the distinc-
tion between expenditures/costs/needs equalization is blurred. This is not
surprising. Equalization is first and foremost a question of redistributive
justice among SNGs; this is to ensure the equal or similar treatment of
residents of a country wherever they live. Thus, equalization is pervaded
with value judgements that cannot be easily explained by economic theory.
Questions such as ‘how much’ the ‘rich’ jurisdictions should contribute to
equalization and ‘how much’ the ‘poor’ can claim, the estimation of the
degree of capacity – financial, fiscal or tax capacity – together with the
evaluation of the amount to be paid or received are closely – though not
exclusively – related to the concept of ‘solidarity’. This concept can vary
between individuals, political parties and so on often with payers being
inclined to less generosity than beneficiaries. Thus, politicians have as
much to say as economists in policy implementation. Yet, in politics, ‘fiscal
equalization’ is very often poorly defined (elusive), but overused because of
its ambiguity which is precisely a political rhetorical resource.
Confronted with this multiplicity of approaches, the purpose of this
chapter is to offer a benchmark for the economic and political examina-
tion of equalization policies in different countries. When reading papers
about international experiences with equalization schemes, we most often
encounter a descriptive and careful analysis of the institutional process
aimed at some form of fiscal equalization. It is, however, very difficult
to compare one national experience to another due to the absence of an
analytical yardstick. Yet, in the architecture and design of equalization for
any country, the same questions and the same problems always arise. The

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 The practice of fiscal equalization ­43

objective in this chapter is to list the main issues in a sequential, compre-

hensive and coherent way so that one can more easily compare national
experiences about the fundamental architecture of equalization, although
not in all its operational details.
The chapter is divided into five sections. The first one briefly summarizes
the literature on equalization, not to give a full overview, but to highlight
milestone contributions to the political economy of interregional solidar-
ity. The second section examines and explains the possible origins of dis-
parities or differences in the public finance position of SNGs. Disparities
are equalizable, differences not. The third section points out the changes in
the policy objectives from first- and second-generation models: when first
introduced, explicit equalization either ignored expenditure needs equali-
zation (Canada, 1957) or would mix revenue and expenditure needs in one
single formula (Australia, 1934; Switzerland, 1959). The lack of expendi-
ture equalization made reaching the goals of equalization impossible,
while the intertwining of the two objectives unduly complexified matters.
It is now clear that for proper outcomes to be attained, expenditure needs
equalization cannot be ignored; and revenue equalization and expenditure
needs equalization must be addressed explicitly by themselves, yet in
complementary fashion. The fourth section presents a comprehensive and
coherent listing of the key issues in equalization policy. The last section
proposes a synopsis of possible determinants of disparities that can be
used to guide the design of the architecture of equalization policies.

4.2 
SOLIDARITY AND EQUALIZATION: A
SUMMARY OF THE LITERATURE

This first section presents a summary, not a survey, of the literature on

equalization in order to introduce step by step the main arguments leading
from solidarity between SNGs, a political concept, to equalization, its
economic/fiscal counterpart that makes the concept operational, with the
main obstacles and difficulties that implementation faces.
In his seminal pieces on equalization, Buchanan (1950, 1952) argues for
a similar treatment not of SNGs but of individuals, wherever they reside in
a country, in terms of fiscal residual or net fiscal benefit (that is, the value
of public goods and services provided minus the tax cost). He updated
these pieces 50 years later without much change (Buchanan, 2002).
In response to Buchanan, Scott (1950) argues that equalization from
rich to poor regions means that the latter can offer public services at an
incorrect price to their residents. This creates a distortion in the allocation
of resources between regions and slows down labour mobility. Workers in

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 44 Intergovernmental transfers in federations

the poor region benefit after equalization from more public services than
what they could afford with their own resources, reducing maximization
of national output. Buchanan (1952) replies by arguing that equalization
reduces inefficient migration.
Buchanan and Goetz (1972) argue that since migrants do not take into
account that their movement increases the per capita fiscal price in their
region of origin, reduces it in their region of destination while perhaps
creating congestion in it, equalization internalizes social costs and is thus
desirable. Boadway and Flatters (1982) synthesize the arguments of effi-
ciency and equity in the debate on equalization. Since net fiscal residuals
in SNGs are not zero when the user-pay principle does not apply, there are
two possibilities for correcting this: adjustment for individuals through
central taxes (as proposed by Buchanan) or equalization between SNGs
with higher and lower net fiscal residuals.
Von Hagen (2000) analyses equalization as a type of insurance against
shocks to the economy of SNGs. Today’s rich SNGs in terms of resources
and with little or no needs can become poor tomorrow because of globali-
zation, changes in demand or technological obsolescence. Equalization
helps alleviate these shocks. Thus, a rich SNG may well want to contribute
to equalization, knowing that one day it may draw benefits from this
programme.
While these papers do not explicitly examine the link between resources
and needs equalization, it is clear that key dimensions of equalization have
not been agreed to among scholars. They can be summarized as follows:

●● The fiscal residual is with respect to individual taxpayers. Some

argue for replacing equalization by transfers to individuals. The
argument is that otherwise rich taxpayers in poor SNGs benefit from
both kinds of equalization.
●● Migration is not only by individuals but can also be carried out by
firms to benefit from tax competition/public subsidies. Thus, some
ask why resource equalization should allow SNGs to lower tax
burdens for firms. This may be appropriate if the tax burdens before
equalization were substantially higher in poor SNGs (to finance
adequate public services) leading to an inefficient use of immobile
resources.
●● Expenditure equalization often accounts for social costs and conges-
tion associated with urban areas. Reducing these costs through
expenditure equalization may lead to urbanization over an optimal
level. In these situations, corrective transfers should intervene within
the concerned territories and not through a nationwide equalization
policy.

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 The practice of fiscal equalization ­45

In the late 2000s, the pertinence of equalization was not so much

debated; it was accepted that ‘fiscal equalization transfers are conceptually
justified on grounds of fiscal efficiency and regional fiscal equity’ (Shah,
2008, p. 35). The discussion was on operational issues (OECD, 2007). It
is important to note that equalization in practice does not consider the
individuals as Buchanan did, but only the SNGs as jurisdictions and terri-
tories. Whereas revenue equalization had been largely accepted, most often
in the form of an RTS (Representative Tax System), the more debated
question is whether expenditure need equalization is worth doing. The first
practical (operational) issue is identifying the origin of fiscal disparities.
Whether equalization is desirable depends on the functions and revenue
sources devolved to SNGs, their population average size, geographical and
territorial diversity, urban/rural, mountain divide (Kim and Lotz, 2008).
Table 4.1 addresses these variables.

4.3 FISCAL DISPARITIES VERSUS DIFFERENCES

A typical textbook explanation of fiscal disparities is that ‘fiscal disparities

arise because the capacity to raise revenue to finance publicly provided
services relative to the amount needed to provide a standard package of
public services varies across jurisdictions’ (Ladd, 1999, p. 123). In this
definition, resources are balanced against a ‘standard package’ of local
public services. Thus, we can identify three possible origins of fiscal dis-
parities: the capacity to raise (tax) revenues, the expenditure needs, or the
net residual which is expressed as ‘needs minus capacity’. Still this remains
too vague to allow drawing the policy-relevant frontier line between ‘differ-
ences’ that result from local choices and ‘disparities’ which have exogenous
causes.
Yet the literature is not very abundant on this distinction; only a few
contributions to the political economy of equalization tackle this issue;2 we
do this in Table 4.1. It distinguishes three possible origins of fiscal dispari-
ties (A, B and C) outside the control of SNG authorities and two origins
of differences in the fiscal position of decentralized government units (D
and E). Items A and E relate to the revenue side; A concerns the potential
tax bases at the disposal of SNGs (something that can be approximated by
an RTS, as we shall argue later) and E corresponds to the tax arrangements
that are possible at the local level given the flexibility of the legal system of
taxation, notably between various forms of taxes and the mix of taxation
and user charges. Items B to D refer to local expenditure functions. Classes
B and C group the conditions of provision of local public services; only
class D is about local preferences in public service provision. Differences

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 46 Intergovernmental transfers in federations

Table 4.1 Possible origin of fiscal disparities/differences

A. Differences in the access to resources (Oakland, 1994). It takes two forms:

(i) differences in the income and wealth of community residents, or (ii)
differences in communal property and/or natural resource endowment. Also:
differences in SNGs’ taxable resources (Smart and Bird, 1996; Dafflon,
1995); tax bases (Gilbert, 1996); taxable resources per head (King, 1997);
economic position and opportunity (Dafflon and Vaillancourt, 2003);
territorial distribution of the unequal tax bases (Bird and Vaillancourt, 2007)
B. The amount of mandatory public goods that the SNGs must provide for
exogenous reasons (Gilbert, 1996); needs per head (King, 1997). Also: (i)
differences in the number of units of standardized service required per capita
owing to demographic reasons: age structure, different participation rates
in social programmes by persons of different ages (Bird and Vaillancourt,
2007), the socio-demographic composition of the population (Break, 1980;
Reschovsky, 2007); (ii) the fact that some populations are more costly to serve
than others (Oakland, 1994)
C. Cost differences due to input-output relationship (Break, 1980, cited in
Shah, 1996). Also: (i) cost differences per unit of mandatory public goods,
quantity and composition of input that is necessary for producing the public
service (Dafflon, 1995; King, 1997; Dafflon and Vaillancourt, 2003); (ii) cost
differences due to the natural conditions of service areas, for example, due
to climatic or geographic features, density, distance or other environmental
factors (Break, 1980) or (iii) differences in labour cost across regions (on
the basis of real private sector wages, Bird and Vaillancourt (2007)); (iv)
economies of scale in the service provision (Dafflon, 1995; Dafflon and
Vaillancourt, 2003)
D. Differences due to specific tastes of residents in the various SNGs or to
policy decisions at the local level (Break, 1980). Local preferences either for
optional services or for quantities or quality above the minimum standard
level in the provision of mandatory services (Dafflon, 1995; Gilbert, 1996;
Dafflon and Vaillancourt, 2003)
E. Local preferences among different forms of taxes and between taxation and
user charge (Inman and Rubinfeld, 1996)

Sources: Adapted from Dafflon (2007), Dafflon and Mischler (2008).

under D and E result from local preferences and hence they need not be
compensated by any kind of equalization or transfer payment.
Table 4.1 establishes the fundamental distinction between disparities and
differences. Disparities A, B and C are outside the influence and the policy
choices of SNGs and should be equalized. Differences D and E depend on
local own decisions and should not be compensated. Table 4.1 also identi-
fies the possible origins of disparities; these can be used as indicators in the

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 The practice of fiscal equalization ­47

needs equalization formula. If this rationale for equalization is accepted,

the next and immediate question is whether revenue and expenditure needs
equalization should be integrated into one or run in parallel fashion.
But is this economic approach readily accepted? How do politicians
deal with equalization issues? Will they worry about the distinction
between disparities and differences? Many times, these distinctions are
used by politicians to obtain support from their local voters. In Table
4.1 situations D and E would not be compensated through equalization
transfers. But in politics, politicians at all government tiers impress upon
policymakers the need to compensate for differences in SNGs preferences.
In practice political interference in equalization – or in domains related to
­equalization – is frequent. States are asked to compensate for differences
in local preferences; providing block grants to local bodies for meeting
service delivery deficits is in a loose sense supporting local preferences for
the provision of particular services. With respect to situation D above, one
might argue, for example, that the higher costs of a sprawled municipality
arise from policy choices to encourage, or at least not discourage, urban
sprawl. Equalization should not reward those municipalities that make no
effort to reduce sprawl and, as a result, have higher costs. Yet, Yilmaz et al.
(2012, p. 126) illustrate the conceptual difficulties to distinguish between
impossible economies of scale or reluctance to cooperate, and between
genuine cost disparities versus X-inefficiencies. From this perspective, any
policy of expenditure-based equalization is a tremendous challenge.
Also, since equalization is the operational design of interstate solidarity,
and solidarity is an ethical and social concept, the frontier between the
economic rationale for equalization and political strategy is more a grey
zone than a demarcation line. Thus, in the following sections we do not
assert what should be done, but the objective is to list in a sequential and
coherent way the practical issues which should be answered.

4.4 
FIRST- AND SECOND-GENERATION
EQUALIZATION

Equalization policies introduced in the 1970s or before (we call it ‘first-

generation equalization’ thereafter) either neglected expenditure needs or
when addressing both combined revenue and expenditure disabilities in one
measurement formula. Today experts (for example, see Koller et al., 2012)
recommend separate but parallel and coordinated treatment of these items.
Table 4.2 presents the two types of equalization, both in terms of
what they have in common and in terms of what distinguishes them.
This facilitates identifying the links between resources and expenditures

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 48 Intergovernmental transfers in federations

e­ qualization. Table 4.2 presents the situation of a constituent unit or a sub-

national government relative to other SNGs. For example, cell  (i)–(a)
(upper left corner) describes an SNG with resources per inhabitant higher
than average and also expenditures per inhabitant higher than average.
Two (strong) hypotheses can be presented in a simplified version of
Table 4.2. First, if one accepts that there is no disparity in the revenue
raising capacity of SNGs, columns (a) and (c) can be ignored. Thus, all
SNGs are supposed to benefit from the ‘average’ resources and the only
issue is the relative positions of SNGs in expenditure needs/costs equaliza-
tion (cells ,  or ). Second hypothesis: if one accepts that there is no
disparity in expenditure needs/costs between SNGs, then lines (i) and (iii)
can be ignored. All SNGs are supposed to have the same ‘average’ position
in expenditure needs/costs. Thus, only revenue equalization is necessary,
which correspond to cells ,  and .
Yet, we strongly suspect that these two hypotheses do not correctly
mirror the possible positions of SNGs. With different evolutions in taxa-
tion and decentralized functions, the practical economy of equalization is
nowadays faced with four additional situations: SNG units with: (i) high
tax potential and higher expenditure needs ; (ii) high tax potential low
needs ; (iii) low tax potential high needs ; and (iv) low tax potential
low needs . Equalization that concerns revenue sources only is half
the story and does not encompass the situations described above. And a
unique formula combining tax potential and expenditure needs cannot
answer the four situations. The complementarity of revenue equalization
and expenditure needs equalization must be taken into account. We call it
‘second-generation equalization’.
These four situations apply to regional-local equalization as well as to
federal-regional equalization: the argument that some SNGs have resources
above average but also needs and/or costs above average is also true in large
metropolitan areas. The logic and the key issues (Table 4.2) are the same,
but the implementation must be adapted to local circumstances (especially
the local characteristics and determinants of equalization – Table 4.3).
In first-generation equalization, we observe three situations:
(1a) Equalization does not account for differences in needs or costs: it
is assumed that needs or costs are identical (average level) for all SNGs.
In this case, the equalization of resources is horizontal, from  to  and
thus financed by SNGs for SNGs. One then focuses on potential resources
(line (ii)), with horizontal equalization taking some resources from SNGs
with potential resources (tax base) above average  to redistribute them to
SNGs with a resource potential below average . This could be done by
specific budget lines in SNG budgets or by a redistribution of SNG taxes
collected by the central government.

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 The practice of fiscal equalization ­49

Table 4.2 Foundations of equalization SNGs relative position

Equalization of → Resources (tax potential)

↓
Superior (a) Average (b) Weak (c)
Expenditures Strong (i)   
Needs/costs Average (ii)   
Weak (iii)   

Source: Authors.

A first alternative (1b) is vertical equalization of resources. In that

case, the central government finances equalization from its budget. The
practical question, that needs a political answer, is who are the SNGs that
benefit: those with resources potential below average  only or all SNGs
 – which dampens the impact of resources equalization? The central
equalization fund comes from federal revenues collected in all SNGs; thus,
considered together, economic agents who are federal tax payers and resid-
ing in SNGs with higher potential resources than average contribute more
than all economic agents residing in SNGs with below average potential.3
Thus with vertical equalization, there is de facto some horizontal equaliza-
tion between rich SNGs and poor SNGs. A second alternative (1c) could be
combining vertical and horizontal equalization; yet in this case, only SNGs
in situation  would benefit – one does not see SNGs in  contributing
to horizontal revenue equalization but benefiting from vertical transfers.
(2) In the case some SNGs have expenditure needs above average
(strong, line (i)), equalization formulas help reduce costs differences with
respect to a target cost or to account for excess needs compared to the
average of SNGs. Differences in resources are set aside or it is assumed
that SNGs’ resources are equal (average, column (b) of Table 4.2). Group
 SNGs benefit from expenditure equalization, while those in groups 
or  do not.
Expenditure needs/costs equalization can only be vertical to be efficient.
Horizontal equalization would mean that beneficiaries of services in a low-
cost (need) jurisdiction would accept a tax-price supplement (that is, more
expensive public services) in order to subsidize public services in other,
high-cost (need) SNGs. This would distort the local tax price of public
services and result in allocative inefficiency. This was noted by Yilmaz et
al. (2012): ‘First, for those public services that are financed through user
charges, if the “price” does not reflect benefit, consumers will face false
price signals.’ But they add that:

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 50 Intergovernmental transfers in federations

Second, when the difference between SNG choices, X-inefficiencies and

genuine disparities is not clear, SNGs might indulge in strategic behavior with
the aim of placing themselves in a more favorable equalizing position (in this
case, higher costs and more needs). Vertical needs equalization can be set on
expenditure standards that eliminate functions based on the benefit principle
for their financing and that ignore SNGs potential strategies, but this adds to
complexity.

(3) Some first-generation equalization formulas combine the two types of

equalization (Swiss cantons, 1959–2007, Yerly 2013). In that case the focus
is on cases  and .
Thus, first-generation equalization addressed  for resources, ignor-
ing needs and costs;  for expenditures, ignoring differences in revenue; or
 for combined formulas. Issues  are not relevant.
Second-generation equalization accounts separately yet simultaneously
for resources and expenditures. It recognizes the fact that it is more
common, particularly in urban areas, to have SNGs with resources above
average but also needs or costs (or both) above average. First-generation
equalization formulas do not take this situation into account.
When second-generation equalization includes both equalization
of resources and expenditures, this should be done according to our
judgement using different formulas, coherent and coordinated. Different
(unmixed) since the reference bases are not of the same type. For resources,
evaluating the potential relies on differences in comparable tax/revenue
bases with identical definitions yielding a monetary measure. The RTS
which dates back in its original form to the 1960s is an example of this
approach (Smart and Bird, 1996 for Canada; ACIR, 1962 as a proposal
not implemented for the USA).4 For expenditures, we use for calculations
differences in ‘needs’ yielding a relative measure of needs not expressed in
monetary values. For resources equalization, standardized tax rates are
used, while for expenditures equalization normative costs or needs are
used. Coherence of the two parts of a full equalization system results from
the fact that: (i) both equalizations use a base x indicator approach; (ii)
both use a representative system with potential values, not real ones; (iii)
when more than one tax is used for resource equalization and more than
one variable for expenditures equalization, weights are required in both
based on an analytical approach and not as a result of political bargain-
ing between governments. This is preferable to equalizing fiscal gaps, the
difference between expenditure needs and revenue raising capacity, since it
makes the process clearer.5
In the literature, Ahmad and Craig (1997) examine how to implement
both types of equalization without linking them. Yilmaz, Vaillancourt
and Dafflon (2012) combine three indicators of equalization to calculate

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 The practice of fiscal equalization ­51

full equalization. Expenditure equalization is divided into needs and cost

­differences. This is done to highlight analytically the difficulty of measur-
ing differences in costs.
In general, work linking the two types of equalization does not examine
the determinants of these two types of equalization and their interaction;
we do the latter in section 4.6 of this chapter. Dafflon (2012) presents
a synthesis of the linkages of these two kinds of equalization; the same
author (2007, 2015) shows that equalization of resources and expenditures
equalization (needs variables) can be simultaneous, are complementary
and can be formulated in a coherent fashion. The model put forward
by Dafflon avoids previous difficulties by not using as a measure of
needs service benchmarks; rather variables determining needs (proportion
of school-aged children into total population for schooling needs, for
example) are used, being transparent and statistically verifiable indicators,
avoiding central government interference in SNG decisions.

4.5 KEY ISSUES

We can now turn to the key issues associated with the design of an equali-
zation system. With the second-generation equalization, both revenue
equalization and expenditure equalization must be considered. Three
issues must be addressed: (i) measuring disparities A, B, and C in Table 4.1
in order to construct the appropriate synthetic indicators; (ii) the choice
of the equalization formulas that cover all relevant situations from Table
4.2; and (iii) the importance (amount) and origin of the funds allocated to
equalization. These three issues must be addressed in a parallel fashion.
They are summarized in Table 4.3.
Measurement issues are the domain of experts, while who receives
and how much is allocated are political choices. Thus, in step one, using
technical advice on the most relevant (from an economic perspective)
taxes and tasks the final choice of revenue (tax) sources and the selection
of tasks included in equalization should be left to politicians, after their
characteristics and specificities have been clarified by experts. In step two,
the construction of the formula should be left to experts, but the opera-
tional choice of the appropriate formulas after simulation remains with
politicians since their equalization effects vary from one formula to the
other. Also, in step three, the importance and the institutional anchoring
of the funds is political: it represents the status and extent of solidarity
between SNGs.

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 52 Intergovernmental transfers in federations

Table 4.3 Key issues of equalization

Issues/steps Resources Needs/costs

1. Measuring Measure of tax potential: Evaluation of needs and costs using
disparities norms:
What
●  revenue (tax) sources to ● What specific tasks (spending
include in the measure? items) are included?
What are the tax bases
●  ● What are the causal indicators
(normed, average?) and (explanatory variables) of
What reference rates (normed,
●  disparities? And can they form
average?) to be considered a ‘Representative Expenditure
for the ‘Representative Tax [needs/costs] System’ (RES)?
System’ (RTS)?
Should natural resources be
● 
included? If yes, how are they
measured (stock or flow)?
Construction of an indicator
●  Construction
●  of an indicator of
of tax potential for each relative needs/costs for each task
source used examined
Find appropriate weights to
●  How to calculate a synthetic
● 
calculate a global indicator indicator of expenditures
of RTS [needs/costs] RES? Find the
appropriate weights according to
the specific task included in the
evaluation
2. Choose an Vertical,
●  horizontal, mixed Must be vertical
● 
equalization
formula
If
●  vertical, selection of the Selection
●  of SNG receiving
SNG receiving transfers transfers: needs/costs above
● If horizontal, the average average?
delineates beneficiary and
contributing SNG
● Formula: proportional (linear) Formula
●  linear or progressive
or progressive
● Simulation of various Simulation
●  of various formulas
formulas
3. Determine the Possibilities are: Possibilities are:
envelope for ● % of one or more taxes %
●  of one or more taxes or
equalization? ● proportion related to revenue
equalization
In
●  the law ● In the law
In
●  the annual or pluriannual ● In the annual or pluriannual (3
(3 years? 5?) budget years? 5?) budget

Sources: Authors, drawing on Dafflon (2007, pp. 31 ss); Yilmaz et al. (2012, pp. 120–26).

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 The practice of fiscal equalization ­53

4.6 
ECONOMIC CHARACTERISTICS AND
DETERMINANTS OF EQUALIZATION OF
RESOURCES, NEEDS AND COSTS

This last section focuses on the interaction between the regional economic
characteristics and the determinants of equalization. A key point is that
SNGs with (tax) revenue capacity higher than average often will have
higher unit costs that they can self-finance6 – a situation that is ignored by
first-generation equalization.
As noted in Table 4.3, once equalizable disparities have been identified
the next step is the measurement of these disparities. One way of doing
this is to prepare a list of factors that can lead to differences in resources,
needs or unit costs between SNGs. This is done in Table 4.4, where we
examine one by one the impact of diverse characteristics; one by one since
some characteristics are mutually exclusive. Columns (a) and (b) present
how the relative position of SNGs with respect to each of 16 demographic,
economic, topographic and so on characteristics can have an impact on
its revenue base (column (c)), its needs for public services (d) and the unit
cost of those public services thus affected (e). Table 4.4 shows (combined
analysis of columns (a) and (e)) that the most common determinant of
higher unit costs is the cost of labour. Capitalization in the price of land of
regional (geographic) rents also plays a role.
The list of 16 elements in Table 4.4 was prepared by the authors draw-
ing on their past work in numerous countries and on their knowledge of
various transfer formulas.7 This list is fairly complete but most likely not
exhaustive since specific societal factors are present in every country. The
inferred impacts between the characteristics of SNGs and various equali-
zations result either from typical equalization formulas or from the use of
production and cost functions and supply and demand on input markets.
Thus, a higher labour productivity due to working in resource extractive
industries results in higher remuneration in the private labour market8 that
has a knock-on effect on the public labour market and thus public costs.
The exact impact depends on similarities and differences between the two
kinds of labour and substitution elasticities between labour and other
inputs in the production functions of private goods and services and of
publicly produced goods and services. Also, in general, a higher tax base
is linked to higher unit costs for a given SNG. This is a type  (Table 4.2)
situation that first-generation equalization ignores.

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 Table 4.4 Regional characteristics and determinants of equalization

YILMAZ_9781789900842_t.indd 54
Characteristics Relative position of SNGi Impact on fiscal Impact on needs per Impact on the unit cost of
varying between with respect to all SNGS potential per inhabitant inhabitant (d) public services (e)
SNGs (a) (b) (c)
Population:
1. Size and SNGi has a larger Economies of Higher demand for Reduction of the unit
density population than the agglomeration that can public services linked cost of services of a
average SNG increase productivity to density (police, fire public good type or with
and thus the tax base fighting, parking, green important scale economies
spaces)
2. Younger SNGi has a higher May reduce somewhat Needs are higher for Scale economies possible

54
population proportion of school-aged average earnings per school-related inputs (school infrastructure)
children in total population adult if some parents such as buildings
than in the average SNG withdraw temporarily and perhaps school
from labour force. Small transportation (depends
impact on population density)
3. Older SNGi has an older Variation in the tax Older population → Unit cost per user the same
population population than the base (pension rather higher specific needs for specific services (health)
average SNG than labour income), leisure, culture (651)
and in the tax treatment specialized care (801)
of income (age
exemption . . .); tax
base in SNGi perhaps
lower than average

16/12/2019 10:44
 4. Sicker SNGi has a sicker Illness can result in Sicker population Unit cost per user the same
population population than the average lower productivity and will require more and for specific services (health)
SNG due to past industrial thus lower earnings perhaps specialized
activity, endemic diseases healthcare

YILMAZ_9781789900842_t.indd 55
or heredity
5. Schooling SNGi has a better schooled Since labour Better schooled If schooling level is higher
level labour force than the productivity increases population → less crime, → private wages are higher,
average SNG with schooling, the better health, less needs increasing the unit cost
tax potential (labour for some services. of public services (higher
income) is higher in But higher demand for wages in SNGi → higher
SNGi than the average cultural services cost per hour of input)
SNG
6. Migrant SNGi has a larger Human capital of Specific integration Unit costs of general public
composition proportion of its migrant workers may services (civics, services may be higher if

55
population born abroad be less productive for education) may be additional time is required
than the average SNG part of their work required to provide contextual
life leading to lower information
earnings
7. Linguistic Typical SNG is No impact except if Specific services for Four linguistic groups
composition homogeneous while SNGi returns to language minorities (linguistic in SNGi reduce scale
has four language groups skills varies competencies for economies if all languages
(say 40–30–20–10%) some services such as used, increasing unit cost
education, health, justice)
Geography and territory:
8. Area SNGi larger than average None Needs for more roads, If population is distributed
SNG transportation systems uniformly per km² in each
SNG, then some public
services cost more in SNGi

16/12/2019 10:44
 Table 4.4 (continued)

Characteristics Relative position of SNGi Impact on fiscal Impact on needs per Impact on the unit cost of

YILMAZ_9781789900842_t.indd 56
varying between with respect to all SNGS potential per inhabitant inhabitant (d) public services (e)
SNGs (a) (b) (c)
9. Topography SNGi has a more rugged None More rugged terrain SNGi faces higher unit
terrain (hills, mountains) can create special costs than average for some
than the average SNG needs (twisting roads, public services (roads,
protection against tunnels)
avalanches)
10. Climate and/ SNGi is a nicer place to Land rent in SNGi Climate differences leads Services with land inputs
or natural live than the average SNG higher than in average to different needs: snow will be more expensive
attractivity (climate, beauty, water side, SNG removal/ protection

56
and so on) against tropical storm
11. Geographic SNGi has the sole/major Higher import/export Port and transport No impact on unit costs
position harbour of the country taxes do not impact infrastructures are except drop in transport
SNGi tax base but tax needed: centrally or SNG costs of imported inputs
potential higher due to provided? into public services due to
associated economic lower transport costs
activities (truck stops,
custom brokerages . . .)
Natural resources:
12. Quality of Soil in SNGi is more fertile Tax potential of Possible impact on Higher agricultural revenue
agricultural than in the average SNG farmers higher in SNGi sectoral government leads to capitalization in
soil interventions land prices; public services
with land input may cost
more

16/12/2019 10:44
 13. Non- SNGi has more petroleum Tax potential, direct May require more If natural resources

YILMAZ_9781789900842_t.indd 57
renewable or mining assets and indirect, is higher infrastructures, need for increase private sector
natural environmental protection productivity and thus
resources wages, this could increase
present unit cost
Economic context:
14. Historical SNGi has head offices, Higher tax potential No impact No impact on unit cost
economic research centres or except if special tax except if high demand for
advantage philanthropic foundations regime office space leads to higher
linked to past economic rents paid in public sector

57
activity
15. Regulatory SNGi benefits from Higher tax potential No impact Possible impact on labour
economic a national protection fiscal if regulation unit cost
advantage in specific economic creates monopolistic
sectors such as finance or rents
communications
16. Strength of Unions in SNGi are more Wages are higher, Possible impact on Higher unit cost if impact
unions powerful than elsewhere profits lower; uncertain demand for services for of private sector wages on
impact on tax base workers public wages
(business avoids SNGi)

Source: Authors.

16/12/2019 10:44
 58 Intergovernmental transfers in federations

4.7 CONCLUSION

This chapter contributes to the analysis of equalization by:

●● distinguishing in Table 4.1 public finance disparities that have to be

compensated through equalization because their origins fall outside
the SNGs’ choices, from differences that arise from own choices;
●● presenting in Table 4.2 the nine possible combinations of expendi-
ture needs and resources of SNGs’ interaction between possible
levels of resources and theoretical arguments for equalization;
●● listing in three steps in Table 4.3 the key issues associated with the
design of an equalization system, parallel and coherent for reducing
(tax) revenue and expenditure needs disparities;
●● examining in Table 4.4 plausible relationships between 16 demo-
graphic, geographic (including natural resources) and economic
characteristics of SNGs, on the one side, and resources, needs and
cost elements of equalization, on the other side. Additional charac-
teristics not addressed by the authors should be analysed in similar
form.

The theoretical literature shows that it is not as easy to equalize expendi-

tures as it is to equalize revenues (Reschovsky, 2007; Yilmaz et al., 2012).
The difficulties come from: (i) identifying the functions that would be
selected for equalization; (ii) distinguishing expenditures that result from
the standards set by the federal government that oblige SNGs from expen-
ditures resulting from their own choices; and (iii) solving the problem of
measuring needs or unit costs precisely. We also demonstrate the necessity
of running simultaneously and in a coherent way revenue and expenditure
needs equalizations when there is a strong relation between higher tax
potential and higher expenditure needs or unit costs of public services.
Finally, how the politicians deal with equalization issues needs to be
explored in greater detail; they are unlikely to care much about the distinc-
tion between disparities and differences. Good political inputs are needed
for good equalization but good politics leading to re-election may conflict
with this; thus, good equalization is an elusive concept, but it remains
worth striving for.

NOTES

* Thanks to Guy Gilbert, Andrew Reschovsky, Enid Slack, Serdar Yilmaz and Farah Zahir
for their comments and suggestions on an earlier version of this chapter.

YILMAZ_9781789900842_t.indd 58 16/12/2019 10:44

 The practice of fiscal equalization ­59

1. Dafflon and Vaillancourt (2003) were among the first economists to give a formal presen-
tation of equalization setting out the issues for operational purposes. This approach was
updated and further developed in Yilmaz et al. (2012). For a more complete presentation
on the equalization issues and a survey of the existing literature, see Dafflon (2007, 2012);
Dafflon and Mischler (2008).
2. For example, in The Oxford Handbook of State and Local Government Finance (Ebel
and Petersen, 2012), only 12 pages (Yilmaz, Vaillancourt, Dafflon) out of 982 pages
are devoted to the equalization issue. First contributions on the origin of disparities
and differences in SNGs’ public finance in an equalization perspective are noted in
Table 4.1.
3. Residents with the same high income pay the same federal income tax in rich or poor
SNGs. But since it is likely that more residents with high income live in rich SNGs (A in
Table 4.1), rich SNGs contribute more to the federal financing of equalization through
the federal current budget. Thus, vertical revenue equalization indirectly includes hori-
zontal effects.
4. In these two papers, the SNGs’ per capita entitlement in a revenue category is equal to
its per capita tax base deficiency in the category, relative to a per capita standard for
the category, multiplied by the calculated national average tax rate for the category.
Yet, according to Bahl (1972, footnote 2) ‘The term RTS in no way connotes any model
system selected on purely normative ground. The adjective “representative” is used here
instead of “average” only because of tradition’. In the normative model, the assessment
of the tax bases is identical for all SNGs, whereas the tax rates considered are not
calculated on the average SNGs’ tax effort but based on an identical tax rate schedule. In
a piggyback tax system for SNGs, the reference for measuring the tax disparities in the
individual SNG would be the per capita tax base standard and the tax rate schedule fixed
in the law, fully – 100 per cent – considered).
5. For more on this concept see Chernick and Reschovsky (2015).
6. Calculations by the authors for Canadian provinces using revenue capacity from
Courchene (2013, T1) and a cost index by Gusen (2012) show a 0.86 positive correlation.
Similarly, there is a 0.94 correlation between revenue capacity and wage indicators of
Australian States, using data from the Commonwealth Grants Commission (2015 –
Main Report Table 2, p. 5 for revenue capacity and Figure 6, p. 92 for wage costs). For
Switzerland, the correlation coefficients present the right sign, but are not significant
(chapter on Switzerland in this volume).
7. A tentative list is given in Bird and Vaillancourt (2007). For a detailed technical description
of certain variables in Table 4.4, see Dafflon and Mischler (2008) and Dafflon (2012). For
a practical detailed exposé of the three-steps method described in Table 4.3 and its compo-
nents in Table 4.4, see www.fr.ch/Scom/sommaire/perequation-financière-intercommunale.
8. Higher wages in extractive industries may reflect in part the risk of workplace accidents;
this is not accounted for in equalization calculations.

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 PART II

Intergovernmental Transfers in Mature

Federations

YILMAZ_9781789900842_t.indd 63 16/12/2019 10:44

 5. 
The German model of addressing
vertical and horizontal fiscal
imbalances
Paul B. Spahn

5.1 
INSTITUTIONAL SETUP OF THE MODERN
GERMAN FEDERATION

Today’s Germany consists of 16 states (Länder) with their own constitu-

tions, which are entrenched in the federation as sovereign entities. Local
governments enjoy budget autonomy, but are subject to policy constraints
determined by their respective state. As a concession to German history
there are three city-states, Hamburg and Bremen – the ‘Hanse cities’ – and
Berlin, which introduces minor asymmetries into intergovernmental fiscal
relations since these states execute local government function as well.
In order to achieve similar or equivalent living conditions and homoge-
neity of policies, there must be uniform – typically centralized1 – guiding
principles for the whole nation. This by itself introduces a new type of
asymmetry at the vertical level.
While other federations such as the United States or Canada accept
concurring sovereignties at various levels, with full taxing and expenditure
powers for each tier, the German model of federalism can be characterized
as asymmetrical power-sharing among tiers of government. In this differ-
ent paradigm, the federation (apart from its exclusive competencies such as
foreign affairs and defence) sets out a general framework for policymaking
for all Länder (and eventually municipalities), while the latter implement
and administer such policies within the general framework. The historic
roots of this form of power-sharing can also be found in the German
Reich where the states (and municipalities) had already had a long tradi-
tion of public administration that the centre could build upon, while the
Reich itself had no comparable infrastructure on its own (excepting the
structures for its newly acquired exclusive responsibilities such as defence).
The vertical sharing of powers is as follows:

64

YILMAZ_9781789900842_t.indd 64 16/12/2019 10:44

 The German model of addressing fiscal imbalances ­65

●● The federation exercises

 – Exclusive powers conferred to the federation by constitution
(e.g. defence, foreign policy, citizenship);
 – Concurrent powers, where both federal and state governments
may act or intervene, but the federal rule overrides the states if
in conflict (e.g. civil law, labour legislation, public welfare).
●● The sovereign states control
 – All residual powers (e.g. education, culture, police, hospitals).

As a rule, legislation is typically centralized in Germany (federal) where

the states, as said, inject their voice conjointly through the vote by the
state house (Bundesrat). However, the administration or implementation
of laws and their enforcement as well as public service delivery are almost
entirely decentralized. Formerly the federation had the power to legislate
an incomplete ‘framework’, which the states had to complete by state
legislation. This led to conflicts because the federal power to legislate was
not well determined. Framework legislation was hence abolished in 2006.2
Homogeneity of policies is also fostered at the national level through
the voting mechanism for the national parliament (Bundestag), which fol-
lows the model of proportional representation while excluding all parties
that fall below 5 per cent of the vote. This provision tends to neutralize
extremist and factional parties, which had once played a key role in ruining
the Weimar democracy. This mechanism represents another example of
asymmetric institutions designed to foster homogeneity and ultimately
symmetry of outcomes at the national level.
Although the political landscape has varied quite considerably during
the history of the Federal Republic of Germany – with new entrants
in parliament such as the greens, the former communists, and, more
recently, a nationalistic party – the political system and its institutions
are relatively robust, relying heavily on consensus-forming according to
the preferences of the median-voter. He or she will ultimately determine
the pace of politics at the national level, and the states and municipalities
are being compelled to implement and administer such policies within a
common national framework. Collective decision-making in the Bundesrat
is another mechanism to form consensus.
The limited policy discretion at lower tiers of government, and the
‘emptiness of the agenda’ of state parliaments combined with the inability
of states to use own tax instruments, is exacerbated by a host of intergov-
ernmental transfers that are all destined to foster national homogeneity
and similarity of living conditions. It begins with the formula apportion-
ment of the jointly appropriated value added tax (VAT) onto regions
(mainly population based and highly equalizing); it proceeds through

YILMAZ_9781789900842_t.indd 65 16/12/2019 10:44

 66 Intergovernmental transfers in federations

the h
­ orizontal redistribution of resources among states according to the
Equalization Law (Finanzausgleich); and is completed through a number
of asymmetrical vertical grants by the federal government in favour of
some ‘needy states’ however defined. This interregional solidarity is
pushed to a point where the average command of public resources per
capita is now very close to the national average per capita.3

5.2 
THE MAIN TRAITS OF THE GERMAN
FINANCIAL ARRANGEMENTS

Intergovernmental revenue allocation follows four steps in Germany:

●● First, the Constitution assigns own resources, including shared

revenues, to each layer of government (revenue allocation).
●● Second, the VAT shares are gauged in a way to align aggregate
revenue with aggregate expenditures for each layer of government
(vertical fiscal balance).
●● Third, the allocation of resources to states aims at achieving horizon-
tal fiscal balance. In this regard there are two distinctive mechanisms:
a)  The aggregate VAT share is distributed predominantly on the
basis of population, which is implicitly equalizing (equalization
effects of VAT); and then
b)  State revenues are reallocated among jurisdictions in line
with their fiscal capacities (explicit horizontal equalization, or
Finanzausgleich in a narrow sense).
●● Fourth, the federation completes horizontal equalization by supply-
ing supplementary funds to selected states according to legislation
(asymmetrical vertical compensations).

5.2.1 Revenue Allocation

It is consistent with the nature of German fiscal federal arrangements that

taxes are not only uniform but also shared. This is true for all major taxes
representing about three-quarters of total revenue (including the main
municipal tax, the Gewerbesteuer).
The sharing of tax revenues is illustrated in Figure 5.1. Revenue from
exclusive state taxes is only three per cent of the total; municipalities collect
local taxes that represent about nine per cent of all taxes. The majority
of all taxes is collected conjointly as shared taxes that ought to be passed
on through redistributive mechanisms. This leads not only to a jumble of
political responsibilities; it also tapers financial autonomy through the

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YILMAZ_9781789900842_t.indd 67
Local taxes
9% Income taxes Corporate tax
39% 4%
State taxes
3%
Shared taxes
74%

67
Federal taxes
13%
VAT
31%
Share of EU
1%

Source: Author’s calculation from the Federal Ministry of Finance.

Figure 5.1 The structure of assigned and shared taxes in Germany, 2017

16/12/2019 10:44
 68 Intergovernmental transfers in federations

packaging of tax policy and a mix-up of joint financing schemes. These

limitations at the fiscal edge are now widely considered to narrow state
sovereignties in particular. They tend to blur political accountability and
restrain the principle of subsidiarity.

5.2.2 Vertical Fiscal Balance

5.2.2.1 Gauging the VAT share

The federal and Länder shares of corporate tax and income tax are
invariably laid down in the Constitution (the Grundgesetz – GG). The
vertical sharing of key taxes in Germany is depicted in Table 5.1. Half of
the revenue from income taxes is allocated to both the federation and the
states – with municipalities participating in the share of personal income
taxes. This rule is technically simple, even as to their horizontal apportion-
ment, which follows the derivation principle,4 except for the wage tax that
is allocated according to the residence of the taxpayer.
However, the allocation of VAT can, and will, be flexibly adapted to
vertical fiscal imbalances between the federal government, the Länder and
the municipalities. Hence VAT sharing plays the decisive role in establish-
ing vertical fiscal balance. It aims at correcting differences in financial
strength (without, however, fully offsetting them); at supporting financial
self-responsibility of the states; and at securing ‘fairness’ among the
federation and its constituent states. Indeed, the states’ shares have moved
considerably, notably increasing after unification. This reflects the need to
reach consensus with the old states on the incorporation of the new states
into the intergovernmental fiscal machinery. A compromise was found
only at the expense of the federal share in VAT.5
The vertical equalization among the federation and the states through
VAT sharing is based on article 106, sections 3–9 of the Constitution, and
a federal law requiring the consent of the Bundesrat governs the allocation

Table 5.1 The vertical distribution of shared taxes, 2017

Income tax Corporate tax VAT

Federation 42.5% 50% ≈ 49.7%
States 42.5% 50% ≈ 48.3%
Local governments 15.0% – ≈ 2.2%

Allocation criteria: Derivation ¾ population

¼ ‘frail’ states

Sources: Constitution, and Ministry of Finance.

YILMAZ_9781789900842_t.indd 68 16/12/2019 10:44

 The German model of addressing fiscal imbalances ­69

of its proceeds. The Constitution presumes that it is possible to define ‘nec-

essary expenditures’ at both levels – state and federal governments – and
to achieve a ‘fair compensation’ (billiger Ausgleich) between them (article
106, section 3). Technically, this is approximated by calculating ‘coverage
ratios’ (Deckungsquoten), which represent the arithmetical ratio of income
(excluding income from loans) to expenditure (excluding expenses for
repayments) for each level of government in the aggregate. The coverage
ratios are then used to determine resulting gaps and hence the aggregate
claims on VAT between tiers of government.
According to the objectives of the Constitution, and to the way VAT is
calculated to cover potential vertical gaps in financing, there is no ‘vertical
fiscal imbalance’ in Germany as exists in other federations with exclusive
tax assignments (such as Australia or Canada). This may be considered
an advantage, although the political and technical implementation of this
constitutional rule is fraught with problems and always subject to dispute.

5.2.2.2 Equalizing effects of VAT

It is important to note that the derivation and residency principles for
allocating taxes to lower-tier governments play up economic imbalances
that may exist among them. This is true in particular for personal and cor-
porate income taxes in Germany. However, the VAT share is not allocated
according to derivation, but predominantly by the number of inhabitants.
In addition, states with below-average tax revenues receive so-called sup-
plementary VAT shares. These allocation rules mitigate the differences of
fiscal capacity among regions. Although this can be considered a first step
towards horizontal equalization, this interpretation is officially rejected
in Germany since the VAT share constitutes ‘own revenue’ of the states;
it is not considered a vertical federal grant with equalizing effects (as in
Australia, for instance).
As to the horizontal allocation of VAT, three-quarters of VAT is appor-
tioned to the states according to population in a first instance. The other
quarter is reserved for those states that are considered ‘financially frail’.
They receive supplementary transfers from VAT in order to bring their
fiscal potential up to at least 92 per cent of the average of total state taxes
per capita.6
The implicit redistribution effects of VAT sharing are often underesti-
mated. When considering only the new states of the East (without Berlin),
their initial tax potential was only 8.9 per cent of the national average,
but reached a level of 13.3 per cent of the national average including VAT
revenues in 2016. It implies that Eastern states acquire roughly 60 per cent
more VAT per capita than their Western counterparts.
The equalizing effects of the VAT sharing process are indeed extensive.

YILMAZ_9781789900842_t.indd 69 16/12/2019 10:44

 70 Intergovernmental transfers in federations

They reduce the (unweighted) standard deviation for own state revenues
per capita of 28.5 per cent before VAT to 7.2 per cent after VAT. Although
the population-based allocation of VAT has significant levelling effects,
this is officially not considered part of the Finanzausgleich in Germany
since the VAT shares represent own state revenue in a legal sense.

5.2.3 Horizontal Fiscal Balance

5.2.3.1 Equalization ‘philosophies’

Whatever approach is taken to establish horizontal fiscal balance in a
nation, there must be clear procedures and firm criteria that govern equali-
zation. At the international level, interregional equalization schemes have
adopted varying philosophies.

●● In the United States, for instance, an explicit regional redistribution

programme is nonexistent, but there are implicit redistribution
effects resulting, for instance, from the workings of a progressive
national income tax. Also, there are regional asymmetries entrenched
in the multitude of federal programmes entailing either transfers to
persons, or specific-purpose or block grants to regional jurisdictions.
However, the regional pattern of redistribution will fluctuate in
accordance to variations in the local ‘take-up’ rate of such grants, in
particular for cost-sharing programmes.
●● At the other extreme, Australia has put in place an explicit and
ambitious equalization scheme that underpins the distribution of
goods and services tax (GST) revenue to the states and territories.
In establishing a point of reference for such a scheme, Australia does
not only attempt to evaluate detailed standardized taxing powers of
her states, but also standardized expenditures adjusted for needs and
costs differentials among jurisdictions.
●● In Germany (like in Canada) the focus of equalization is on taxable
capacity only, with little or no concern for specific burdens. As the
tax law is uniform throughout Germany (except for some limited dis-
cretion of municipalities to vary their tax rates), there is no need to
standardize taxable capacity among regions (as in Canada), because
effective tax collections can be considered to reflect the regional
variations of tax potentials.7

5.2.3.2 Explicit horizontal equalization (Finanzausgleich)

In addition to the implicit redistribution effects of joint taxes, in particular
of VAT, there is an explicit regional equalization programme that is ­working
horizontally among states in a ‘brotherly fashion’ (Finanzausgleich, or

YILMAZ_9781789900842_t.indd 70 16/12/2019 10:44

 The German model of addressing fiscal imbalances ­71

equalization proper). Indeed, this scheme leads to a horizontal redistribu-

tion of resources among the states without federal interference (except for
legislation and administration). It is the logical consequence for a situation
where there is no vertical fiscal imbalance. Where such imbalances do
exist – as in Australia in favour of the Commonwealth, or in the European
Union (EU) in favour of the member states – regional equalization schemes
would typically be implemented in the form of vertically asymmetrical per
capita grants (downwards in Australia, upwards in the EU). In the absence
of vertical imbalance, however, regional equalization must be arranged
horizontally among the participating states. Germany is distinctive in
having created such a system among states,8 which is, of course, based on
a federal law governing the mechanics of the scheme with uniform rules.
The definition of differentials in tax capacities requires a benchmark. It
is found in a standardized ‘equalization yardstick’ (Ausgleichsmesszahl) for
state fiscal potentials, which is roughly the average tax revenue per capita,
including VAT, multiplied by the population for each state. The procedure
is, however, more complex. In particular it comprises an asymmetric bias
in favour of city-states, whose populations are weighted by a factor of 1.35
(compared to 1.0 for the other states), and other special provisions.9
The equalization yardstick is compared with the effective financial
situation of each state, and the gap is subsequently equalized according to
a formula. States below the average (ausgleichsberechtigte Länder) receive
a compensation that is to be financed, in progressive steps, by the states
above the average (ausgleichspflichtige Länder). The sum of payments
received always equals the sum of disbursements; the scheme is thus a
complete clearing mechanism. In the interest of the fiscal autonomy and
sovereignty of the states, the differences in state fiscal capacities are only
partially increased or reduced by financial equalization.
The size of the compensation payments to fiscally weaker states depends
on the amount by which their financial capacity per (fictitious) inhabit-
ant falls below the average financial capacity per inhabitant. A linear-
progressive compensation schedule is used to calculate by how much the
difference from the average is partially topped-up. Similarly, the size of the
adjustment amounts that fiscally stronger states have to pay depends on
the amount by which their per capita financial capacity exceeds the average
fiscal capacity per inhabitant. The difference from the average is skimmed
off partially using a progressive ‘tariff’ (Ausgleichstarif).10

5.2.3.3 Asymmetrical vertical compensations

In a final step, there is a corrective of the distribution of public resources
in the form of asymmetrical vertical grants by the federal government:
so-called supplementary federal grants (Bundesergänzungszuweisungen).
­

YILMAZ_9781789900842_t.indd 71 16/12/2019 10:44

 72 Intergovernmental transfers in federations

They exhibit both vertical and horizontal equalization effects. Such

transfers according to article 107(2) of the GG have been widely used after
unification, while they were almost insignificant before. They were also
decisive in establishing consensus among the various jurisdictions with the
aim of compensating the formerly socialist Eastern states.
Two types of federal supplementary grants are to be distinguished: (i)
general federal supplementary grants to cover the general financial require-
ments of all underperforming states in the amount of 77.5 per cent of the
deficits remaining after the implementation of the Länder fiscal equaliza-
tion system (at 99.5 per cent of the equalization yardstick). All states
receive this type of gap-filling grant to varying degrees. (ii) Moreover,
10 states out of 16 receive ‘special-needs’ federal grants to relieve them
of the costs of ‘political management’ (politische Führung), and the new
Eastern states as well as some Western counterparts receive federal grants
in compensation of ‘special burdens’, for example, higher unemployment.
The federal grants have met criticism not only by economists, who
tend to stress the inefficiencies of ‘softening’ budget constraints, but
also by politicians and lawyers – and specifically the Constitutional
Court – who stress the excessive redistribution effects of this type of
grant. The Constitution had reserved such forms of asymmetrical vertical
­intervention by the federal government for exceptional circumstances (such
as unification, for instance); there was no intention to use them as regular
instruments for ‘filling gaps’ in the budgets of a majority of states.

5.2.3.4 Comprehensive allocation and distribution effects

The importance by volume of each of the three steps of horizontal equali-
zation is shown in Table 5.2.
If the equalizing effects of the various steps of resource allocation and
distribution are combined, measured in terms of deviations from their
averages in per cent, the picture in Figure 5.2 is obtained.

Table 5.2 Volume of redistributed resources, 2016

VAT Finanzausgleich Federal supplementary

(only supplement payments) equalization ‘proper’ grants
In billions of euros
15.3 10.6 9.9
In per cent of total fiscal capacity
4.6% 3.2% 3.0%

Source: Bundesministerium der Finanzen (2017).

YILMAZ_9781789900842_t.indd 72 16/12/2019 10:44

 6.5
BY
17.6
HE 5.9
15.7
BW 4.3
10.5

YILMAZ_9781789900842_t.indd 73
HH 0.5
0.9
–0.8
NW
–3.4
–0.8
SH –4
–0.8
NI –4.2
–0.9
RP
–4.5
–1.2
SL

STATES
–8.3
–1.2
ST –9.7
–1.2
BB

73
–9.8
–1.4
SN –11.4
–1.4
TH –11.7
–1.4
MV –12.5
After federal grants
–2.3 After fiscal equalization
HB –26.8
–2.5 Before fiscal equalization
BE –30.7
–40 –30 –20 –10 0 10 20 30
DEVIATION FROM AVERAGE IN PER CENT

Sources: Federal Ministry of Finance (2017); own representation.

Figure 5.2 Horizontal distribution effects of VAT allocations, of fiscal equalization and of federal supplementary grants
in 2017

16/12/2019 10:44
 74 Intergovernmental transfers in federations

The figure shows that the equalization fund is ‘sponsored’ by three larger
Southern states (Bavaria, Baden-Württemberg and Hessen) and the city-state
of Hamburg. All other states benefit from the scheme at varying degrees.

5.2.4 Solidarity versus Efficiency

While interjurisdictional solidarity through equalization facilitates con-

sensus within an intergovernmental framework, and has achieved a high
degree of homogeneity in policy outcomes, this is not without political
and economic costs. The redistributive process among states and among
the federation and lower tiers of government breaks the link that should
exist between expenditure decisions and their financing. This reduces the
accountability of policymakers, and diminishes the influence citizen-voters
can exert on politicians. Moreover, the German states lose any interest
in developing their own tax bases, for instance through more effective
tax administration or better economic policies. In a formal sense, inter-
regional solidarity tends to reduce the financial autonomy of states even
further – which is severely curtailed by the Constitution anyway. This
jeopardizes the independence of their budgeting, and hence of policies.
Moreover, equalization arrangements that put high penalties on any excess
fiscal capacity relative to the national average tend to encourage inefficient
budget behaviour, especially if combined with federal grants that e­ ffectively
bail out non-performing governments.
The analysis of the implicit marginal burden inherent in the combined
system of interstate equalization poses the question, how much of a ficti-
tious increment of own revenues of a state will ultimately remain at the
disposition of that state? Conversely, what would the implicit marginal
burden on incremental own revenue be? If a state is guaranteed a mini-
mum, and if that state’s resources fall below that minimum, any increment
of own resources is virtually ‘taxed’ or diverted through the system of
equalization. This explains the lack of interest of such states in developing
their own tax base.
Figure 5.3 indicates the high degree of implicit marginal burdens on own
taxes inherent in the German system of intergovernmental finance. It depicts
‘marginal retention rates’ for selected taxes, that is, it shows what a state will
keep from any amount of additional tax collected in its jurisdiction.
If, for instance, a state makes an explicit effort to increase its tax revenue,
say, of the corporate tax through better tax administration, most of it will
be lost through redistribution among states. Hamburg is in the privileged
position to keep at least 26.6 per cent of the additional corporate tax
­collected, a maximum. Neighbouring Bremen retains only 0.7 per cent.
For wage taxes, the marginal retention rates vary between about 33 and 7

YILMAZ_9781789900842_t.indd 74 16/12/2019 10:44

 70.0%
HAMBURG 26.2%
32.8%
63.5%
BAYERN 20.0%
26.6%
62.2%
BADEN-WÜRTEMBERG 19.1%
25.6%

YILMAZ_9781789900842_t.indd 75
59.0%
HESSEN 17.1%
23.4%
54.5%
NORDRHEIN-WESTFALEN 11.5%
17.7%
48.1%
NIEDERSACHSEN 4.9%
11.4%
44.7%
RHEINLAND-PFALZ 2.7%
8.9%
44.1% Property tax
SCHLESWIG-HOLSTEIN 2.0%
8.3%
42.9%
Corporate tax
BERLIN 3.0%
8.9% Wage tax
42.8%
SACHSEN 2.8%
8.7%

75
42.0%
BRANDEBURG 1.6%
7.7%
41.7%
THÜRINGEN 1.5%
7.6%
41.7%
SACHSEN-ANHALT 1.5%
7.6%
41.1%
MECKLENBURG-VORPOMMERN 0.3%
7.3%
41.0%
SAARLAND 0.8%
6.8%
40.2%
BREMEN 0.7%
6.6%

0.0% 10.% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0%

Sources: Wissenschaftlicher Beirat (2015); own calculations and representation.

Figure 5.3 Marginal retention rates in per cent for selected taxes collected by a state

16/12/2019 10:44
 76 Intergovernmental transfers in federations

per cent. Of course, there is little incentive to increase tax collections under
these circumstances.
The marginal retention rates are highest for the local property tax, but
even this tax, which is acclaimed to be an ideal local tax because of its
immobile tax base and hence full local incidence, exhibits severe ‘leakages’
in Germany. From additional property tax, municipalities retain only
between 70 and 40 per cent according to the state they are in. The rest is
‘taxed’ through equalization.
A further aspect of the system is related to potential moral hazard by
state authorities. A transfer system that takes actual revenue and expendi-
tures into account, such as the federal supplementary grants, favours irre-
sponsible budget behaviour. Subnational governments are almost invited
to carry budget deficits, since they can expect, through the principle of
intergovernmental solidarity, to receive compensating grants to a large
degree. Hence, a state can spend more than corresponds to its original
fiscal capacity, knowing, or confiding in, that the community of states or
the federal government will ultimately bail it out. Although it is difficult to
prove such behaviour in practice, it is true that the Finanzausgleich and the
federal grants soften any hard budget constraint that may exist at the state
level. This entails economic inefficiencies and waste of public resources.

5.3 THE REFORM 2020

The financial constitution of Germany did not remain without challenge.

In particular two of the larger contributors to the scheme, Bavaria and
Hesse, have asked for a verdict of the Constitutional Court on the arrange-
ments in 2013. Since a new scheme was to be introduced in 2020 anyway,
there was a broad discussion that produced a number of reform proposals,
inter alia from the Scientific Council at the Federal Minister of Finance.11
The Council called for greater transparency of intergovernmental
finance, for mitigating disincentives in revenue policy through higher reten-
tion rates, and the inclusion of all local taxes conjointly with a reduction
of the progressivity of the compensation tariff for Finanzausgleich. Since
the reform of the federal fiscal equalization system is made more difficult
by the limited ability of the states to generate their own revenues, a reform
was also expected to ensure greater revenue autonomy. To strengthen tax
autonomy, the Council proposed in particular a limited surcharge on
income tax or property tax.
The reform, decided in June 2017, brought some marginal changes
­avoiding more comprehensive systemic changes to the system. From 2020
on,

YILMAZ_9781789900842_t.indd 76 16/12/2019 10:44

 The German model of addressing fiscal imbalances ­77

●● The VAT allocation mechanism will be consolidated and simplified.

●● The compensation tariff will be fixed at a uniform 63 per cent of the
deficits or surpluses relative to average national financial capacity.
●● The share of municipal taxes to be incorporated is raised from 64 to
75 per cent.
●● The tariff of the general federal supplementary grants is raised in
favour of financially weak states.
●● The scope of special-needs federal supplementary grants is extended,
and partly increased.

So, the reform 2020 of the German financial constitution does not touch
upon the fundamentals of the system, but simplifies (VAT allocations),
extends (higher share of municipal taxes; federal supplementary grants)
and also reduces the scale of progressivity. Like after unification, agree-
ment among the states was once again reached by the federal government
tossing in additional own resources. However, the federal government also
acquired more constitutional powers than before.
The Constitution stipulates the ‘creation of equivalent living condi-
tions’ in Germany, and a comparable performance of tasks in the case
of different economic conditions among states. This is to be achieved by
vertical and horizontal equalization as discussed. However, the new rules
from 2020 onwards are unlikely to noticeably counteract the increas-
ing inequality in the distribution of general funds and total available
revenues.

The new financial equalization system also falls short in terms of transparency.
Many special regulations and new interdependencies between the Federal
Government and the Länder are creating new systemic dependencies. And it
can be assumed that the federal government will let its more powerful position
vis-à-vis the Länder be felt.12

Finally, it is unlikely that the setup of the German financial constitution

will change dramatically given that the majority of states, which exert
strong legislative voting powers through the second chamber of parlia-
ment, are still at the receiving end of the scheme.

5.4 LOCAL FINANCES

5.4.1 Municipal Own Revenue

German local governments possess an autonomous status under federal

and state legislation. This status is guaranteed by the Constitution (art.

YILMAZ_9781789900842_t.indd 77 16/12/2019 10:44

 78 Intergovernmental transfers in federations

28, s 2): ‘The municipalities must be guaranteed the right to regulate

all affairs of the local community under their own responsibility within
the framework of the law. . . . The guarantee of self-administration also
includes the principles of financial self-responsibility . . .’. The municipali-
ties are responsible for all tasks rooted in the local community (principle
of universality).
As to their own resources, municipalities control the property tax, the
trade tax (Ge­werbesteuer, a tax on business profits) and local excise duties
and expense taxes. The structure of local revenues in Germany is depicted
in Figure 5.4.
While own resources of municipalities constitute a significant part of
their aggregate revenue, their grants dependency remains relatively high
on average (40 per cent of total revenue). In addition to grants, municipal
finances benefit from the direct sharing of state taxes such as the personal
income tax (15 per cent of total tax), the capital yields tax (12 per cent) and
the VAT (2.2 per cent), and the obligatory indirect sharing of Länder rev-
enues from income tax, corporate tax and turnover tax in accordance with
the respective state legislation. Conversely, the municipalities must share
the trade tax with their state and the federation in a standardized form
using a complex algorithm and differentiated parameters. Of course, there
are large discrepancies in local revenue among states and, within states,
among municipalities. One important political indicator for Germany is
the relative fiscal capacity between Western and Eastern states, which was
roughly 100:78 per capita in 2016.
A large part of municipal taxes is derived from the property and trade
taxes, where local revenue autonomy is expressed through optional munici-
pal tax rate setting (on a nationally standardized tax base to be assessed
by their respective state). Obviously, there is a large variation of tax rates
among German municipalities (see Table 5.3).
Of course, differences in local tax rates entail horizontal tax competition
among jurisdictions, except for the property tax where the tax base is
immobile. In particular, differences in trade tax rates may have a significant
impact on locational decisions of firms. If an enterprise has permanent
establishments in several municipalities, or if the permanent establishment
extends over the territory of several municipalities, the tax assessment
amount is distributed to an individual municipality on the basis of payroll.
As discussed before, a certain portion of the (standardized13) trade tax
is shared with the federal and state governments. This, together with the
inclusion of municipal taxes in the interstate equalization formula, leads
to a significant ‘confiscation’ of own resources through redistribution even
for classical local taxes such as the property tax (see Figure 5.4). So, the
German local tax system is far from being neutral as to the allocation of

YILMAZ_9781789900842_t.indd 78 16/12/2019 10:44

YILMAZ_9781789900842_t.indd 79
Income tax share
14%
Federal/state grants
40%

Taxes
38% Trade tax
12% VAT share
2%

79
Local excises
Fees
and expense taxes
8%
5%
Property tax
5%

Other revenue
14%

Sources: Deutscher Städtetag (2017); own calculations and representation.

Figure 5.4 The structure of German municipal revenues, 2017

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 80 Intergovernmental transfers in federations

Table 5.3 
The variation of tax rates (Hebesätze) among German
municipalities*

Property tax A Property tax B Trade tax

Lowest 100% 100% 200%
Highest 690% 700% 900%
Average 343% 377% 369%
Coefficient of variation 6.7% 7.5% 5.9%

Note: * Excepting outliers. The tax rate is uniform and incorporated in the taxable base.
The Hebesatz (leverage ratio) allows the increase of that rate implicitly.

Sources: Statistische Ämter des Bundes und der Länder (2017); own calculations.

own revenue. This is true in particular for the trade tax where municipali-
ties compete for investors through attractive rates.14

5.4.2 Grants and Intermunicipal Equalization

The basis of the municipal equalization system is found in article 106,

paragraph 7 of the GG:

From the state share of the total revenue of joint taxes, a percentage to be deter-
mined by the state legislation shall flow to the municipalities and associations of
municipalities. Moreover, the state legislation determines whether and to what
extent the revenue of the state taxes accrues to the municipalities (associations
of municipalities).

Article 107(2) of the Constitution requires that municipal financial

resources be equalized to allow them to provide standard local services.
However, since the responsibility for intermunicipal equalization rests in
the hands of the state, it follows that the various intermunicipal equaliza-
tion systems vary to a considerable degree.
Typically, however, there are asymmetrical vertical state grants that
complement the municipalities’ own resources in each state.15
This is effected through an equalization fund (Verbundmasse) destined to
support local governments, whose volume is determined by the annual state
budget. It corresponds normally to a share of state taxes, the state share of
joint taxes, and of transfers. As a rule, the fund is split into separate sub-
funds for different categories of local government (cities, counties (Kreise),
municipalities). From the fund (or sub-funds), a percentage determined by
a formula is assigned to each municipality (Schlüs­selzuweisungen).
To determine this percentage, the tax potential (Steuerkraftsumme) of

YILMAZ_9781789900842_t.indd 80 16/12/2019 10:44

 The German model of addressing fiscal imbalances ­81

each municipality is examined. In doing so the tax potential is normalized

by using standard (average) tax rates for local taxes since tax rates may
differ. Normalization is to avoid penalizing (rewarding) local governments
whose tax rates are above (below) the average. The fiscal capacity (FC) per
capita of the municipality is then compared with financial needs (FN) per
capita.

●● If FN . FC then the municipality is entitled to equalization

payments.
●● If FN , FC then the municipality will not receive transfers, but
usually does not have to pay either (except in Brandenburg and
Schleswig-Holstein).

The resulting ‘gap’ is not fully equalized. Equalization transfers may cover
between 50 and 90 per cent of the fiscal gap.
All federal states assume that the demand for public services does not
grow proportionally with the size of a municipality. Instead, larger cities
provide infrastructure and related services (including for the surrounding
area) that smaller cities do not have: public transport, schools, clinics,
museums, theatres – that grow disproportionately with the size of the
municipality. They also have greater responsibilities in social protection to
cope with: the unemployed and other transfer recipients such as migrants
are often concentrated in the cities, and facilities and services to cope
with their needs must be made available. Municipal financial equaliza-
tion, which is based on a per capita financial requirement, takes this into
account by giving greater weight to the population figures of larger cities
(Einwohnerveredelung).
Finally, some states also account for special needs (Sonderbedarfe)
such as culture, transportation of pupils, and so on, and for area size, in
particular for rural counties. In other Länder social burdens are taken into
account, for example, on the basis of the number of unemployed. Also, in
most Länder the needs-measurement figure is fictitious; it is not based on
actual financial needs, but determined in such a way that the Verbundmasse
provided for in the Land budget is actually exhausted by all the municipali-
ties of the respective type.
In the state of Hessen, for example, the municipal equalization fund con-
sists of about a quarter of the state resources from income tax, corporate
tax, VAT, motor vehicle tax, property transactions tax and the state share
of the municipal trade tax (Gewerbesteuer). Its size depends on an analysis
of financial needs in the past to establish vertical fiscal balance in a similar
vein as for federal-state relations. However, there are additional constraints
to be observed.

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 82 Intergovernmental transfers in federations

Table 5.4 Specific transfers from the Land Hessen to its municipalities

Specific recurrent transfers Specific capital transfers

Expenditures
●  for schools (incl. General
●  investment (lump sum)
student care) Construction
●  of roads
Social expenditures
●  Public transportation
● 
Alleviation of the burden from
●  Institutions for old-age care
● 
labour market reform Village refurbishment and renovation
● 
Local care for children and youths
●  Water and sewage plants
● 
Subsidies for kindergartens and for
●  Hospitals
● 
care of the under 3-year-olds
Recurrent cost of public
● 
transportation
Theatre, libraries, museums, music
● 
schools, culture
Maintenance of roads, interest
● 
subsidies for special investments

In Hessen, the State Court of Justice, with its ruling of 21 May 2013, has
specified two levels of financial resources to be observed for each munici-
pality: the ‘minimum financial envelope’ must be calculated in such a way
that the municipalities (i) can perform their compulsory tasks; and (ii) are
able to fulfil a minimum of voluntary tasks. This level of funding must be
ensured by the state irrespective of a municipality’s financial capacity. The
lynchpin of the resource distribution is, after all, the assumed financial
requirements of the municipalities. Its determination is often complex and
complicated, and is often at the centre of court disputes.
In addition to general revenue in the form of equalization payments,
municipalities may also receive transfers for specific municipal functions.
These are given for both recurrent and investment purposes. Examples of
these functions are given in Table 5.4.
In addition to these conventional instruments, many Länder have set
up their own programmes to support structurally indebted municipalities,
for which they have found imaginative names (e.g. ‘protective umbrella’ or
‘strengthening pact’). Finally, there are always support programmes and
special allocations outside regular municipal equalization, in particular the
co-financing of municipal projects.

5.4.3 Cost Sharing and Incentives

There are a very limited number of programmes where the federation (via
the state) may co-finance local government activities indirectly. According

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 The German model of addressing fiscal imbalances ­83

to article 104b of the Constitution the federation may grant financial aid
to the Länder for particularly significant investments by the Länder and
the municipalities (associations of municipalities) in order (i) to prevent
a disturbance of the macroeconomic equilibrium; (ii) to balance different
economic strengths; or (iii) to promote economic growth. However, it may
only provide such funding where it has legislative powers; all objects and
measures that fall within the competence of the state are not eligible for
funding.
However, the federal government can grant the states financial assis-
tance for nationally important investments by financially weak local
governments in the area of municipal education infrastructure (art. 104c).
Also, the area of urban renewal and development remains a mixed-funded
investment area, to which the federal government can provide financial
assistance to be specified in the budget. Previously, the federal government
had also responsibility for municipal transport financing (in part) and the
promotion of housing, yet these responsibilities have been transferred
to the states through a reform on federalism in 2006. The corresponding
federal grants continue, but will no longer be earmarked for a specific
purpose, and their use was consigned to the budgetary autonomy of the
states. The aim was to strengthen state autonomy more generally. However,
the states will pass on some of these resources to municipalities in the form
of co-financing or matching grants.
Local mass transportation is an area in which the federal government
had taken interest by supporting integrated local transport systems and
creating incentives for internalizing regional spillovers and fostering inter-
municipal cooperation. For this purpose, federal legislation had provided
financial aid to the states to improve the conditions for municipal mass
transportation (Gemeindeverkehrsfinanzierungsgesetz). However, this co-
financing was criticized as blurring political accountabilities and setting
wrong incentives. In 2007 co-financing between the federation and state
governments was hence terminated by the Law on Disentanglement
(Enflechtungsgesetz), except for some areas (such as regional economic
development) that are enumerated in articles 91a-c of the Constitution.
Yet co-financing local mass transportation through matching grants
remains a powerful instrument at the state level. Matching grants are prob-
ably the only financial instrument with positive incentives in Germany.
While this author has advocated for intergovernmental joint financing in
the past,16 it is doubtful whether this kind of incentivizing is appropriate
in all circumstances.
Where the matching share of the state is too high (as in the case of mass
transportation: 70 per cent of construction costs in Hessen), there is a
risk that projects are carried through only because of the grant, and for

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 84 Intergovernmental transfers in federations

little other reasons. This may be different where the share is to compensate
vertical spillover effects that are measurable.
Performance-based transfers among government do not exist in
Germany, which fully respects the sovereignty of states and the financial
autonomy of municipalities. Paternalistic financial instruments such as
grants based on performance indicators do not fit in such an environment.
It is difficult enough to conceive intergovernmental finances in a way to
keep the system reasonably incentive-neutral, for example to avoid implicit
penalties for making an extra effort in raising taxes through better admin-
istration and collection. Given the high degree of interstate redistribution
through equalization and the provisions that govern municipal finances
this modest goal remains unrealistic in Germany.

NOTES

1. Indeed, centralizing such principles is the rule, but uniform or analogous principles can
also be established through horizontal coordination among states. In Germany this
is achieved in conferences of state ministries and conforming treaties among govern-
ments. One prominent example is the cooperation in education and culture through the
Kultusmi­nisterkonferenz.
2. The concept was, however, influential on European legislation, which has the instru-
ment of ‘directives’. It requires member states to achieve a particular result without
dictating the means of achieving it.
3. More precisely: a mainly population-driven equalization yardstick.
4. The horizontal distribution of business taxes is not without problems, however. The
regional allocation of the corporate and the local business taxes adopt formulae to
count for firms with multiple regional activities (Zerlegungsgesetz). The formulae are
mainly based on wages (for the producers and distributors of energy: on capital). The
same is true for the local business tax (Gewerbesteuergesetz).
5. It should be noted, however, that the federal government was partially compensated by
higher federal taxes (in particular on mineral oil) and by a federal ‘solidarity’ surcharge
on the income tax.
6. State taxes are defined in paragraph 7(1) Finanzausgleichsgesetz (FAG).
7. A uniform state tax regime is, of course, immune against horizontal tax competition
among states in a legal sense. However, there could be incentives for the states to relax
their tax administration in an effort to attract and foster economic activities in their
jurisdiction. Such incentives are to be expected if the shortfall of revenue from lenient
tax administration is fully compensated through equalizing grants, which is true for a
number of states in Germany. Although there has been suspicion of leniency in some
instances, it is, of course, difficult to prove in practice. The redistribution effects follow-
ing the primary allocation of taxes will also induce lenient states (strategical reasons,
administrative inertia, weaker tax compliance where authorities are seen to be lenient)
to go on with their practice since they may make up 92 per cent of the difference through
equalization.
8. In Switzerland, the cantons also participate in a horizontal revenue equalization scheme
complementary to the vertical confederation-canton equalizing scheme.
9. The equalization yardstick also accounts for tax revenues of the state’s municipalities
(at 64 per cent). The weighting procedure for the population is ruled in paragraph 9(2)
FAG for the states, and in paragraph 9(3) FAG for local governments. For local taxes,

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 The German model of addressing fiscal imbalances ­85

of which municipalities can vary the tax rate, an average national tax rate is used to
standardize revenue. The differential weights for city-states and larger municipalities
can be interpreted as accounting for some ‘agglomeration costs’ of larger jurisdictions.
The higher weighing of population (between 102 and 105 per cent) for local taxes of
the Eastern states Mecklenburg-Vorpommern, Brandenburg and Sachsen-Anhalt is
motivated by their sparse population.
10. To ensure the sum of the adjustment amounts corresponds with the sum of the
adjustment payments, the adjustment amounts are either increased or decreased by a
corresponding percentage.
11. See Wissenschaftlicher Beirat (2015).
12. See Holler and Nürnberger (2017); own translation.
13. In particular, differences in municipal tax rates are evened out to ensure that high taxing
municipalities do not have to share their individual tax ‘effort’ with higher-level jurisdic-
tions (incentive neutrality).
14. It should be noted, however, that revenue from trade tax, which is also very sensitive to
the business cycle, is not the only decision parameter for local decision makers. Most
municipalities would value the location of firms probably more under the aspect of job
creation and job security.
15. There is hence no ‘brotherly’ horizontal equalization at the municipal (except for
Brandenburg and Schleswig-Holstein).
16. Spahn (2015).

REFERENCES

Bundesministerium der Finanzen (2017). ‘Bund/Länder-Finanzbeziehungen auf

der Grundlage der Finanzverfassung’, BMF-Dokumentation (Oktober), Berlin.
Bundesministerium der Finanzen (2018). ‘Ergebnisse des Finanzausgleichs 2017’,
Monatsberichte (März), Berlin.
Deutscher Städtetag (2017). ‘Gemeindefinanzbericht’, Berlin/Cologne.
Holler, Franziska and Henrik Nürnberger (2017). ‘Neuer Finanzausgleich: Geld
für die Länder, Macht für den Bund’, Public Governance: Zeitschrift für öffentli-
ches Management, Institut für den öffentlichen Sektor e.V., pp. 14–15.
Spahn, Paul Bernd (2015). ‘Contract federalism’, in Ehtisham Ahmad and
Giorgio Brosio (eds), Handbook of Multilevel Finance, Cheltenham, UK and
Northampton, MA, USA: Edward Elgar Publishing, pp. 144–60.
Statistische Ämter des Bundes und der Länder (2017). ‘Hebesätze der Realsteuern’,
Düsseldorf.
Wissenschaftlicher Beirat (2015). ‘Reform des bundesstaatlichen Finanzausgleichs:
Gutachte des Wissenschaftlichen Beirats beim Bundesministerium der Finanzen’,
1/2015, May, Berlin.

YILMAZ_9781789900842_t.indd 85 16/12/2019 10:44

 6. The United States grant system*
Howard A. Chernick

Intergovernmental grants form an important part of the system of public

finances in the US. In 2017, 17 per cent of federal government outlays
were grants to state and local governments ($675B), under some 1,700
separately authorized programmes (Keegan 2012).1 In 2016, 30 per cent of
total state revenues came from the federal government, while 33 per cent
of local government revenues came from grants, mainly from their states.
This chapter discusses the major features of the US system of intergovern-
mental grants and assesses the effectiveness of this important allocation of
fiscal resources in our federal system of government.2
The chapter has five sections. The first section describes the general
features of the US grant system. Section 6.2 assesses the effectiveness of
grants in addressing horizontal fiscal disparities – fiscal equalization – and
the countercyclical role of grants. The equalization discussion considers
federal aid to states and cities, and state grants to localities. Section 6.3
discusses the fiscal politics of grants-in-aid, focusing on the geographical
distribution of grants. Section 6.4 considers the fiscal response of state and
local government to the receipt of grants, including a section on capital
grants. A final section 6.5 summarizes the main points.

6.1 
GENERAL FEATURES OF THE US GRANT
SYSTEM

A. Aggregate Amounts

Figure 6.1 shows the amount of grants, both as a share of the federal budget
and as a share of GDP, from 1960 to 2017. The grant percentage went from
7.6 per cent in 1960 to 15.5 per cent in 1980, fell back to 11 per cent in 1990,
rose to almost 17 per cent in 2011, and has remained at that level since 2011.
As a share of GDP, grants followed a similar pattern, rising in post-­recessions
periods, and falling somewhat during recovery periods. In 2017 federal grants
equalled 3.5 per cent of GDP, greater than any year other than 2011.

86

YILMAZ_9781789900842_t.indd 86 16/12/2019 10:44

 The United States grant system ­87

20
Recession Years Highlighted ACA Medicaid Expansion Begins

15
Percentage

10

0
1970 1980 1990 2000 2010 2020
year

Share of Budget Share of GDP

Share of Budget Share of GDP

Source: OMB, Federal Budget History, Table 12.1.

Figure 6.1 Federal grants as share of federal budget and GDP 1975–2017

By function, the dominant feature is the increasing share of grants for

health, from 44 per cent in 2000 to 60 per cent in 2018. Next is income
security, declining from 24 per cent to 15 per cent. Transportation’s share
has hovered around 10 per cent over this period, while the aggregate
category of education, employment, training, and social services dropped
from 13 to 9 per cent. Community and regional development grants were
about 4 per cent.
The Office of Management and Budget (OMB) divides grants into
payments to individuals, that help pay for income transfers, physical
capital investment, and other. The major payments to individuals are
for health insurance for low-income people (Medicaid), income security
and nutrition, while the major capital investments are for highways and
public transportation. There has been a rapid increase in the share going
to individuals, reaching 76 per cent in 2017, and a parallel decline in the
capital investment share, going from almost half of federal grants in 1960
to less than 12 per cent.

B. Grant Characteristics

Grants can be distinguished in terms of conditionality, the fiscal terms

on which funds are provided, the distribution mechanism and the
requirements imposed on grant recipients. Highly conditional aid, called

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 88 Intergovernmental transfers in federations

c­ ategorical grants, is for narrowly defined purposes, for example to hire

additional police in a city. Block grants represent an intermediate degree of
conditionality, with grant recipients allowed broad discretion in determin-
ing the uses of the grants. Examples are grants for urban development and
welfare spending. Unconditional grants are provided without program-
matic or functional area restrictions. Grants may be matching – recipient
governments have to pay a share of the costs – or lump-sum. Matching
grants, in turn, may be open-ended – the granting level of government
matches any eligible expenditures – or closed ended, that is, matched only
up to some maximum grant level. Grants may have maintenance-of-effort
(MOE) requirements, requiring recipients to maintain prior levels of
spending. Formula grant amounts are awarded on the basis of legislatively
determined formulae. Project grants are awarded to a subset of eligible
grant recipients based on a competitive application process (Keegan 2012).
Of the 1,714 authorized grant programmes as of 2012, the vast majority
are relatively narrow categorical grants, authorized for specific purposes.
Most categorical aid is distributed as project grants, but formula grants
dominate in terms of dollars. In 2009, 84 per cent of grant dollars were
distributed under the ten largest formula grant programmes (GAO, 2009).
The distributional criteria for both formula and project grants are the
outcome of legislative bargaining, both within particular congressional
committees and across the entire legislature.3
Since at least the 1960s, when the number of categorical grant pro-
grammes increased substantially as part of the Great Society initiative,
there has been concern about the complexity and administrative unwieldi-
ness of the categorical grant structure. Complaints arise both from local
officials, who object to the lack of control over such funds and the interfer-
ence in their own budgetary prerogatives, and from Congress, which has
questioned the efficacy of having so many separate programmes. There
have been periodic efforts to reduce this complexity, by folding numerous
categorical programmes into block grants.4 Despite repeated efforts to
simplify the grant system, small categorical aid programmes have proved to
be quite durable. Categorical aids are able to develop strong, albeit narrow,
constituencies of providers, beneficiaries and legislators, while providing
a greater measure of federal control over use of the funds than for block
grants (Weingast et al., 1981). Because the use of grants is narrowly
defined, and frequently earmarked for capital investment, categorical
grants (at least in appearance) are less fungible with own-source revenues
than broader purpose grants. Hence, they appear to be more effective at
actually inducing spending on particular purposes.5
Narrow categorical aids also enable the federal government to enlist
recipients as agents in introducing new or innovative services or delivery

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 The United States grant system ­89

modes (Schultze, 1974, Aaron, 1985). Under this model, it is appropriate

for the higher-level government to finance most of the grant (high match-
ing rates), and to place strict limits on the total amount of aid.
In contrast, block grants, because they are diffuse in purpose, fail to
develop powerful constituencies, and become more vulnerable to budget-
ary pressures at the granting level. Because block grants tend to be larger in
amount, they are almost always distributed by formula, reducing the role
of bureaucratic or legislative discretion in the award of grants. Typically
lacking binding matching requirements, and broad in the allowed use of
funds, it is easier for recipient governments to substitute grants for own
resources. Most federal countries, the US included, go through periodic
cycles of increased then decreased categorization of grants. As the restric-
tions on local policy choices grow, resistance to categorical grants rise.
However, when replaced by broader block grants, constituency and legisla-
tive support tends to wane, leading to reintroduction of categorical aids.6
By far the largest grant programme is Medicaid, which provides
healthcare to low-income children and families. Federal outlays in 2017
were equal to $375B, more than half of all grant dollars. The Medicaid
programme will be discussed in section 6.2.A of this chapter. Other major
programmes are the highway grant programme ($44B), Child nutrition
($22B), rental assistance ($20.6B), Education Aid for the Disadvantaged
($16.2B), Family Assistance ($16B), Special Education ($12.5B) and Urban
Mass Transportation ($12B). Smaller programmes include Children and
Family services, Foster Care and Adoption, Food Assistance, Community
Development, and Child Care and Social Services. Disaster relief fluctu-
ates widely from year to year.7
A major goal of federal aid to state and local governments is to
provide assistance to low-income individuals and families. The largest
grant categories, for health and income assistance, are for means-tested
benefit programmes. The two biggest grant programmes in education
are for aid to poor school districts (Title 1), or for assistance in meeting
the high costs of educating students with disabilities. The biggest grant
from the Department of Housing and Urban Development is for rental
assistance to low-income families. Grants for economic development, such
as the Community Development Block Grant, are intended to promote
­development in the poorer areas of cities.

C. Grants and Tax Expenditures

Grants are just one component of the fiscal relationship between the fed-
eral government and subnational governments.8 Tax expenditures under
the federal income tax, equal to almost 20 per cent of federal grants, also

YILMAZ_9781789900842_t.indd 89 16/12/2019 10:44

 90 Intergovernmental transfers in federations

provide important subsidies to state and local governments. In 2017, the

largest of these tax expenditures were the deductibility of individual state
and local taxes ($101B), and the exclusion of interest on general obligation
bonds of states and localities ($26B) (Joint Committee on Taxation, 2018).
The Tax Cut and Jobs Act of 2017 (TCJA) capped state and local tax
deductions (SALT) at $10,000, reducing them by nearly 75 per cent. While
the merits of SALT deductibility are subject to debate, the politics of the
TCJA cap clearly reflect an intentional shift in federal tax burdens from
low to high tax states.9 For many of the direct grant programmes, there are
also parallel tax expenditures, for example low-income housing credits for
community development.10

6.2 
FISCAL EQUALIZATION UNDER THE
FEDERAL GRANTS SYSTEM

A common goal of intergovernmental aid is to offset differences in fiscal

capacity or expenditure need among lower-level governments, using uncon-
ditional grants with no matching requirements. However, while variation
among US states in capacity and need are wide and growing (Yilmaz et al.,
2006), fiscal equalization is not a primary feature of the US grant system.11, 12

A. Equalization at the Federal Level

At the federal level, the US relies on categorical aid, typically with match-
ing requirements, to provide assistance to particular target populations
or areas.13 The most important categorical programme is the open-ended
matching grant for Medicaid. The federal government matches eligible state
expenditures using a formula known as the Federal Medical Assistance
Percentage (FMAP). The FMAP is inverse to a state’s per capita personal
income (as measured by the average of the three most recently available
years of data), relative to national per capita income, with lower and upper
bounds of 50 and 83 per cent. The formula is

(statepci) 2
FMAP 512 c d *0.45, 0.5 , FMAP , 0.8314 (6.1)
(natrlpci) 2

Evidence suggests that the price incentive under the matching grant has
been successful in inducing increased spending on healthcare for the poor
(Carlino and Inman, 2016). However, despite highly favourable matching
rates for low-income states, adequacy varies widely across states (Holahan,
2003).

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 The United States grant system ­91

While the Medicaid formula does not take direct account of differences
in need across states, to the extent that per capita income is negatively cor-
related with the percentage of the population eligible for services, the vari-
able matching rate goes some way towards addressing differential needs.
Fiscal bargaining between states and the federal government over the
effective matching rate has also been used, though unevenly, to compensate
for differential costs.15, 16
The income factor in the FMAP provides a measure of risk sharing as
states’ relative economic positions change over time. However, the lower
bound of 50 per cent mitigates the degree of fiscal equalization in the dis-
tribution of federal funds. Over time the distribution of federal Medicaid
funds has shifted towards the richer states, despite the favourable matching
rates enjoyed by poorer states, suggesting that for higher income states
income effects outweigh price effects. The lower bound on the matching
rate is crucial in this regard. If the relative income of states at the 50 per
cent lower bound increases, there is no additional price effect to offset
the increased demand for medical services for the poor that accompanies
increased fiscal resources. An enhanced FMAP (30 per cent above the
regular FMAP) is also used to distribute funds under the Children’s
Health Insurance Program (SCHIP), which provides capped funding for
health insurance for children who are not Medicaid-eligible but live in
low-income families.17
The Affordable Care Act (2010) represents the latest effort to expand
health services for low-income persons, providing coverage up to 138 per
cent of the Federal Poverty Line. Given the budgetary pressure on states
from rapid growth in traditional Medicaid spending, (almost) full federal
financing of the expansion was a necessary condition for the bill’s passage.
As of this writing, 36 states had accepted the expansion, with a number of
the 14 non-expansion states likely to do so in the near future.
With the exception of Medicaid, all major grant programmes are capped
in total amount, with distributions based on population and a variety of
other criteria. Highway funds are distributed based on population and
road miles, with minimum amounts for small states.18 Urban transporta-
tion funds are based on population and passenger miles. School subsidies,
community development, social services and child care block grants use
poverty counts. Capital programmes have high matching rates, but are
capped in amount. Minimum grant constraints and grandfathering of
prior levels of aid tend to push block grants and capped matching aid
towards equal per capita distributions across states.
Gordon et al. (2016) evaluate grant distributions using the fiscal gap
approach, defined as the difference between revenue capacity plus federal
grants, and expenditure need. States with the largest negative gaps are

YILMAZ_9781789900842_t.indd 91 16/12/2019 10:44

 92 Intergovernmental transfers in federations

c­oncentrated in the South, while Northeastern states show the largest

positive fiscal positions. Operationally, equalization is undermined by
matching and MOE requirements, grant-minimums and hold-harmless
provisions, even as economic and fiscal conditions change.

B. Equalization at the State Level

Fiscal equalization, while not a primary feature of the federal grant system,
is important at the subnational level. Between 2012 and 2016 about 37 per
cent of local general revenue came from intergovernmental grants. Grants
from states make up almost 90 per cent of that aid, with the remainder
from the federal government.19
In 2016, 60 per cent of all state aid was for elementary and secondary
education, comprising 47 per cent of local education revenues (US Census
Bureau, 2016). Federal aid provided 8 per cent of school revenues. The
major trend in state aid in the US has been an increase in the state share
of education finance, and the incorporation of equalization criteria in
the distribution of aid to local schools.20 Before the 1970s, state aid was
typically distributed to local school districts on a per pupil basis. Because
property, the base for the main local revenue source, is unequally distrib-
uted, even aid distributed on a per pupil basis is equalizing as compared
to local financing. Evans et al. (1997) find that, under the impetus of a
number of court decisions, state aid for education became more equalizing
over time.21 The General Accounting Office (GAO, 1998) found an average
state equalization effort of 62 per cent in 1997, where 100 per cent would
imply that each school district could attain the statewide spending per
pupil with an average fiscal effort.22 Notably, equalization was increased
more by increasing the state share of total financing then by greater
targeting of state aid to poorer districts. However, the degree of equaliza-
tion differed substantially across states. Federal aid, though small relative
to total funding (7 per cent), was highly targeted to poor students, and
increased spending on poor students by 77 per cent. For a sample of 149
big US cities, Chernick and Reschovsky (2018) found that education aid
was by far the most equalizing of all categories of state aid, but the range
across states was substantial.23, 24
While state aid is equalizing, direct federal aid to cities is positively
correlated with local tax capacity (Chernick and Reschovsky, 2018).
This pattern does not appear to be due to differences in poverty rates,
but instead may reflect the greater ability of richer cities to negotiate the
administrative procedures for obtaining federal aid, and enhanced ability
to satisfy matching or MOE requirements (Chernick, 1979).25

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 The United States grant system ­93

C. Grants as Countercyclical Fiscal Instruments

An important role of intergovernmental grants-in-aid is to offset fiscal

contractions of state and local governments during economic downturns.
Almost all states and localities are subject to annual balanced budget rules.
While these rules vary in their degree of stringency (Bohn and Inman,
1996), they nonetheless imply that recession-related decreases in tax
revenues and increases in expenditure needs force spending cuts and/or tax
increases, thus exacerbating recessions. Increased federal grants can help to
offset contractionary fiscal behaviour on the part of states while protecting
vital public services.
Figure 6.2 shows grants as a share of state general revenues from 1992
to 2011, with an increase in the federal share in the aftermath of each
downturn. The increase reflects both an increase in federal grants and a
decrease in state tax collections. Countercyclical fiscal relief has both auto-
matic and discretionary components. The automatic component comes
from recession-related increases in spending on programmes for the needy,
mainly for Medicaid, and the automatic increase in federal matching funds
which results. The automatic feature of open-ended matching grants con-
stitutes an important risk-sharing mechanism during cyclical downturns.
There have also been a variety of discretionary countercyclical federal
grant programmes. In the mid 1970s, several billions of dollars of

0.36
Grant Shares Following Recession

0.34
grant shr state rev

0.32

0.30

0.28

0.26
1990 2000 2010 2020
year

grant shr state rev grant shr state rev

Source: U.S. Census Bureau, Annual Survey of State Government Finances, various years.

Figure 6.2 Federal grants as share of state general revenues

YILMAZ_9781789900842_t.indd 93 16/12/2019 10:44

 94 Intergovernmental transfers in federations

s­ upplemental aid went to states and local governments. In 2003 and 2004
some $20B was allocated to states, half on a per capita basis, and half
in enhanced Medicaid funding. Responses in both periods have been
criticized as being both for being poorly targeted in terms of need, and
lacking in timeliness, with funds arriving after the recessions had already
ended (GAO, 2004).
Fiscal relief to state and local governments in the aftermath of the Great
Recession dwarfed any of the prior amounts post-World War II. The bulk
of the $300B in funds was earmarked for the two largest categories of
state and local spending, health and education, $90B for Medicaid, and
$100B for education. The remaining funds went for assistance to low-
income families ($18B), for unemployment compensation ($39B) and for
infrastructure spending ($58B).
In contrast to the timing problem of prior countercyclical fiscal assis-
tance programmes, in which funds typically arrived too late, fiscal relief
to states under the American Recovery and Reinvestment Act of 2009
(ARRA) was delivered on a relatively timely basis. However, the rapid
drawdown of ARRA funds to states after 2011 can be criticized as hap-
pening too fast. Not only was the drop in state tax revenue in the Great
Recession the sharpest since the Depression, but the recovery has also been
the slowest. In 2015, six years after the official end of the recession, fiscal
pressure on states and cities remained severe. For example, in large cities
the two most important sources of local government revenue, the property
tax and state aid, were only slightly higher in 2015 than they were in 2000
(Chernick and Reschovsky, 2018).26
In both the 2001 and 2007–09 recessions, enhanced Medicaid matching
rates were used as a vehicle for fiscal relief. In 2003, the Medicaid matching
rate (FMAP) was increased by 2.95 percentage points for five quarters.
From 2009 to 2011, the federal matching rate was increased by at least 6.2
percentage points for all states, with additional matching rate supplements
for high unemployment states, and a hold-harmless provision in matching
rate adjustments for states whose relative income had increased.27 Given
the size of the Medicaid programme, a temporary increase in the federal
matching rate has proved to be an efficacious way to increase federal sup-
port to states during recessions.
A uniform increase in the federal matching share makes the increase
in federal Medicaid payments proportional to the amount of prior state
spending. This approach sidesteps the difficult political issue of win-
ners and losers in the distribution of incremental assistance. In 2009,
the variation in matching rate enhancement based on differences in the
increase in unemployment was small relative to the uniform increase. As a
consequence, more than a third of relief payments went to the five states

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 The United States grant system ­95

with the largest Medicaid enrolments (Kaiser Commission on Medicaid

and the Uninsured, 2011). The Medicaid relief Act included an MOE
requirement to prevent states from tightening eligibility standards. Even
with this requirement, the recession-induced pressure on Medicaid spend-
ing in most states was less than the amount of extra funds provided.28 This
allowed states to divert substantial portions of the increased federal aid
into general revenue, which could be used to offset reductions in tax rev-
enues. Despite the importance of fiscal relief under the enhanced Medicaid
match, Carlino and Inman (2017) find that the price reduction was still
much more effective than lump-sum federal aid in terms of countercyclical
stimulus per dollar of federal aid.29
The other major share ($100B) of Great Recession fiscal relief for
states was for elementary and secondary education. States were awarded
about $60B based on school age and overall population, with the funds
distributed to local school districts using each state’s basic state formula
for school aid. An additional $10B was allocated to supplement education
aid for low-income students. In response to the pressure on local resources,
local education agencies were allowed to use their supplemental Title I
appropriation to satisfy the MOE requirement.
Initial research on the efficacy of the Great Recession fiscal relief pack-
age suggested that most of the funds went into state balances (Cogan and
Taylor, 2012). However, Carlino and Inman (2017), using a much longer
panel of data, find that the enhanced Medicaid match was effective at
releasing resources for low-income individuals that otherwise would have
been spent on medical care. Leduc and Wilson (2013) find a strong stimu-
lus effect for increased aid for highways under the ARRA. While there was
a sharp increase in direct federal grants to cities from 2009 to 2011, this
increase was more than offset by declines in city tax revenues and state aid.

6.3 THE POLITICS OF GRANTS

A. Geographical Distribution Patterns

In 2010, per capita federal grant amounts vary widely across states. High
grant states include some small population states – Montana, North and
South Dakota and Wyoming – high spending states in the northeast –
New York, Vermont and Maine – and very poor states – Mississippi and
Louisiana. The four lowest grant states were Virginia, Nevada, Colorado
and Utah. Florida and Texas also received a relatively small amount of aid
on a per capita basis. The basic patterns were similar in 2017 (Rockefeller
Institute, 2018).

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 96 Intergovernmental transfers in federations

The geographic distribution of grants depends on the formula criteria,

and matching requirements. Population is a key factor, though grants for
education, community development, social services and child care also take
account of the number of children in poverty (GAO, 2005, 2009). Penner
(1979) argues that the geographic distribution of grants was roughly equal
on a per capita basis. Grants favouring poor states were offset by minimum
constraints favouring small states, and greater ‘pull-in’ of funds by wealthier
states for discretionary project grants and open-ended matching grants. The
differential growth of Medicaid spending by state since the early 1980s has
tended to undo this per capita balance, favouring states with high percent-
ages of the population enrolled in Medicaid and/or relatively generous
benefit packages. The Affordable Care Act has reinforced this trend.30
An alternative way to look at grant distributions is as a share of state
revenue. In 2016, on average 32.6 per cent of state revenues came from
federal grants (Tax Foundation, 2019). The most dependent states have
high concentrations of poverty, high Medicaid matching rates and limited
tax collections.31 The least dependent states get relatively low Medicaid
grants, while states in the middle have levels of taxation high enough to
offset high levels of Medicaid spending.32

B. Broader Perspectives on Intergovernmental Fiscal Flows

Grants are only one component of the fiscal flows between central and
subnational governments. Another important component is direct federal
spending, particularly for national defence. Whether intentional or not, a
case can be made that the US substitutes military spending for equalizing
grants, using its exceptionally large national defence budget to redistribute
resources to the poorest regions of the country. In 1997, per capita defence
spending (prime contract awards plus compensation) was almost equal to
grants ($762 versus $870) (GAO, 1998). Comparing spending by the four
census regions, outlays for defence were equal to 4.5 per cent of income
in the South, compared to an average of 2.8 per cent in the others, while
per capita income in the South was 9 per cent lower than the rest of the
country.33, 34 This distribution reflects population-based rules, combined
with strong support for military spending in the South, and the success of
southern legislators in controlling key congressional committees (Carsey
and Rundquist, 1998). These results suggest that if defence spending were
included together with intergovernmental grants, the negative fiscal gaps
for poor states found by Gordon et al. are likely to be substantially reduced
or even eliminated.
An even broader perspective on fiscal flows is to include both taxes
paid to the federal government and federal expenditures, to arrive at a

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 The United States grant system ­97

‘balance of payments’ estimate for each state. A recent study finds that
the poorer the state, the larger the positive balance of payments (Schultz
and Cummings, 2019). The main explanatory factor is differential federal
income and payroll taxes by region.35

6.4 
EFFECT OF GRANTS-IN-AID ON STATE AND
LOCAL EXPENDITURES
The fiscal impact of grants may range from full substitution of grant for
recipient dollars, to fully additive effects or even to stimulating state and local
spending. Fiscal impacts are likely to vary over time, by type of grant (match-
ing versus lump-sum), by the degree of conditionality (categorical versus
block grant) and by the extent to which any MOE requirements are binding.
At the macro level, Figure 6.3 shows federal grants and state and local
own revenues by year. Over most of the period from 1970 to 2017, both
own revenues and federal grants increased in tandem.36 During recession
periods, particularly the years following the 2007–09 recession, federal
grants increase as state–local revenues decline.37 The overall pattern of
grant supplementation reflects joint federal-state funding of Medicaid, the
largest and fastest growing federal grant.

2,000
2009–2011
1,500
Bars denote Recession Periods
2001
1,000

1990
500

0
1960 1980 2000 2020
year

State–local revenues from own sources Federal grants

State–local revenues from own sources Federal grants

Source: OMB, Federal Budget History, Tables 12.1 and 14.1.

Figure 6.3 Federal grants and state–local own-source revenues (billions of

nominal $)

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 98 Intergovernmental transfers in federations

An early paper by Gramlich and Galper (1973) found that state fiscal
responses to unrestricted aid were approximately equally divided between
spending increases, tax reductions and increases in state savings. Carlino
and Inman (2016) find that a dollar increase in federal aid through higher
federal matching rates leads to an additional 70 cents in spending for lower
income households, with the rest of the response going to tax relief and an
increase in state savings, at least partially funded by a reduction in other
state spending.38 By contrast, a dollar increase in project aid (largely for
infrastructure and education) is equally divided between increased spend-
ing and increased public sector savings.
The long-run average annual rate of growth in Medicaid spending is
striking, equal to 6.25 per cent per year from 1996 to 2019, and exceeding
the average rate of increase in state revenues (Rudowitz et al., 2018). The
increase is due to both increased enrolments and increased spending per
beneficiary, particularly for the aged and disabled.39 State dollars spent
on Medicaid have gone from 12 per cent of own-source revenues in 2000
to 17 per cent in 2012, and remained since at that level.40 The increase
in Medicaid’s share of state revenues has led to concern that Medicaid
growth is crowding out other state spending areas, particularly education
and other welfare spending.41
States’ fiscal incentives for redistribution changed when Aid to Families
with Dependent Children (AFDC) was converted to a block grant under
the welfare reform Act of 1996. Because the amount of aid is fixed, states
must bear the full cost of any increase in the welfare rolls, but realize the
full savings from a decline in the rolls. States were constrained in how much
they could reduce their own spending on cash assistance by MOE require-
ments, set in nominal dollars. The main state response to the Temporary
Assistance for Needy Families (TANF) block grant has been to freeze or
decrease cash assistance, by promoting a rapid reduction in the number of
people getting assistance. When it was created in 1996, the federal TANF
block grant was funded at $16.5B per year. It has remained at that nominal
level since. While the lifetime limits on welfare receipt have clearly played a
role, the decline in welfare spending suggests that the change from an open-
ended matching grant to a fixed block grant has had a powerful effect in
reducing overall spending on cash assistance to the poor, and in increasing
inequalities across states (Ayala et al., 2017).42
A widely discussed effect of grants-in-aid is the so-called flypaper
effect, under which the impact of a dollar of aid on recipient spending
greatly exceeds the impact of a comparable increase in resident income
(Inman, 2009). One explanation is that the fiscal terms on which the
grant is awarded may be misidentified. Administrative discretion in the
awarding of project grants may lead to greater amounts of aid awarded

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 The United States grant system ­99

to j­urisdictions that are more willing to match federal contributions

(Chernick, 1979).
Knight (2002), using congressional representation as instruments to
address endogeneity in the award of federal highway grants, finds that
funds are disproportionately awarded to high demand states. Thus, he
argues that highway grants substitute federal for state dollars, rather than
increasing total spending. However, these results have been challenged by
Leduc and Wilson (2013), and Fisher and Wassmer (2015), both of whom
find substantial stimulus effects of augmented aid for highways as part of
the ARRA recovery Act of 2009.
The fiscal impact of grants differs depending on the functional purpose
of the grant, and the amount of recipient spending in that functional
area. Gordon (2004) finds that, despite non-supplant regulations, over
time, federal grants to cities displace local resources. In contrast, Chernick
(2017) finds that each dollar of direct federal aid to cities – mainly for child
care, social services and community development – is associated with more
than a dollar of total spending increase. A dollar of state aid to cities leads
to spending increases between 64 and 87 cents. Thus, both state and direct
federal aid to cities appear to be mainly additive to local spending effort.
How can the various results regarding grant effects be reconciled?
Because, for most grants, there is no matching at the margin, differential
price effects are not likely to be important. However, another factor is the
size of the grants relative to own spending. For example, education aid
for the disadvantaged represents a small fraction of total local spending
on education. Over time, it becomes difficult to enforce the non-supplant
rules based on earlier spending levels, making grant dollars fungible with
local dollars.
By contrast, direct federal aid to cities goes primarily for social services,
and housing assistance. Under the pressure of the most recent recession,
cities have cut back own spending in these particular functional areas, rely-
ing more and more on outside aid. Nonetheless, overall public spending
may also be higher in cities that receive more aid.43 The delivery mode for
social services, with cities largely relying on contracting out to non-profits,
may also affect the ability of cities to more rapidly adjust spending levels in
response to changes in grant amounts.44
Capital grants are almost always closed ended categorical matching
grants, with high federal matching rates.45 Federal grants comprised 38
per cent of state and local capital spending on water and transportation
in 2014, and 45 per cent of public transportation capital outlays (Mallett,
2018). Fisher and Wassmer (2015) find that state and local capital invest-
ment tends to show an increase in the years following recessions, as coun-
tercyclical federal grants are translated into increased spending. However,

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 100 Intergovernmental transfers in federations

following the 2007–09 recession, the increase in federal grants for capital
spending was not sufficient to offset the severe fiscal stress states and
localities faced from the declining economy. Between 2009 and 2013, state
and local capital outlays fell by 20 per cent (Fisher and Sullivan, 2016).46
Gramlich and Galper (1973) find that about half of what they term C
grants (categorical grants with closed-end matching) increase spending,
while the other half goes to tax relief. Fisher and Wassmer (2015) find
a low elasticity of state/local capital expenditures with respect to federal
grants, but a higher elasticity for stimulus funds following the Great
Recession. Estimates of the fiscal impact of highway grants range from full
displacement to actually stimulating spending from own resources. At the
aggregate level, the high shares of federal monies in water and transporta-
tion suggest that capital grants in these functional areas may be displacing
at least some state and local effort. Announcement effects, wherein the
prospect of award of discretionary capital grants leads states or cities to
defer projects, may also contribute to substitution.47 However, state and
local capital spending is sensitive to the business cycle, and augmented fed-
eral capital grants in periods of recession have clearly helped to maintain
capital spending, or to reduce the magnitude of cuts.

6.5 CONCLUSION

Federal grants to states and localities are an important feature of federal-

ism in the US, comprising 17 per cent of all federal spending in 2017 and
33 per cent of state general revenues. The share of funds that ultimately
go to individuals, mainly for healthcare, has increased, while the share for
capital expenditures has diminished sharply. Some 84 per cent of all grant
money is awarded on the basis of congressionally determined formulae,
though categorical project grants have been a persistent feature of the US
grant system. Over time a number of categorical grants have been replaced
by block grants, allowing greater leeway in the use of funds.
A principal goal of the US system is to provide a floor on support for
the poor and reduce the incentives for a race to the bottom in redistribu-
tion, while still preserving subnational fiscal autonomy and competitive
federalism, as these concepts are interpreted in the US tradition. Unlike
most federalist countries, the US does not use untied grants for fiscal
equalization. Instead, it subsidizes subnational provision of certain merit
goods, using income-adjusted matching grants or block grants. Medicaid,
expanded and incentivized with highly favourable matching rates under
the Affordable Care Act (2010), and the Children’s Health Insurance
Program, set a floor on medical services for the poor, but still allows for

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 The United States grant system ­101

wide variation in coverage and benefits across states. Though rapid growth
in healthcare spending under Medicaid may lead to lower spending in
other functional areas, the welfare implications of this shift are ambiguous,
depending on programme effectiveness and the social value states assign to
public spending on different groups.
Education is primarily a local function in the US, though almost half
of all revenues come from state aid. The equalizing effect of state aid
has increased over time, bolstered by an increase in state dollars and
the incorporation of equalization criteria into state education formulae.
Nonetheless, wide disparities both across and within states persist.
Grants play an important role as countercyclical fiscal instruments,
increasing both in amount and in share of state revenues in times of reces-
sion and providing a buffer against reduced tax revenues and increased
expenditure needs. Fiscal relief to states following the 2007–09 recession,
through enhanced Medicaid matching rates and an increase in school aid,
dwarfed any of the prior efforts following World War II. Research suggests
that fiscal relief to states played an important role in maintaining services,
enhancing capital investment and stimulating state economies.
Overall grant distributions have moved away from equal per capita
towards favouring richer states, due to their higher Medicaid expenditures.
However, as a share of state revenue, federal grants favour states with high
concentrations of poverty and limited tax collections. Federal military
expenditures in the US, almost equal in magnitude to grants-in-aid, tend to
offset any tendency for grants to favour high-income states.
At the macro level, grants are roughly additive to own revenues, a direct
result of the open-ended matching requirement for Medicaid. However,
conversion from open-ended matching to fixed block grants for cash assis-
tance has been accompanied by a sharp drop in spending, and an increase
in interstate benefit differentials. The stimulus effect of other categorical
aid varies depending on the size of the grant and the degree of specificity.
The literature on substitution for capital grants is ambiguous, with results
ranging from full to very little substitution.
The US grants system distributes large amounts of fiscal resources to
incentivize states and their localities to provide services to the poor, and
enhance their capital stocks. While there is some modest fiscal equaliza-
tion, interstate and intrastate differences in spending for redistribution and
education, both between and within states, remain substantial. One lesson
is that federal attempts to induce spending on the poor must be accom-
panied by very strong financial carrots. Mandates alone are insufficient,
and untied funds are ineffective. Capital grants, though politically salient,
may in some cases lead to displacement of own state fiscal resources, sug-
gesting that enhanced federal spending on infrastructure must be carefully

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 102 Intergovernmental transfers in federations

designed to minimize the displacement effect. There is clearly a role for

policy analysis in providing ongoing analysis of the effectiveness of each
dollar spent on grants-in-aid.

NOTES

* I would like to thank William Fox, Richard Bird, Serdar Yilmaz and Farah Zahir for
helpful comments on earlier drafts.
1. In 2008, the last year before the great recession (2007–09), over 15 per cent of the federal
budget went for grants, which then comprised about 27 per cent of state and local own-
source revenues. Between 2009 and 2011 the amount and budget share of federal grants
were augmented by $216B of stimulus funds to state governments and local school
districts as part of the American Recovery and Reinvestment Act of 2009 (ARRA). In
addition, beginning in 2014, the Affordable Care Act’s federally funded expansion of
eligibility for Medicaid, the programme of health insurance for low-income individuals.
2. Gordon (2018) provides a concise review of the US grants system, and considers
changes in distributional criteria to target the economic development of lagging regions.
3. Knight (2005) finds evidence for the ability of proposal committee members to increase
federal project grant allocations to their own congressional districts.
4. One such example was the 1974 Community Development Block Grant (CDBG), which
combined seven categorical grants into a single grant for community development.
5. Theory suggests that the greater the degree of specificity of grant earmarking, the
more likely is the grant to at least initially increase spending on that particular category.
However, over time the fiscal impact of narrow categorical grants may diminish, if
recipients are able to reduce spending in closely related categories of spending. Evidence
on the fiscal response of recipient governments to earmarking is discussed in Section
6.4.
6. See the discussion by Gillette (2004) on the role of categorical and block grants in
Sweden.
7. For example, spending was equal to $5.3B in 2017, but rose to $20B in 2018.
8. While most federal grants are funded from general revenues, one of the largest grant
programmes, for transportation, is funded by an earmarked tax on gasoline. The tax,
currently at a rate of 18.3 cents per gallon, is used to pay for highway construction and
mass transit projects.
9. Arguments for allowing SALT deductibility, in terms of reducing interstate tax competi-
tion, offsetting differential costs of the public sector and encouraging subnational tax
progressivity, are discussed in Chernick (2018).
10. Even more broadly, the federal government and the states must ultimately share the
same tax base, and are thus in potential competition for tax revenues (Chernick and
Tennant, 2010; Gordon and Cullen, 2012).
11. The ratio of per capita income of the five richest states to the five poorest states
increased from 1.44 to 1.64 between 1980 and 2016.
12. In theory, the equalization grant could actually be negative for states with positive fiscal
residuals, implying little or no net cost to the federal treasury. In this case, the grant
would represent a pure horizontal transfer. For political (and legal) reasons, negative
grants have never been used in the US.
13. The only such grant was general revenue sharing (GRS), enacted under President Nixon
in 1972, and ended completely under President Reagan in 1986. In 1978, GSR made up
about 9 per cent of total grants. The formula for distribution, which took into account
both state income and fiscal effort, and was reflective of the need to build a broad
coalition of support, meant that there was relatively little fiscal equalization under GRS
(Sawicky, 2001). This result is consistent with the primary rationale for GRS, which was

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 The United States grant system ­103

not to offset differences in fiscal conditions between states or localities, but to address
vertical fiscal imbalances between the federal government and the states (Heller and
Pechman, 1967).
14. In 2019, 14 states are at the lower bound, while the highest federal share (Mississippi) is
74 per cent. In 2000, 11 states were at the lower bound, while the highest federal share
was 76 per cent. While the poorest states have consistently received the highest federal
shares since the FMAP was first instituted in 1961, the identity of a number of states at
the lower bound has changed considerably.
15. Another factor in the expansion of Medicaid has been the maximization strategies
employed by states to increase Medicaid funding. Since the 1990s, the federal share of
Medicaid spending has grown more rapidly than the state share in certain states because
the federal government helps to finance extra hospital spending for states with high
levels of charity care. In the past, the Medicaid programme has allowed states to satisfy
the matching requirement for this type of spending with a variety of special financing
devices. These strategies have increased the overall Medicaid matching rate from 56 per
cent to almost 60 per cent. One may view this process as part of the ongoing bargaining
relationship between the federal government and the states, in which the states try to
extract additional federal financing as the price for expanding coverage or services. In
this interpretation, Medicaid maximization strategies are but one step in the historical
evolution of the financing of health insurance for low-income individuals (Ku and
Coughlin, 1992).
16. For example, Ohio was at 50 per cent in 1967, and is now at 63 per cent.
17. The programme has an MOE requirement for eligibility and spending, and an 88 per
cent federal matching rate. Because funding is capped globally and for most states, there
is typically no price reduction at the margin.
18. The federal matching rate is 80 per cent.
19. A portion of federal grants to states are ‘passed through’ to localities. Hence, the 5 per
cent figure for federal grants to local governments understates the total fiscal impact of
federal grants to local governments. It was not possible to get an overall estimate of the
amount of pass-through aid. For the city of New York, budget data suggest that such
aid is roughly equal to 5 per cent of total city revenues.
20. The equalization goal is typically reflected in aid programmes which make state funds a
function of the gap between own property tax base and the average base, multiplied by
the average property tax rate in the state. A number of states also include cost factors in
the formulae.
21. They found that in 1992 equalization criteria removed almost half of the inequality in
spending that would have occurred if aid were distributed on a per pupil basis.
22. To address cost differentials, the study uses a cost index for teachers in its calculations,
but ignores cost differentials due to differences in the demographic composition of the
student body. The resultant cost differences are quite important (Reschovsky, 1994).
23. The simple correlation between state aid and a representative tax system measure of city
fiscal capacity was negative (ρ 5 20.32), while other state aid was positively correlated
with city fiscal capacity (ρ 5 0.23).
24. Since 2000, both the negative correlation for state aid and the positive correlation for
other types of state aid have increased. For example, in 2014 state aid’s share of city
spending on education was 85 per cent or more for the ten highest share cities, compared
to less than 39 per cent for the ten lowest share cities. For the period 2000–14, the cor-
relation between state aid and city fiscal capacity, not taking account of differences in
expenditure need, was a negative 0.55 in Texas, 0.49 in New York, 0.28 in California, and
a positive 0.03 in Florida.
25. This interpretation is strengthened by the finding that direct federal aid to cities is
unusually stimulative, with an extra dollar of federal aid associated with more than an
extra dollar of total spending (Chernick, 2017).
26. The main reason for the sharp decline in property tax revenues was the decline in home
values that followed the bursting of the housing bubble in 2006 (Chernick et al., 2018).

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 104 Intergovernmental transfers in federations

27. The unemployment-based adjustment to the federal share was roughly half of the basic
adjustment, with larger states tending to receive greater increases than smaller states.
28. Holahan and Garett (2009) find a strong relationship between changes in unemploy-
ment and expansion in the Medicaid rolls. However, Chernick and Reimers (2019) find
only a very weak relationship between the increase in state unemployment rates from
2007 to 2010 and the overall increase in Medicaid spending. The same lack of a strong
relationship holds for the increase in the percentage of the population below 200 per
cent of the federal poverty line.
29. Carlino and Inman (2016) estimate that the 10 percentage point increase in the fed-
eral Medicaid matching share under the ARRA increased spending for poor families
by about $70 for each $100 of federal spending. The added federal price incentive led
to a reduction in other state spending, and an increase in government saving and tax
relief.
30. Given the dominant role of Medicaid in the federal grant system, and the fact that the
non-expansion states are on average poorer than the expansion states, the Supreme
Court’s decision to make Medicaid expansion optional has undoubtedly made the
federal grant system less equalizing than before. At the time of writing, 14 states have
declined to take the Medicaid expansion.
31. For the year 2009, I estimate an elasticity of taxes per capita with respect to personal
income of about 1.0.
32. High share states include Mississippi and Kentucky, low share states include Virginia
and Kansas, while middle share states include New York and California.
33. When one divides the US into nine census divisions, as opposed to four regions, high
defence spending is concentrated primarily in ‘Division 5’ (Delaware, the District of
Columbia, Florida, Georgia, Maryland, North and South Carolina, Virginia and West
Virginia) as opposed to the other states in the South.
34. The distribution of defence spending can be addressed by regressing 1997 per capita
defence spending by state on region and state per capita income.

SPENDPC 5 2194321096 (Northeast) 2817(Midwest) 2265(West) 0.132 per

capita personal income (6.2)

SPENDPC: Per capita amounts by State for Prime Contract Awards and Compensation,
Department of Defense.
All variables are significant at the 5 per cent level or higher.
The omitted region in the above regression is the South, indicating that, controlling
for income, average defence spending is almost $1,000 lower in the Northeast and the
Midwest than in the South. The fact that per capita income has a positive effect on
defence spending suggests that the concentration of defence spending in the South is not
due to lower wages in that region.
35. By region, southern states tend to have relatively large positive balances, while states in
the Northeast have the largest negative balances. The balance of payments results are
primarily a result of the interaction between regional income disparities and graduated
income taxation.
36. This visual picture is supported by regression analysis showing that for every dollar
increase in federal grants, state–local revenues increased by $2.
37. The decline in state–local receipts reflects the sharp drop in tax revenues from a decline
in state and local tax bases in the aftermath of a deep and prolonged recession, rather
than a choice to decrease tax rates on a stable base (Dadayan and Boyd, 2013).
38. These estimates translate into an elasticity of welfare spending with respect to the price
−0.43, within the range reported by Chernick (1998) for the AFDC programme.
39. The latter category now comprises two-thirds of all Medicaid spending.
40. Eight states spent more than 20 per cent of their own revenue on Medicaid, while five
states spent less than 10 per cent.
41. Kane et al. (2005) find that Medicaid crowds out higher education spending. In a

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 The United States grant system ­105

c­ omment, Inman (2005) argues that the instruments used by these authors are not valid,
and that Medicaid spending represents a choice by states. Baicker (2001) finds that
federal mandates to enhance Medicaid coverage have the effect of crowding out other
types of welfare expenditures.
42. The spending reduction effect has been more powerful than predicted from analyses of
the effect of variation in matching rates on welfare spending prior to TANF (Chernick,
1998).
43. Chernick and Reschovsky (2018) found that cities with higher fiscal capacity received
more direct federal aid.
44. Adjustments in staffing levels for non-government agencies than for government
employees are likely to be more rapid, as cities shift the risk underlying uncertain
resource flows to the non-profits.
45. Capping the amount of grant dollars to any one recipient allows a spreading of federal
resources among more recipients, thus increasing political support for the grant.
46. These cuts are similar to the patterns for large cities, where capital outlays declined by
19 per cent from their peak in 2009, the most of any category of city spending.
47. There has been some concern in the literature that federal funding of capital as opposed
to operating expenses can lead to inefficiencies. Cromwell (1989) finds that federal
capital grants for mass transportation have led to premature replacement of older buses
by newer ones. However, the degree of inefficiency is not particularly large.

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Gordon, N. (2004). ‘Do Federal Grants Boost School Spending? Evidence from
Title I.’ Journal of Public Economics, 88 (9–10), 1771–92.
Gordon, R. and J.B. Cullen (2012). ‘Income Redistribution in a Federal System of
Governments.’ Journal of Public Economics, 96 (11–12), 1100–109.
Gordon, T. (2018). ‘Harnessing the U.S. Intergovernmental Grant System for
Place-Based Assistance in Recession and Recovery’. The Hamilton Project,
Policy Proposal. September.
Gramlich, E. and H. Galper (1973). ‘State and Local Fiscal Behavior and Federal
Grant Policy.’ Brookings Papers on Economic Activity, 1, 15–65.

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 The United States grant system ­107

Heller, W. and J. Pechman (1967). ‘Questions and Answers on Revenue Sharing.’

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Testimony to U.S. Joint Economic Committee, 107–22. Washington, DC: U.S.
Government Printing Office.
Holahan, J. (2003). ‘Variation in Health Insurance Coverage and Medical
Expenditures: How Much is Too Much?’ In Federalism and Health Policy, John
Holahan, Alan Weil and Joshua Wiener (eds), 111–44. Washington, DC: The
Urban Institute Press.
Holahan, J. and A. Garrett (2009). ‘Rising Unemployment, Medicaid and the
Uninsured,’ Kaiser Commission on Medicaid and the Uninsured, Washington,
DC (January).
Inman, R. (2005). ‘Comment on Kane et al.’ Brookings-Wharton Papers on Urban
Affairs, 147–9.
Inman, R. (2008). ‘The Flypaper Effect.’ National Bureau of Economic Research
Working Paper 14579.
Joint Committee on Taxation, U.S. Congress (2013). ‘Estimates of Federal Tax
Expenditures for Fiscal Years 2012–2017.’ U.S. Government Printing Office 78-317,
Washington: 2013 JCS-1-UU13. Accessed January 15, 2019 at https://www.jct.gov/
publications.html?func=startdown&id=4504.
Joint Committee on Taxation, U.S. Congress (2018). ‘Estimates of Federal Tax
Expenditures for Fiscal Years 2017–2021.’ May. JCX-34-18.
Kaiser Commission on Medicaid and the Uninsured (2011). ‘Impact of the
Medicaid Fiscal Relief Provision in the American Recovery and Reinvestment
Act (ARRA).’ October. Accessed June 13, 2018 at http://www.kff.org/medicaid/
upload/8252.pdf.
Kane, T., P. Orszag and E. Apostolov (2005). ‘Higher Education Appropriations
and Public Universities: Role of Medicaid and the Business Cycle’. Brookings-
Wharton Papers on Urban Affairs, 99–146.
Keegan, N. (2012). ‘Federal Grants-in-Aid Administration: A Primer.’
Congressional Research Service, Report for Congress 7-5700. 3 October.
Knight, B. (2002). ‘Endogenous Federal Grants and Crowd-Out of State
Government Spending: Theory and Evidence from the Federal Highway Aid
Program.’ American Economic Review, 92 (1), 71–92.
Knight, B. (2005). ‘Estimating the Value of Proposal Power.’ American Economic
Review, 95 (5), 1639–52.
Ku, L. and T.A. Coughlin (1995). ‘Medicaid Disproportionate Share and Other
Special Financing Programs’. Health Care Financing Review, 16 (3), 27–54.
Leduc, S. and D. Wilson (2013). ‘Are State Governments Roadblocks to Federal
Stimulus? Evidence from Highway Grants in the 2009 Recovery Act.’ Federal
Reserve Bank of San Francisco, WP 2013-16.
Mallett, W. (2018). ‘Federal Public Transportation Program: In Brief.’ Congressional
Research Service. 30 April. Accessed February 12, 2019 at https://fas.org/sgp/crs/
misc/R42706.pdf.
Penner, R. (1979). ‘Reforming the Grants System.’ In Fiscal Federalism and Grants-
in-Aid, COUPE Papers on Public Economics 1, Peter Mieszkowski and William
Oakland (eds), 111–37. Washington, DC: The Urban Institute.
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Journal, 47 (1), 185–97.
Rudowitz, R., E. Hinon and L. Antonisse (2018). ‘Medicaid Enrollment and Spending
Growth: FY 2018 and 2019.’ Kaiser Family Foundation. Accessed February 14,

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 108 Intergovernmental transfers in federations

2019 at https://www.kff.org/medicaid/issue-brief/medicaid-enrollment-spending​
-growth-fy-2018-2019.
Sawicky, M. (2001). ‘An Ideal whose Time has Returned: Anti-Recession Fiscal
Assistance for State and Local Governments.’ Economic Policy Institute.
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uploads/2019/01/1-7-19b-Balance-of-Payments.pdf.
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Elementary-Secondary Education Finance Data, Table 1. Accessed February 15,
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Disparities across States, FY 2002.’ Urban Institute and the New England Public
Policy Center at the Federal Reserve Bank of Boston, Washington, DC.

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 7. 
Federal finance arrangements in
Canada: the challenges of fiscal
imbalance and natural resource
rents*
Marcelin Joanis and François Vaillancourt

INTRODUCTION

Federal arrangements in place at a point in time in a country are (given

preferences and technology) the result of five factors: geography, history,
demography, economics and politics. This chapter, which focuses on
the intergovernmental finance arrangements in Canada, presents in its
first part the key aspects of Canadian fiscal federalism. The second part
provides a critical overview of some of the changes in Canadian fiscal
federalism over the past three decades, with a focus on a debate on fiscal
imbalance in the 1995–2005 period that still resonates in 2019. The third
part focuses on current natural resources issues in Canadian federalism,
examining: (1) the treatment of natural resource rents in equalization; (2)
the difficulties over access to the sea for inland oil and gas; and (3) the
taxation of carbon. The second of these three items illustrates how geogra-
phy interacting with political agendas can create conflicts in a federation.
The third one examines interaction between multilevel taxation, regulation
of the environment and international environmental commitments; here
geography, economics and politics interact with a multi-generational
dimension in the background.

7.1 FISCAL FEDERALISM IN CANADA: A PRIMER

7.1.1 Demography, Economy and Institutions

Canada comprises ten provinces, three territories, numerous first nations

but no national capital territory. Appendix Table 7A.1 presents key

109

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 110 Intergovernmental transfers in federations

characteristics of these 13 subnational governments (SNGs). Provinces

account for 99 per cent of Canada’s population and have substantially
more autonomy than territories, especially in terms of financing.1 Thus,
throughout the chapter, we focus on the provinces.
Key facts (documented in Appendix Table 7A.1) about Canadian
provinces include:

●● Area-wise, Québec is the largest province followed by Ontario and

British Columbia (BC);
●● Population-wise, Ontario is the largest followed by Québec, with
BC and Alberta fairly similar afterwards. Population is older in the
Maritime provinces, Québec and BC;
●● Alberta has the highest gross domestic product (GDP) per capita,
almost twice that of Prince Edward Island (PEI). Petroleum produc-
tion is concentrated in Alberta; and
●● PEI is the province most dependent on federal transfers and BC, the
least.2

Two institutional features should also be noted. First, Canada has a bicam-
eral parliament but the appointed upper house (Senate) does not have the
role of representing the regions. Second, while English and French are the
official languages of Canada (Constitution Act of 1982), only 18 per cent
of Canadians know both languages.3 Francophones are concentrated in
Québec, creating two fairly distinct labour markets in Canada.4
We now turn to a description of the key fiscal federalism arrangements.

7.1.2 
Assignment of Spending/Regulatory Responsibilities and Taxation
Powers

In terms of responsibilities, the federal government has the standard sover-

eign functions of defence, foreign affairs and money and banking. It is also
responsible for telecommunications, broadcasting, non-road transporta-
tion, unemployment insurance, child benefits and old age pensions as well
as immigration and agriculture (jointly with provinces). Provinces provide
universal public health services, education, welfare, worker compensation
and roads. Municipalities provide local services such as fire protection,
roads, culture and sports, water and waste. Policing is provided by all three
levels of government.
Turning to taxation, the federal government and Canadian provinces are
constitutionally able to tax anything they want, except that international
and interprovincial trade is not taxable by provinces. Natural resource rents
are provincial revenues. Provinces can set their own tax base (­definition of

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 Federal finance arrangements in Canada ­111

income, exemptions, deductions and so on), their own rates and collect
their own taxes. In practice:

●● Nine provinces (not Québec) use the federal Canada Revenue

Agency (CRA) to collect their personal income tax (PIT), while eight
(not Québec or Alberta) use it to collect the corporate income tax
(CIT). To be able to use CRA services free of charge, provinces must
use the federal definition of income but can set their own brackets
(number, boundaries for the PIT) and their tax rates;5
●● Five provinces (not Québec, the Prairie provinces and BC) use the
services of the CRA to collect the Harmonized Sales Tax (HST),
a joint federal-provincial value added tax (VAT) that combines the
federal GST (Goods and Services Tax) and provincial taxes. Québec
collects its own sales tax and the GST on behalf of the federal
government.

7.1.3 Federal-Provincial Transfers

There are three major federal-provincial transfer programmes in Canada:

equalization and the Canada Health and Social Transfers. Before turn-
ing to these main transfers, let us note that there also exists a diverse
set of transfers that can be grouped under the label ‘small transfers’
(Vaillancourt, 2000).6 These transfers are conditional grants for specific
items such as social housing, agricultural income support and so on. Each
is subject to specific cost-sharing conditions.

7.1.3.1 Equalization
Equalization was introduced in 1957 to facilitate the reintroduction by
provinces of PIT, CIT and succession duties, levied by provinces before
World War II, but ‘rented out’ to the federal government to finance the war
effort. It is a Representative Tax System (RTS) formula with no needs or
cost indicators. The main aspects are as follows.

Legal From 1957 to 1982, the programme was supported solely by a

federal law. In 1982, as part of a package of constitutional changes, the
principle of equalization was included in the Constitution as follows:

Parliament and the government of Canada are committed to the principle

of making equalization payments to ensure that provincial governments have
sufficient revenues to provide reasonably comparable levels of public services at
reasonably comparable levels of taxation. (The 1982 Canada Constitution Act,
Section 36(2)7)

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 112 Intergovernmental transfers in federations

The envelope and the allocation criteria are specified in federal legisla-
tion. The equalization programme has been formally reviewed a few times
(Gilbert and Vaillancourt, 2007); the last time was in 2004–06 (Expert
Panel on Equalization and Territorial Formula Financing, 2006).

Funding Equalization in Canada is a vertical transfer, entirely funded

by the federal government from general revenues. Over the 1957–2019
period, the total amount of equalization has been most of the time deter-
mined as the sum of provincial entitlements. Thus, the allocation formula
has also been the envelope driver; this explains in part why it has been
changed several times over that period (Joanis, 2018). In some years an
aggregate amount (usually a cap, see below) has been implemented.

Allocation formula In general, the following is calculated for each of the

tax bases in the formula:

Right Fiscal capacity Fiscal capacity Average Population

5 ca standard 2 province j b * tax rate d * province j
province j

(7.1)

The sum of equalization rights for each of the sources gives the equaliza-
tion payment that province j is entitled to receive for a given year. Provinces
for which the formula yields a negative amount do not need to pay; they
simply do not receive any equalization, that is, Canada has a gross equali-
zation scheme.
The number of revenue sources included started at three in 1957 but
over time has increased to take into account all types of provincial revenues
(sales taxes, liquor revenues, gambling). Before 2007, equalization amounts
were calculated for each such source. Since then, five tax bases are used to
calculate equalization.
From 1957 until 1967, the fiscal capacity of the two richest provinces
(two out of Alberta, British Columbia and Ontario, varying over time) was
the standard except for 1962–63 (national average). In 1967, the standard
became the national average fiscal capacity. From 1982 to 2007, the stand-
ard was the average of five ‘representative provinces’ (Québec, Ontario,
Manitoba, Saskatchewan and British Columbia); in 2007, it reverted to
the national average.
Currently (2019), the total equalization payments are determined by the
following calculations:8

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 Federal finance arrangements in Canada ­113

1. 
Calculate the two-year lagged, three-year weighted average (50 per
cent weight for the nearest and 25 per cent for each of the two furthest)
of non-resource fiscal capacity;
2. Calculate the same for resource fiscal capacity;
3. 
Calculate the equalization entitlements as the highest for each province
with either zero or 50 per cent resource revenue inclusion;
4. 
Calculate the equalization of each province so that it does not exceed
the Fiscal Capacity Cap (FCC, discussed below); and
Adjust the payments to each province to account for an overall (total)
5. 
cap or floor on the sum of payments to provinces.

There can be important differences between the amounts calculated in step

(3) with or without including 50 per cent of resource revenues. For exam-
ple, Newfoundland is entitled to equalization with 0 per cent of resource
revenues included but not with 50 per cent.
The FCC is different from fiscal capacity for equalization (FCE); both
include 100 per cent of non-resource fiscal capacity (step 1 above) but FCE
adds only 50 per cent of resource capacity (step 2), while FCC adds 100 per
cent of resource capacity and equalization entitlements. The calculation of
the FCC depends on the share of the population that receives equalization
payments as follows:

1. 
When equalization-receiving provinces represent less than 50 per
cent of the Canadian population, the FCC is determined by the total
post-equalization per capita fiscal capacity of the lowest non-receiving
province (usually Ontario); or
When equalization-receiving provinces represent more than 50 per cent
2. 
of the Canadian population (which means Ontario is a receiving prov-
ince), the FCC is determined as the average total post-­equalization per
capita fiscal capacity of all equalization-receiving provinces.

Turning to step 5, the aggregate equalization amount (AEA) that is the

total cap or floor is set at $14,185 million for 2010–119 based on the total
produced by the pre-AEA formula for the preceding year and with indexa-
tion applied (Finance Canada, 2008a); it is then indexed to the average
growth of nominal GDP for the three calendar years preceding a fiscal
year.10
If the AEA is a cap, then the (federal) Minister shall determine the
per capita reduction for a fiscal year but if it is a floor there may be paid
to a province for that fiscal year an adjustment payment (underlined by
authors).11 From 2009 to 2018, the AEA acted as a cap on equalization
payments. For 2018–19 and 2019–20 it is acting as a floor. This ­possibility

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 114 Intergovernmental transfers in federations

was noted by Nadeau (2014), predicted by Eisen et al. (2017) and well
described by Tombe (2018b). Thus, in 2018–19, about 10 per cent of
equalization payments are due to the adjustment payment. Ontario
receives this payment even if it is not entitled to equalization since its total
fiscal capacity would be below that of any equalization-receiving province
without them, an upward adjustment based on the FCC concept. For
2019–20, this adjustment payment is only 2 per cent of equalization as
Ontario no longer receives it. The federal minister of finance does not
need to justify exceeding the floor; Tombe (2018b) argues that ‘whether
equalization does or doesn’t have a floor is ultimately a policy question
for the government’. It is also a political question; all receiving provinces
were given more than they would have received otherwise and thus none
complained.

7.1.3.2 Health and social transfers

History and legal aspects The CHT and the CST were established in 2004
(Finance Canada, 2014). They replaced the Canada Health and Social
Transfer (CHST) established in 1996, when the Established Programs
Financing (EPF) and the Canada Assistance Plan (CAP) transfers were
merged. The EPF had been created in 1977 as a block grant, replacing three
separate cost-sharing federal transfers: (1) Post-Secondary Education; (2)
Hospital Insurance and Diagnostic Services; and (3) Medical Care. The
CAP financed welfare on a 50-50 cost sharing basis. The amount (base
and growth) of the CHT and CST, both financed out of general federal
revenues, is decided unilaterally by the federal government. It has been
subject to various changes overtime.
The CHT requires the Medicare plan of a province to satisfy the
criteria of the Canada Health Act, which are: Public administration;
Comprehensiveness; Universality; Portability; Accessibility; Prohibition
of extra-billing and of user charges. Madore (2003) presents in detail
their exact meaning. Not respecting the prohibition requirement results
in a reduction in federal transfers equal to the amount thus collected.12
Provinces otherwise have great leeway in the organization, delivery and
type of services provided (Health Canada, 2015).

Financing Before 2014 the CHT resulted in a cash transfer to each prov-
ince, calculated according to the level of the national per capita transfer
set at the federal level, provincial population, and the value of tax points
transferred to provinces in 1977. The use of transferred tax points in cal-
culating cash transfers appears unique to Canadian fiscal federalism. Tax
points in lieu of cash transfers, while first used in 1960, became important

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 Federal finance arrangements in Canada ­115

in 1966 when Québec was allowed to opt/contract out of major federal

transfers, with the federal government reducing the amount of federal taxes
it collects in that province, thus allowing Québec to collect more provincial
PIT.13 Thus, tax points refer to the tax room (measured as a percentage of
taxable income) vacated by the federal government. Starting in 1977, the
federal government considered the value of these tax points to be federal
transfers, while the provinces treated them as own revenues. This created
confusion as to the value of federal financing of CHST programmes. Since
2007 for the CST (Gauthier, 2012) and 2014 for the CHT, per capita cash
transfers are the same for all provinces.

CHT calculations14 The Canada Health Transfer is currently calculated

in two parts:

1. 
Setting the size of the overall CHT envelope. The envelope was last
reset in dollar terms in 2005;15 it was indexed at 6 per cent per year
from 2006–07 until 2017–18. Starting in 2017–18, the total CHT
envelope grows in line with a three-year moving average of nominal
GDP growth, with a minimum annual growth of 3 per cent.
2. 
Allocating the envelope to each province. CHT is allocated on an equal
per capita basis across provinces.

CST calculations The Canada Social Transfer is calculated in two parts:

1. 
Setting the size of the overall CST envelope. The envelope was last
reset in dollar terms in 2009;16 it grows automatically by 3 per cent per
year.
2. 
Allocating the envelope to each province. The CST is allocated on an
equal per capita basis across all provinces.

7.1.4 Financial Flows

Table 7.1 presents the main financial indicators of relevance. It shows that:

●● Federal transfers to other levels of government (essentially prov-

inces) account for one-fifth of spending and of provincial revenues;
this is about 3 per cent of GDP; and
●● Equalization is about one-quarter of major transfers to provinces.
The biggest transfer is the CHT.

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YILMAZ_9781789900842_t.indd 116
Table 7.1 Federal government spending (total and by type) and provincial revenues, Canada, 2014–18

Year Transfers to Transfers Direct Total federal Provincial Federal Equalization CHT CST
persons as to other 1 debt spending revenues transfers as % ($000 000) ($000 000) ($000 000)
% of federal governments spending ($000 000) ($000 000) of provincial
spending as % of as % of revenues
federal federal
spending spending

116
2014–15 27.0 22.3 50.7 282 896 377 941 18.0 16 669 32 113 12 582
2015–16 27.8 22.1 50.1 298 314 385 695 19.0 17 341 34 026 12 959
2016–17 29.1 22.0 48.9 312 452 399 542 20.0 17 880 36 068 13 348
2017–18 28.2 21.2 50.6 332 567 422 459 19.0 18 254 37 150 13 748

Note: In Canadian dollars ($).

Source: Finance Canada, Fiscal Reference Tables 7, 8, 9, 11 and 31–32 (accessed 19 September 2019 at https://www.fin.gc.ca/frt-trf/2018/frt-trf-18-
eng.asp and accessed 19 September 2019 at https://www.fin.gc.ca/fedprov/mtp-eng.asp).

16/12/2019 10:44
 Federal finance arrangements in Canada ­117

7.2 
FISCAL IMBALANCE AND THE EVOLUTION
OF CANADA’S FEDERAL-PROVINCIAL FISCAL
ARRANGEMENTS17

The last three decades have seen a series of changes to Canada’s main
federal-provincial transfers, some of which were highlighted in the previ-
ous sections. This section provides a critical overview of some of these
developments.

7.2.1 The Fiscal Imbalance Debate in the Late 1990s and Early 2000s

The introduction in equalization calculations of the five-province standard

in 1982 and of a cap (new framework) on the total amount in 2004 were
aimed at reducing the programme costs. The introduction of the CHST
was accompanied by important (Laurent and Vaillancourt, 2004) unilateral
cuts in health and social transfers18 in the 1995 federal budget to facilitate
achieving a balanced federal budget. Provinces could, in various proportions,
reduce their spending, increase their taxes or borrow over the 1995–98 period.
Yet, a few years later new federal programmes were reintroduced in the social
policy field (Laurent and Vaillancourt, 2004) following the reappearance of
federal surpluses. A historical look at federal spending initiatives shows that
high federal revenues and potential surpluses are often accompanied by new
cost-shared programmes, while drops in federal revenues are accompanied by
cuts to the funding of these programmes leaving the provinces in the lurch.
Such changes led to the emergence of federal-provincial confrontation
on ‘fiscal imbalance’ in the federation. Provincial demands at the time were
reviewed by Quebec’s Commission on Fiscal Imbalance (CFI), also known
as the Séguin Commission.19
The CFI was mandated ‘to identify and analyze the basic causes of the
fiscal imbalance between the federal government and Québec’. Its final
report (CFI, 2002, p. vii) states that:

The fiscal imbalance between the government of Canada and the Québec
government and, more generally, between the federal government and the prov-
inces, stems essentially from three separate causes, namely imbalance between
spending and access to sources of revenue, the inadequacy of intergovernmental
transfers from the federal government to the provinces and the ‘federal spending
power’.

The main recommendations of the Séguin report were:

●● To address vertical fiscal imbalance, the replacement of the CHST by

a once-and-for-all tax-point transfer, either for the PIT or the GST;

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 118 Intergovernmental transfers in federations

●● To address horizontal fiscal imbalance, changes to the equalization

programme to make it a true RTS; and
●● Various changes to the institutional framework of the federal-
provincial fiscal arrangements, mainly to reduce the federal govern-
ment’s ability to make arbitrary changes.

These recommendations were guided by three ‘principles of fiscal balance’:

Accountability principle: each level of government must be account-

1. 
able to its electorate for the decisions taken in its own constitutional
fields of responsibility.
Fiscal capacity principle: each level of government must have the nec-
2. 
essary financial resources to fulfil its own constitutional expenditure
responsibilities.
3. 
Autonomy principle: each level of government must have the necessary
decisional and budgetary autonomy in its own fields of constitutional
responsibilities.

7.2.2 The Fiscal Arrangements after the Séguin Report

In 2004, the need was felt by both the federal government and the
provinces to rethink the equalization programme once more. Two reports
would eventually be produced, one by the Council of the Federation20 and
one by the federal department of Finance (the O’Brien taskforce).
The O’Brien report’s main recommendations, all pertaining to the
equalization programme, were:

●● To simplify the RTS by reducing the number of tax bases used in

calculating revenue capacity to five, one of which would be for
natural resources;
●● To adopt a ten-province standard; and
●● To set the inclusion rate of natural resource revenues at 50 per cent.

While the O’Brien and Séguin reports agree on the ten-province stand-
ard, the 50 per cent inclusion rate for natural resource revenues in the
O’Brien report can be seen as violation of the integral respect of the RTS
defended by the Séguin report. Respecting the RTS integrally would treat
all revenue sources in the same way and include them all fully (100 per
cent) in equalization calculations. Yet, it represented a compromise with
those advocating their full exclusion on the basis that natural resources
are provincially owned according to the Constitution and thus yield
private revenues.21 However, since 2007, provinces now receive the highest

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 Federal finance arrangements in Canada ­119

amount of equalization based on calculations using either 50 or 0 per cent

of natural resource revenues. This fulfils the Conservative Party’s electoral
promise to fully exclude natural resource revenues from the equalization
formula.
Looking back, we can examine how the system of federal-provincial
transfers meets the main recommendation of the CFI (Joanis, 2014):

1. 
Replacing the CHST by a transfer of tax points was not done; we now
have the CHT and the CST;22
2. 
Replacing the five-province standard by the national average in equali-
zation calculations is done;
3. 
Setting the total amount of equalization through the formula is not
done: floors and ceilings are in place;
4. 
Full inclusion of natural resources is not in place, in part because of
the Atlantic Accords (see Box 7.1); and
5. 
Unilateral changes in indicators can still be imposed by the federal
government.

Generally speaking, the recommendations of the CFI have not been

followed. In retrospect, it is interesting to note that issues pertaining to
natural resources were almost entirely absent from the CFI report with the
exception of a critique of the Atlantic accords. Since the most contentious
issues in Canadian federalism in 2018–19 pertain to natural resources, we
examine them in the next section.

7.3 
NATURAL RESOURCES AND FISCAL
FEDERALISM IN CANADA: CONTEMPORARY
ISSUES

Three contemporary issues dealing with natural resources will be addressed

here: (1) accounting for natural resource rents in equalization; (2) pipelines;
and (3) carbon taxation.

7.3.1 Hydroelectric Rent: A Dissipated Resource?

A first contentious issue has to do with the way in which the equalization
programme incorporates provincial revenues derived from various natural
revenues. Revenues are used for this tax base while taxable capacity is used
for the four other tax bases. Thus, there is a possibility of ‘dissipated rents’
for oil, natural gas and so on. However, the debate has focused on the
dissipated rents associated with hydroelectric production.

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 120 Intergovernmental transfers in federations

BOX 7.1 THE ATLANTIC ACCORDS

There are three agreements commonly referred to as the Atlantic Accords:

The 1985 Atlantic Accord with Newfoundland-and-Labrador(I);
The 1986 Offshore Petroleum Resources Accord with Nova Scotia(II); and
The 2005 Offshore Arrangements with both provinces(III).
The two goals of the Accords are:

● To allow these two provinces to tax offshore resources as if they owned them
(the federal government is the lawful owner); and
● To maintain for a set period, in whole or in part, equalization payments even
if taxable capacity has increased.

(I) provided Newfoundland-and-Labrador with transitional protection, for a 12-year

period beginning in 1999–2000, using a two-component formula:

● The offset floor component guarantees Newfoundland-and-Labrador a

certain percentage (at least 85 per cent) of its total equalization and offset
floor entitlement for the previous year; and
● The phase-out component provides additional protection against declines
in payments, by guaranteeing a certain percentage of year-over-year
declines in total equalization and offset floor payments. This percentage
gradually declines over the 12-year period.

(II) provided Nova Scotia with transitional protection, for a 10-year period begin-
ning in 1993–94, from reductions in equalization. A formula sheltered a declining
percentage of offshore revenues from equalization over a 10-year period. In 2004,
the government of Canada made payments to Nova Scotia to effectively reset the
start of the 1986 Accord payments.
(III) The two Accords provide:

● 100 per cent protection from equalization reductions resulting from the inclu-
sion of offshore revenues in the equalization programme for eight years
(from 2004–05 to 2011–12) as long as the province receives equalization;
● An upfront payment in 2005 of $2.0 billion to Newfoundland and $830 million
to Nova Scotia, made in 2005, to allow the province immediate flexibility to
address its unique fiscal challenges. This is a pre-payment in respect of the
new 100 per cent protection;
● In addition, this arrangement provides for a further eight-year extension if
the province receives equalization in 2010–11 or 2011–12 and its per
capita debt servicing charges have not become lower than that of at least
four other provinces;
● During the second eight-year period, if the province no longer qualifies for
equalization, it would receive transitional payments for two years: in the first
year, this payment would equal two-thirds of the offset payments and in the
second year one-third of the offset payments the province was entitled to the
last year it received equalization; and

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 Federal finance arrangements in Canada ­121

● The province could requalify for offsets and transitional payments if it again
became eligible to receive equalization payments.

In our opinion, two key items to note are:

● Upfront payments to allow the province immediate flexibility to address its

unique fiscal challenges (this is a pre-payment in respect of the new 100 per
cent protection); and
● The link between per capita debt service charges and the length of the
agreement.

Source: Authors, drawing on Finance Canada (2008b, 2008c).

The first proposal to account for these dissipated (uncollected) hydro-

electric rent for equalization purposes is by Zuker and Jenkins (1984).
They argue that: ‘Because the benefits of lower electricity rates arising
from low-cost hydro sites are not available to the residents of all provinces
[. . .] fiscal benefits arising from hydro-electric consumption should be
equalized in the same way as the benefits arising from the revenues on oil
and gas and other natural resources’ (p. 1). Courchene (2013, p. 10) takes
this up 30 years later: ‘it seems appropriate to act on the many recom-
mendations to bring hydro-electricity rents more fully and formally into
the equalization calculations for these provinces’. Feehan (2014, p. 18) also
argues for this.
What is the evidence on the geographic disparities of hydroelectric
rent? Line 13 of Appendix Table 7A.1 shows that the largest share of
hydroelectricity is produced in Québec, with BC the next largest producer.
Electricity prices are the lowest in Québec, followed by Manitoba and BC,
and highest in PEI, at 2.5 times that of Québec for residential consumers.23
In 2011 in Canada, 39 per cent of households use electricity as their main
energy source for heating; in Québec, it is 85 per cent and in Alberta, 9
per cent.24 So there is empirical support for rent dissipation occurring
unequally between provinces.
There are two issues to be addressed to include it in the equalization for-
mula. First, equalization in Canada is based on the RTS. ‘Representative’
is implemented as what is done by the provinces in various tax/revenue
fields. For instance, gambling revenues were added in the 1970s after gam-
bling became legal in Canada and provinces started offering various types
of gaming. In the case of hydroelectricity, it appears that the representative
behaviour of provinces is not to fully price hydroelectricity; why should a
different criterion be used for this revenue source? This would be a first in
Canadian equalization and would open the door to other ­judgement-laden

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 122 Intergovernmental transfers in federations

choices. What would prevent arguing that a province with a higher payoff
from gaming or lower markups from alcoholic beverages than other
provinces is subsidizing these purchases (dissipating potential revenues),
and therefore should see its taxable capacity adjusted upwards and its
equalization payments downwards?
Second, this would treat revenues derived from one natural resource dif-
ferently from all other resource revenues in the equalization formula, using
notional rather than real prices and revenues. The price to be used is not
always clearly stated by proponents of this approach, but Feehan (2014,
p. 18) argues that ‘the increased development of competitive wholesale
electricity markets in North America has resulted in prices that can serve
as indicators of the value of electricity [. . .]’. This would explicitly intro-
duce in the Canadian equalization formula American prices; we are not
aware of any national intergovernmental transfer formula, equalization or
other, which has as an explicit parameter a foreign value. If one examines
the pricing of provincial and foreign sales of electricity for the two largest
producers of hydroelectricity for 2015, one finds an average domestic price
per kilowatt of $0.064 for Québec and $0.094 for BC, while for exports one
finds $0.056 and $0.035. Thus, there is no dissipated rent when real prices
are used. One would also need to account for the fact that part of the
dissipated rent results in higher economic activity and higher consumption
of other goods and services that thus increase the tax base of dissipating
provinces.

7.3.2 Pipelines

Alberta is a landlocked province that historically sent its petroleum prod-

ucts to Canadian and US refineries. The emergence of US shale oil since
2000 has dampened the price of petroleum in the US, while constraints on
pipeline capacity have led to the use of rail shipping that is more expensive
than pipelines. As a consequence, the price of Western Canada Select
(WCS) is often lower than the West Texas Intermediate (WTI) price.25
Thus, there has been a demand by Alberta for new pipelines, a federal gov-
ernment responsibility when they cross provincial or international borders.
Three pipelines from Alberta to the sea shore were under discussion in
early 2015:

1. 
‘Northern Gateway’: a new pipeline in the North of BC was blocked
by the federal government in Fall 2016;
2. 
‘Trans Mountain’ pipeline (TMP): an expansion of an existing pipeline
in the south of BC was approved by the federal government in Fall
2016; and

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 Federal finance arrangements in Canada ­123

3. 
‘Energy East’: a new pipeline to Québec refineries and New
Brunswick was dropped by Trans Canada Pipeline (TCP) in Fall
2017. This was linked to the acceptance by the Trump administra-
tion of the TCP Keystone project to ship to the US, reversing an
Obama administration decision but Québec politicians were also
strongly opposed.26

The TMP pipeline approval was, however, just a starting point since build-
ing it has not begun as of May 2019.27
The 2015–19 pipeline debate in Canada has thus seen:

●● An attempt by one province, BC, to subvert federal powers on

pipelines28 through environmental regulations. In so far as the
environment is a shared policy field, provinces do have a role to play
in it but, in general, federal laws and regulations predominate given
the doctrine of paramountcy.29
●● An attempt by one province, BC, to obtain a share of natural
resource royalty revenues earned by another province, Alberta, in
exchange for a right of way for these resources. This was an unprec-
edented demand that was not acceded to and was abandoned. It
would erect barriers to trade that do not seem to fit within a federal
framework.
●● A law to reduce access by one province, BC, to the natural resources
of another one, Alberta. This law, entitled ‘Preserving Canada’s
Economic Prosperity’, would impose licencing requirements on
firms exporting oil from Alberta; these licences could be used to
deprive BC of oil and gasoline.
●● Some political posturing to link the receipt of equalization payments
to the approval of a pipeline. The Alberta government elected in
April 2019 proposes to hold a referendum in 2021 on equalization, a
constitutionally protected federal programme.

Overall, the Canadian federation has seen its degree of interregional

solidarity challenged by the pipeline debates of the 2015–19 period.

7.3.3 Carbon Taxation

In 2015, the federal government of Canada signed the Paris accord on

climate change.30 Since environmental policy is a shared jurisdiction in
Canada, its implementation is most easily attained by a combination of
federal and provincial policies. The Pan-Canadian Framework on Clean
Growth and Climate Change was adopted in December 2016. It states that:

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 124 Intergovernmental transfers in federations

The federal government outlined a benchmark for pricing carbon pollution by

2018 [. . .] The goal of this benchmark is to ensure that carbon pricing applies
to a broad set of emission sources throughout Canada and with increasing
­stringency over time either through a rising price or declining caps. The bench-
mark outlines that jurisdictions can implement (i) an explicit price-based system
(a carbon tax or a carbon levy and performance-based emissions system) or
(ii) a cap-and-trade system. (Environment and Climate Change Canada, 2016,
p. 7)

The federal benchmark comprises the following elements (p. 50):

●● ‘For jurisdictions with an explicit price-based system, the carbon

price should start at a minimum of $10 per tonne in 2018 and rise by
$10 per year to $50 per tonne in 2022’.
●● ‘Provinces with cap-and-trade need [a system] that correspond[s], at
a minimum, to the projected emissions reductions resulting from the
carbon price that year in price-based systems’.
●● ‘Revenues remain in the jurisdiction of origin. Each jurisdiction can
use carbon-pricing revenues according to their needs, including to
address impacts on vulnerable populations and sectors and to sup-
port climate change and clean growth goals’.

And, of particular importance, there is a federal backstop: ‘The federal

government will introduce an explicit price-based carbon pricing system
that will apply in jurisdictions that do not meet the benchmark. The federal
system will be consistent with the principles and will return revenues to the
jurisdiction of origin’.
Two provinces, Manitoba and Saskatchewan, refused to agree at that
time. But since then, Ontario in June 201831 (following the election of a
new government), Alberta in August 201832 (following the federal court
judgment stopping TMP) and Manitoba in October 201833 (a political
choice) have pulled out. As of 1 September 2019, the federal backstop thus
applies in six provinces: PEI (a provincial choice), New Brunswick (since its
provincial tax was deemed insufficient), Ontario, Manitoba, Saskatchewan
and Alberta.34 The money collected will be mainly (90 per cent) returned to
taxpayers of the province through the federal income tax system. For 2019,
this should be paid out in advance of collection since it will be returned
in the spring when tax returns for 2018 are finalized (Mertins-Kirkwood,
2018). The amount known as the ‘Climate Action Incentive Payments’ will
be the same for each household of a given size in a province but will vary
between provinces ($248 in New Brunswick to $598 in Saskatchewan on
average for 2019). It should, according to Finance Canada, on average
exceed the cost incurred by a household (Finance Canada, 2018).

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 Federal finance arrangements in Canada ­125

Saskatchewan, Ontario and Manitoba have all challenged the federal

law through a reference to their respective Court of Appeals35 as of 1 May
2019 with the Ontario and Saskatchewan courts deeming it constitutional
in their respective judgments.36
The federal climate policy was introduced in part to counterbalance the
approval of some pipelines. It is an innovative way to share a tax field,37
although there is a precedent for using the federal tax return to compensate
residents of specific provinces.38

7.4 CONCLUSION

This chapter has described key elements of the Canadian federation and
of its fiscal federalism arrangements, then focused on recent developments
related to natural resources. These developments reveal the political econ-
omy considerations that are at work in shaping the fiscal arrangements in
a country with important horizontal imbalances in resource endowments
across provinces.
Overall, the Canadian federal-provincial fiscal arrangements can be seen
as being the result of an ongoing trade-off between three oft-conflicting
objectives:

1. 
Respecting the equalization programme’s constitutional principle;
2. 
Ensuring the political acceptability of all transfer programmes; and
3. 
Respecting the federal government’s budget constraint.

Objective 1 implies no preferential treatment for natural resource revenues.

Objective 2 has tended in recent years to limit redistribution of these
revenues as a response to political considerations (mostly in the West).
Objective 3 adds an additional limit to redistribution when horizontal
fiscal imbalances become too important given the federal government’s
fiscal policy targets. The latter has arguably dominated the federal govern-
ment’s choices since the mid-1990s. With the centre of gravity of federal
politics having shifted westward over the last decade, objectives 2 and
3 have aligned themselves as forces acting towards limiting the extent
of redistribution through the equalization programme. In recent years,
the pursuit of these two objectives appears to have been instrumental in
weakening objective 1.
In sum, the main federal-provincial transfers in Canada achieve (limited)
redistribution across provinces. While the Constitution mandates the
federal government to provide equalization to ‘ensure that provincial
governments have sufficient revenues to provide reasonably comparable

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 126 Intergovernmental transfers in federations

levels of public services at reasonably comparable levels of taxation’, the

‘social’ transfers (CHT and CST) are essentially equal per capita across
provinces. Beyond redistribution, they do not achieve other equity or
efficiency related goals, nor do they take provincial needs into account.
In the case of Canada, one could see the age structure of the population
taken into account in equalization or, if not feasible, in the CHT as age
differences (Appendix Table 7A.1) are one driver of differences in spending
need between provinces.
Finally, we note that recent work by the Parliamentary Budget Office
(2018) shows that: ‘Current fiscal policy at the federal level is sustainable
over the long term [. . .] (while) for the subnational government sector
as a whole, current fiscal policy is not sustainable over the long term’
(p. 2). The fiscal imbalance that the CFI documented in the early 2000s
is thus alive and well as we enter the third decade of the twenty-first
century.

NOTES

* We thank the editors of this volume and Trevor Tombe for useful comments.
1. For more detail, see Finance Canada (2016a) and Finance Canada (2011).
2. Québec receives less cash transfer payments than other provinces as it occupies a
larger portion of the personal income tax field, under the ‘Québec abatement’ scheme.
Québec’s cash transfers are reduced dollar for dollar against the yield of these tax
points. This is worth about $4.5 billion for 2017 according to Finance Canada (2017).
For a general presentation of this, see Finance Canada (2016b).
3. Statistics Canada data: accessed 19 September 2019 at https://www12.statcan.gc.ca/
census-recensement/2016/dp-pd/hlt-fst/lang/Table.cfm?Lang=E&T=21&Geo=00.
4. Statistics Canada data (rounded numbers, mother tongue definition): accessed 19
September 2019 at https://www12.statcan.gc.ca/census-recensement/2016/dp-pd/hlt-fst/
lang/Table.cfm?Lang=E&T=11&Geo=00.
5. CRA collects fees for ‘non harmonized measures’, that is provincial measures that differ
from the federal ones. In 2017, CRA collected $112 million in fees from provinces and
$113 billion of provincial tax revenues. Thus, fees account for 0.1 per cent of provincial
revenues collected by CRA (Canada Revenue Agency (2018), pp. 26 and 30).
6. The total amount in 2017–18 was $9 billion according to the Public Accounts of
Canada 2017–18 (Government of Canada (2018), Section 6). We subtract the Finance
Canada amount from the total of transfers to obtain this number.
7. Enacted as Schedule B to the Canada Act 1982, (U.K.) 1982, c. 11, which came into
force on 17 April 1982. This is the last legal intervention by the United Kingdom
Parliament in the constitutional history of Canada. The first one was in 1867 (30 & 31
Victoria, c. 3. (U.K.)).
8. Following Tombe (2018a), we disaggregate step 1 from Nadeau (2014).
9. Paragraph 3.4(5) Federal-Provincial Fiscal Arrangements Act (R.S.C., 1985, c. F-8).
10. Fiscal year is 1 April–31 March for the federal and provincial governments in
Canada.
11. Ibid., sections (7) and (8) respectively.
12. Totalling $47.5 million over the 1984–2018 period (Health Canada, 2019, p. 30).
13. In operational terms, this means that Québec residents calculate federal income tax

YILMAZ_9781789900842_t.indd 126 16/12/2019 10:44

 Federal finance arrangements in Canada ­127

­ ayable like all other Canadians (same exemptions, deductions, rates and so on) but
p
reduce the amount of federal PIT to be paid by 16.5 per cent.
14. A historical perspective is found in Finances Québec (2017).
15. As follows: 24.1 (1) The Canada Health Transfer is to consist of a cash contribution
equal to $19 billion for the fiscal year beginning on 1 April 2005 (Federal-Provincial
Fiscal Arrangements Act (R.S.C., 1985, c. F-8), accessed 19 September 2019 at https://
laws-lois.justice.gc.ca/eng/acts/F-8/page-12.html#h-26).
16. Paragraph 24.4 (1) The Canada Social Transfer is to consist of a cash contribution
of $10.537 billion for the fiscal year beginning on 1 April 2008, and (2) the product
obtained by multiplying the cash contribution for the immediately preceding fiscal year
by 1.03, rounded to the nearest thousand, for each fiscal year beginning after 31 March
2009 (accessed 19 September 2019 at https://laws-lois.justice.gc.ca/eng/acts/F-8/page-13.
html#docCont).
17. This section and the conclusion are based on previously unpublished portions of the
working paper version of Joanis (2018), which appeared in the working paper series of
the School of Public Policy, University of Calgary (Joanis, 2014).
18. For more on the deficit-slaying 1995 budget, see Wobel (1995).
19. The Commission was presided over by Yves Séguin, who would go on to serve as
minister of finance in Jean Charest’s first (Liberal) cabinet. Though hardly an apolitical
exercise – it was commissioned by Bernard Landry’s Parti Québécois government – the
report was well received in provincial circles across the country and would be an impor-
tant building block of subsequent positions adopted by the Council of the Federation.
20. See http://www.canadaspremiers.ca/about/ (accessed 19 September 2019); this council
has no legal role in federal arrangements in Canada.
21. The O’Brien report reviewed a series of other arguments in favour of an intermediate
inclusion rate, including considerations related to the volatility of natural resource
revenues and to the disincentive effect of equalization’s ‘tax-back’ of revenues accruing
from the development of the natural resource industries.
22. While the recommendations of the Séguin Commission were not implemented as such,
the federal government reduced its GST rate from 7 per cent to 6 per cent then 5 per cent
in the 2007–08 period, Québec increased its Québec Sales Tax rate by these 2 percentage
points; it was the only province to occupy immediately this vacated tax room.
23. See Ontario Hydro (accessed 19 September 2019 at http://www.ontario-hydro.com/
electricity-rates-by-province) or Hydro-Québec (accessed 19 September 2019 at http://
www.hydroquebec.com/data/documents-donnees/pdf/comparison-electricity-prices.pdf).
24. Statistics Canada (2011).
25. Oil Pricing, accessed 19 September 2019 at https://www.nrcan.gc.ca/energy/oil-
sands/18087; for a calculation of lost revenues, see Aliakbari and Stedman (2018).
26. Media source: Warren Mabee, ‘What really Sank the Energy East Pipeline?’, Canada’s
National Observer, accessed 19 September 2019 at https://www.nationalobserver.com/​
2017/10/20/analysis/what-really-sank-energy-east-pipeline.
27. The saga is detailed here: CBC, Timeline: Key Dates in the History of the Trans Mountain
Pipeline, accessed 19 September 2019 at https://www.cbc.ca/news/canada/calgary/
timeline-key-dates-history-trans-mountain-pipeline-1.4849370.
28. Under the Canadian constitution, provincial powers include ‘92(10) Local Works and
Undertakings other than such as are of the following Classes: [. . .] other Works and
Undertakings [. . .] or extending beyond the Limits of the Province’.
29. See Surtees (2017) and Becklumb (2013).
30. Media source: CBC, Canada Will Meet Climate Targets despite Emissions Gap:
Environment Minister, accessed 19 September 2019 at https://www.cbc.ca/news/politics/
emissions-gap-mckenna-2030-target-1.4563801.
31. Media source: Catherine McKenna, ‘Ontario Cancelling Cap and Trade akin to Pulling
out of Climate Framework’, accessed 19 September 2019 at https://www.cbc.ca/news/
politics/ontario-federal-government-cap-trade-1.4734182.
32. Media source: CBC, ‘Alberta Makes it Official: Bill Passed and Proclaimed to Kill

YILMAZ_9781789900842_t.indd 127 16/12/2019 10:44

 128 Intergovernmental transfers in federations

Carbon Tax’, accessed 19 September 2019 at https://www.cbc.ca/news/canada/edmonton/

alberta-carbon-tax-repealed-1.5162899.
33. Media source: CBC, ‘We Say No’: Manitoba Defies Ottawa by Killing its Carbon Tax Plan,
accessed 19 September 2019 at https://www.cbc.ca/news/canada/manitoba/manitoba-car​
bon-tax-green-plan-1.4849128.
34. See Carbon Pricing in Canada, accessed 19 September 2019 at https://en.wikipedia.org/
wiki/Carbon_pricing_in_Canada.
35. Provincial governments in Canada can ask their top provincial court (Court of Appeals)
legal questions. In this case, the question is about the constitutionality of the federal law.
The federal government can do the same by referring to the Supreme Court. There is no
constitutional court or council in Canada to decide such questions.
36. Media source: CBC, Saskatchewan Premier Plans to Appeal Carbon Tax Decision
to Supreme Court, accessed 19 September 2019 at https://www.cbc.ca/news/canada/
saskatchewan/carbon-tax-saskatchewan-appeal-1.5121414.
37. Another innovative approach is the renting of the exclusive use of gambling taxation by
Canadian provinces through a joint payment by their lottery authorities to the federal
government (Desjardins et al., 2012).
38. The federal government did that in 1978 when different provinces cut sales taxes in
different ways. It sent a cheque to federal personal income tax filers residing in Québec
in 1977 as it deemed its type of tax cut (industry-focused) inappropriate and thus not
eligible for a revenue replacement payment to the provincial government (Dufour and
Vaillancourt, 1982).

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2017-18-qt2-eng.asp.
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Pricing System. Accessed 22 September 2019 at https://www.canada.ca/en/environ-
ment-climate-change/services/climate-change/pricing-pollution-how-it-will-work/
fall-2018-update-estimated-impacts-federal-pollution-pricing-system.html.
Finances Québec (2017). The Québec Economic Plan: Health Funding – For a Fair
Share of Federal Health Funding. Accessed 22 September 2019 at http://www.
budget.finances.gouv.qc.ca/budget/2017-2018/en/documents/Budget1718_Health.
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Gauthier, James (2012). ‘The Canada Social Transfer: Past, Present and Future
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/201248.
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et en France: mécanismes d’évaluation’, Revue française des finances publiques (99),

September, 75–92.
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vol3-eng.pdf.
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Solution to Political Impasse’, Behind the Numbers. Accessed 22 September 2019
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Territories’, Parliamentary Budget Office. Accessed 22 September 2019 at http://
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statcan/11-526-s/11-526-s2013002-eng.pdf.
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whos-the-boss-jurisdiction-over-the-environment-in-canada/.
Tombe, T. (2018a). ‘Final, Unalterable (and Up for Negotiation): Federal-Provincial
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1947–1998: évolution et évaluation’, in Les défis de la gouvernance à l’aube du XXIe

siècle, A. Downs and G. Paquet (eds), Montréal, Actes du Congrès 1999, ASDEQ,
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 132 Intergovernmental transfers in federations

APPENDIX
Table 7A.1 
Key demographic and economic characteristics of Canadian
provinces, 2015–17

Canada NFD PEI NS NB QUÉ

Area (km²) (1) 9 984 670 405 212 5 660 55 284 72 908 1 542 056
Population (‘000) 2016 (2) 35 152 520 143 924 747 8 164
Population density 2016 (3) 3.52 1.28 25.25 16.71 10.25 5.29
GDP ($000 000) 2017 (4) 2 137 528 33 074 6 652 42 715 36 088 417 173
GDP $ per capita 2017 (5) 60 809 63 639 46 548 46 248 48 304 51 097
Share of total area (%) (6) 100 4.1 0.1 0.6 0.7 15.4
Share of total (7) 100 1.5 0.4 2.6 2.1 23.2
population 2016 (%)
Share of total GDP (8) 100 1.5 0.3 2.0 1.7 19.5
2017 (%)
Share of total oil (9) 100 5.3 – – – –
production 2017 (%)
Provincial/territorial (10) ­– 7 079.00 1 897.00 11 528.00 9 492.00 111 470.00
 government revenues
($000 000) 2017
Share of federal (11) – 23.0 37.3 34.1 33.5 20.4
 transfers (grants) in
provincial/territorial
revenues (%) 2017
Median age 2012 (12) 40.0 44.2 42.6 43.4 43.4 41.5
Share of total (13) 100 9.1 0 0.2 0.7 51.5
 hydroelectric
production 2017 (%)

Note: NFDL: Newfoundland-and-Labrador; PEI: Prince Edward Island; NS: Nova

Scotia; QUÉ: Québec; ONT: Ontario; MAN: Manitoba; SASK: Saskatchewan; AL:
Alberta; BC: British Columbia; YU: Yukon; NO: Northwest territories; NU: Nunavut.

Sources:
1) https://en.wikipedia.org/wiki/List_of_Canadian_provinces_and_territories_by_area#​To​
tal_area (accessed 19 September 2019).
2) Statistics Canada Population by broad age groups and sex, 2016 counts for both sexes,
Canada, provinces and territories, 2016 Census – 100 per cent Data.
3) (2)/(1).
4) Statistics Canada. CANSIM Table 36-10-0222-01 Gross domestic product, expenditure-
based, provincial and territorial, annual.
5) (4)/(2).
6), 7) and 8) Calculations using (1), (2) and (4) as inputs.
9) https://www.nrcan.gc.ca/energy/facts/crude-oil/20064 (accessed 19 September 2019).
10) and 11) Statistics Canada. CANSIM Table 10-10-0017-01 Canadian government
finance statistics for the provincial and territorial governments.
12) Text table 2.1 Population estimates, age distribution and median age as of 1 July 2012,
Canada, provinces and territories Statistics Canada https://www150.statcan.gc.ca/n1/pu​
b/91-215-x/2012000/t583-eng.htm (accessed 19 September 2019).
13) Electric power, annual generation by class of producer Megawatt hours Annual
CANSIM Table: 25-10-0020-01.

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 Federal finance arrangements in Canada ­133

ONT MAN SASK ALTA BC YU NO NU

1 076 395 647 797 651 036 661 848 944 735 482 443 1 346 106 2 093 190
13 448 1 278 1 098 4 067 4 648 36 42 36
12.49 1.97 1.69 6.15 4.92 0.07 0.03 0.02
825 805 71 019 79 513 331 937 282 204 2 895 4 856 2 846
61 405 55 555 72 393 81 614 60 714 80 708 116 214 79 188
10.8 6.5 6.5 6.6 9.5 .8 13.5 21.0
38.3 3.6 3.1 11.6 13.2 0.1 0.1 0.1

38.6 3.3 3.7 15.5 13.2 0.1 0.2 0.1

– 0.9 11.7 80.7 1.4 – – –

140 816.00 15 482.00 14 090.00 44 990.00 51 179.00 1 298.00 2 112.00 2 069.00

17.3 26.0 17.5 16.1 16.8 84.0 74.0 80.9

39.8 37.6 37.1 36.1 41.4 39.4 32.1 24.7

10.2 9.2 0.9 0.5 17.5 0 0 0

YILMAZ_9781789900842_t.indd 133 16/12/2019 10:44

 8. 
Revenue and expenditure needs
equalization: the Swiss answer*
Bernard Dafflon

8.1 INSTITUTIONAL BACKGROUND

Constitutional and organizational requirements of the vertical and hori-

zontal equalization system in Switzerland are complex, with 26 cantons
and 2212 communes,1 where the population is unevenly distributed.2 This
complexity is mirrored in the public finance arrangements at the three
government tiers (federal, cantonal, communal).
At the federal level, the legislative branch is organized in two chambers.
The National Council has 200 members who represent the people. The
larger the number of Swiss citizens in a canton, the more representatives
it has in the National Council: from 35 representatives for the canton
of Zürich (ZH) to 1 only for six cantons – Appenzell Innerrhoden (AI),
Appenzell Ausserrhoden (AR), Glarus (GL), Nidwalden (NW), Obwalden
(OW) and Uri (UR). The Council of States has 46 members representing
all the cantons. Each canton has two representatives, except the half-
cantons (AI, AR, Basel-Landschaft (BL), Basel-Stadt (BS), NW, OW),
which have only one representative. Each canton decides how to elect its
representatives. Both chambers have equal political powers: any federal law
or decree must be accepted by a simple majority of votes in both chambers.
Thus, the cantons’ rights and prerogatives – including those of the smaller
ones – are well protected.
In vertical relations, the federal government, the ‘Confederation’, must
consider the possible consequences of its policy decisions on the cantons
(article 45 of the Federal Constitution – thereafter Cst.), as well as on com-
munes in the urban areas and in the mountainous regions (article 50 Cst.).
Also, when harmonized norms or standards for a particular public service
become a ‘nationwide’ issue, and in the absence of explicit constitutional
provision, it can be dealt with by the cantons, instead of an adoption by
the federal parliament (article 48 Cst.). Thus ‘nationwide’ norms are not
the same as ‘federal’ norms. There are multiple (horizontal) agreements
between the cantons (the so-called ‘concordats’). These agreements cover

134

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 Revenue and expenditure needs equalization ­135

the following areas according to article 48a of the Constitution: the execu-
tion of criminal penalties and measures; compulsory school education;3
cantonal institutions of higher education (professional universities of
applied sciences and universities); cultural institutions of supra-regional
importance; solid waste management; waste water treatment; urban trans-
port; advanced medical science and specialist clinics; institutions for the
rehabilitation and care of invalids.
In the Constitution, fiscal democracy is organized around five princi-
ples (article 43a Cst.): subsidiarity, autonomy, horizontal cooperation,
initiative and referendum. The principle of subsidiarity applies to both
institutional and functional aspects of intergovernmental design. First,
unspecified powers belong to the cantons: their fiscal sovereignty can only
be limited by specific provision written in the Federal Constitution (article
42 Cst.). Yet, any change in the Constitution has to be accepted by the two
federal chambers of equal power and requires a double majority of voters
and cantons. Local or cantonal responsibilities can only be transferred
to a higher level government if they require standardization to respond
to major changes in behaviour or technology: for example, mobility of
persons or economic activities, new technologies in the production and
delivery of public services, or when horizontal cooperation is no longer
feasible. Healthcare is a good example of this centralization trend.
When the Confederation prepares a new law or changes in the existing
federal legislation, or initiates projects of substantial territorial impact,
the cantons, political parties and interest groups are invited to express
their views (article 147 Cst.). The same applies at the cantonal-communal
level. The cantons have organized themselves horizontally in powerful
‘Conferences of Cantonal Ministers’, one for each sector. The Conferences
act as strong negotiating partners. They participate in joint committees
for proposing new federal policies and act as a partner with the federal
government in promoting public policies decided at the federal level but
implemented in and through the cantons. In public finance issues and
fiscal equalization, the Conference of the Cantonal Ministers of Finance
(the CCMF) plays a dominant role as no legislation would be adopted at
the federal level without its prior consent.
At the federal level, initiative and referenda are also important tools
of participative democracy, extensively used in public finance issues. Any
100,000 persons eligible to vote may, within 18 months of the official
publication of their initiative, request a partial revision of the Federal
Constitution in specific terms. Any parliamentary member, political group
or permanent committee or any canton can submit an initiative to the
Federal Assembly. Referendum is mandatory for an amendment to the
Federal Constitution, the accession to supranational organizations, and

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 136 Intergovernmental transfers in federations

emergency decrees that are not based on a provision of the Constitution

(duration is limited to one year). Optional referendum is possible on the
condition that, within 100 days of its official publication, any 50,000 per-
sons eligible to vote or any eight cantons should request it. A referendum
can be organized on federal laws and federal decrees if the Constitution
or a law so requires. Initiative and referenda also exist at the cantonal and
local levels, but procedures and content vary from one canton to another.
In this institutional context, equalization at the federal-cantonal level
needs a constitutional amendment approved by double majority – majority
of the cantons and the voters at the national level. In addition, it requires
an implementation law which is subject to a referendum with the simple
majority of voters (section 8.3 below).

8.2 OVERVIEW OF THE SWISS PUBLIC SECTOR

Quantitative measures of the Swiss public sector and social security are
summarized in Tables 8.1 to 8.3. Table 8.1 presents the tax revenues of
the three government levels (total I). The second part introduces the
social security system including the other compulsory insurances sourced
out to non-profit private companies (total II) or financial institutions
(pension funds, total III). In order to allow for international comparison,
the bottom part of the table gives the fiscal quotes of the three totals in
percentage of GDP.
Table 8.2 details the revenue sources for three levels of government. Year
2016 is fairly representative of the last decade (Dafflon, 2015a). Transfer
revenues received from other government levels are shown separately in
order to measure financial autonomy (own revenues). Direct taxation is
shared between the three tiers; in addition to their own direct taxes, the
cantons receive 17 per cent of the federal direct tax collected at the cantonal
level (Table 8.2: revenue sharing, 6 per cent of the total cantonal revenues).
Furthermore, 13 per cent of the federal direct tax is allocated to revenue
equalization. Value added tax (VAT), consumption and excise taxation are
exclusively federal taxes. User charges are cantonal in the health and educa-
tion sectors. User fees for environmental services (mandatory according to
the federal legislation) are levied by communes. Own revenues represent
100 per cent in the federal budget, 70 per cent on average for the cantons
and nearly 90 per cent for the communes. At the cantonal level, transfer
revenues from other levels of government are: 6 per cent revenue sharing
from federal taxes, 4 per cent from federal equalization, 13 per cent federal
subsidies and specific grants-in-aid, and 7 per cent are contributions of
communes for shared competencies; for the communes, less than 2 per cent

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 Revenue and expenditure needs equalization ­137

Table 8.1 
Tax revenues and compulsory social contributions on wages,
selected years, in per cent GDP

Revenues in millions CHF 2000 2005 2010 2015 2016

Confederation 46 492 47 494 58 700 63 949 63 942
Cantons 28 869 34 030 39 917 44 365 45 595
Communes 20 226 21 089 24 564 27 555 28 439
total I 95 587 102 613 123 181 135 868 137 976
Social security* and other 49 541 56 639 66 541 78 082 79 909
insurances** total II
Occupational pensions*** total III 29 499 35 721 46 336 54 316 54 525
GDP 459 447 508 900 608 831 654 258 660 393
Fiscal quote (in % of GDP) I 21 20 20 21 21
II 32 31 31 33 33
III 38 38 39 41 41

Notes:
* Only the employers’ and employees’ contributions levied on wages. Social security: old age,
disability, unemployment, maternity, social and military services.
** Individual insurance premium in other compulsory insurances: illness, accident, family care.
*** Compulsory additional old age pension schemes. This represented 76 per cent of the
total insurance finances in 2016 (176 736 millions CHF). Subsidies from the public sector
(15 per cent) are not included. The remaining 9 per cent are the interests and dividends from
the insurances’ capital (reserves and compensation funds).

Sources: Federal Finance Administration (FFA), https//:www.efv.admin.ch >

documentation > statistique financière > Données > tous les fichiers; updated 6 September
2018, access date 25 March 2019. For GDP: Federal State Secretariat for Economic Affairs
(SECO), https//:www.seco.admin.ch > Thèmes > Situation économique > PIB estimations,
access date 25 March 2019. Social insurances: CGAS14, https://www.bsv.admin.ch/bsv/fr/ho​
me/assurances-sociales/ueberblick/grsv/statistik.html, access date 25 March 2019.

of their revenues come from revenue sharing, 3 per cent from equalization
at the cantonal level and 7 per cent from cantonal grants and subsidies.
The modest proportion of equalization in cantonal and communal
resources can be explained by the long-term results of their public
finance: almost no deficit since 2000 and low indebtedness in international
comparison (less than 30 per cent GDP) (Dafflon, 2015a). Despite signifi-
cant differences in inter-cantonal or intra-cantonal resource endowments,
neither the cantons nor the communes can count on financial equalization
for the long-term sustainability of their public finances. Above all, equali-
zation reflects a political recognition of solidarity between and within
subnational government tiers rather than bailing out non-performing
subnational governments.
Table 8.3 summarizes the functional distribution of public expenditures

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 Table 8.2 Total revenues, 2016, three government levels

YILMAZ_9781789900842_t.indd 138
Confederation Cantons Communes Confederation Cantons Communes
Million CHF In % of total revenue
Direct personal taxes 10 599 31 913 21 741 15.3 36.5 45.9
Direct corporate taxes 10 532 7 770 4 456 15.2 8.9 9.4
Other direct taxes 5 893 3 611 2 137 8.5 4.1 4.5
Consumption taxes, VAT 35 699 0 0 51.5 0 0
Other consumption taxes 1 218 2 300 104 1.8 2.6 0.2
Total I tax revenues 63 942 45 595 28 439 92.2 52.2 60.0
(as in Table 8.1)
User charges 1 676 7 278 8 285 2.4 8.3 17.5

138
Patent, concession 601 1 637 358 0.9 1.9 0.8
Financial revenues, interest 1 324 2 827 3 170 1.9 3.2 6.7
Other revenues 603 1 200 245 0.9 1.4 0.5
Extraordinary revenues 1 221 2 606 1 383 1.8 3.0 2.9
Total II non-tax own revenues 5 425 15 547 13 441 7.8 17.8 28.4
Revenue sharing 0 5 066 759 0 5.8 1.6
Equalization 0 3 556 1 522 0 4.1 3.2
Federal transfers (vertical) 0 11 585 3 232 0 13.3 6.8
Contributions of communes 0 5 977 0 0 6.8 0
Total III transfer revenues 0 26 183 5 512 0 30.0 11.6
Total I 1 II 1 III 69 367 87 324 47 391 100.0 100.0 100.0

Source: FFA, www.efv.admin.ch > documentation > statistique financière > Rapport > tous les fichiers; updated 6 September 2018, access date
25 March 2019.

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 Table 8.3 Functional public expenditures, 2016, three government levels

Functions Confederation Cantons Communes Confederation Cantons Communes

YILMAZ_9781789900842_t.indd 139
Sub-functions Million CHF In % of total expenditures
Administration 6 079 4 413 5 051 9 5 11
Security, defence 5 820 7 897 3 070 9 9 6
Education 6 403 24 411 12 835 9 28 27
Compulsory education 17 9 476 12 418
Second level education, 768 5 770 343
Tertiary education 2 640 7 300 20
Research 2 970 1 351 2
Other 8 514 52
Culture, sports, leisure 518 1 799 3 380 1 2 7

139
Health 322 12 665 2 030 0 15 4
Hospital, homes for elderly 0 10 629 1 214
Outpatient medical care 0 726 515
R&D, other 322 1’310 301
Social security, social aid 22 694 18 841 9 109 34 22 19
Illness and accident 2 866 4 554 585
Disability 5 460 4 575 961
Old age and widowhood 11 808 2 921 1 458
Family and children 165 1 362 1 449
Unemployment 518 803 180
Social housing 69 112 68
Social aid and refugees 1 804 4 482 4 381
Others 4 32 27
Roads, traffic and telecom 9 209 6 123 4 472 14 7 9

16/12/2019 10:44
YILMAZ_9781789900842_t.indd 140
Table 8.3 (continued)

Functions Confederation Cantons Communes Confederation Cantons Communes

Sub-functions Million CHF In % of total expenditures
Environment 1 032 1 483 4 339 2 2 9
Economy 5 504 4 530 1 546 8 5 3
Finance, taxation 9 914 3 921 1 903 15 5 4

140
Tax administration 185 445 248
Equalization 3 246 1 530 369
Revenue sharing 4 212 759 0
Interest and cost of debt 1 512 902 1 211
Others 759 285 75
Total 67 495 86 083 47 735 100 100 100

Source: FFA, https//:www.efv.admin.ch > documentation > statistique financière > Rapport > tous les fichiers; updated 6 September 2018, access
date 25 March 2019.

16/12/2019 10:44
 Revenue and expenditure needs equalization ­141

at different government levels; 2016 serves as the reference year. The mili-
tary and civil defence are federal responsibilities; security and police forces
are cantonal; neighbourhood policing and market policing are communal.
Compulsory school education is a shared responsibility of the cantons
and communes, but education programmes and teachers’ training are
harmonized through an inter-cantonal agreement (see note 3). The can-
tons finance tertiary education (universities). The Confederation finances
the two federal polytechnic universities – in Lausanne and Zürich (92 per
cent), the Swiss National Science Foundation (100 per cent) and subsidizes
the cantonal universities (25 per cent). It also subsidizes student grants and
mobility within European universities. Expenditures in culture, sport and
leisure are communal responsibilities. Health is a cantonal responsibility.
Homes for the elderly are partly subsidized by communes; sickness and
disability insurances (not included in government expenditures – see Table
8.1) pay medical care; residents pay the accommodation from their pocket.
Social security is federal responsibility, whereas social aid and assistance
are shared between the cantons and their communes. Motorways, railway
traffic and telecom are federal responsibilities; roads are cantonal or com-
munal; urban traffic and public transportation are mainly inter-communal.
Environmental policies provide an interesting case of shared responsibili-
ties: the norms and policy objectives are set in federal laws; coordination
and planning are left to the cantons; implementation, investments and
current management are communal responsibilities. Environmental expen-
ditures for solid waste collection and treatment, wastewater and water
management are financed through local user charges. As for the govern-
ment function ‘finance and taxation’, the majority of spending at the
federal level is for the financial transfers to the cantons in revenue sharing
and for equalization. Categorical incentive grants are accounted in the
relevant functions, not under the finance heading.
Table 8.3 is informative about the links that could exist between the
relative importance of the various functions and the indicators used in
expenditure equalization to evaluate disparities in needs or costs. At the
cantonal level, expenditures in education, social security and aid, and
health are the three domains which require the most resources. In the case
of expenditure equalization, three socio-demographic indicators only (pov-
erty, old age and foreigners – Tables 8.5 and 8.8) refer to sub-functions in
Table 8.3 (homes for the elderly, social aid and refugees). The other health
and social security expenditures are not included: the reason is that their
main financial sources come from contributors outside of the government
sector. Government contributions (federal, cantonal and/or communal)
take the form of specific (conditional) grants-in-aids that benefit individu-
als or institutions and not the cantons as such. Education also is left out

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 142 Intergovernmental transfers in federations

of the equalization scheme between the Confederation and the cantons.

The reason is that the cantons only are in charge of compulsory education,
whereas cantonal tertiary education expenditures are subsidized by the
Confederation outside of equalization. Thus, as explained below, the link
between functional cantonal expenditures and the federal expenditure
equalization scheme is rather diluted.

8.3 EQUALIZATION

8.3.1 The Historical Context

In 1959, the federal parliament introduced the first formula-based equali-

zation system between the Confederation and the cantons. The cantons
were ranked from ‘rich’ to ‘poor’ according to their ‘fiscal capacity’. Over
the years, the formulas combined several indicators of the cantons’ tax
capacity and of expenditure needs in various proportions (Dafflon, 1995:
66 and 70). The revenue equalization scheme contained the distribution of
13 per cent of the Federal Direct Tax (on personal income and business
profit) according to the fiscal capacity and, as an additional indicator,
the inverse of the cantons’ fiscal effort (depending on the canton’s tax
bases – the tax rates needed to obtain the same per capita average tax
revenue). Expenditure needs equalization was organized separately, using
specific indicators for each category of functions (eventually 58 functions
were partly ‘equalized’ in one way or another). Between 1959 and 1992,
the equalization system was modified ten times with regards to both
measurement variables and equalization formulas. Throughout the years,
the system became technically complex, politically infeasible, incoherent
and promoting wrong incentives, with poor equalizing performance (Frey
et al., 1994; Dafflon and Della Santa, 1995; Federal Council, 2001).
The reform of the equalization system was a painful process. A new law
was adopted in the federal parliament in October 2003, after ten years of
contentious discussions (Dafflon, 2004; Federal Council, 2014). For several
years, a group of experts, later a joint commission of cantonal representa-
tives and the Confederation analysed various proposals and scenarios.
The discussions focused not only on the objectives of equalization (how
many fiscal disparities should be compensated), and the respective weights
between revenue equalization and expenditure needs (which functions
would be recognized and how needs would be measured), but also on the
methodology (which variables would be the best indicators of disparities)
and the ways of funding equalization (vertical-horizontal mix and the cost
sharing between the Confederation and the cantons).

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 Revenue and expenditure needs equalization ­143

BOX 8.1 
EQUALIZATION OF FINANCIAL RESOURCES AND
BURDENS (ARTICLE 135 CST.)

1. 
The Confederation shall issue regulations on the equitable equalization of
financial resources and burdens between the Confederation and the cantons
as well as among the cantons.
2. 
The equalization of financial resources and burdens is intended in particular
to:
a. reduce the differences in financial capacity among the cantons;
b. guarantee the cantons a minimum level of financial resources;
c. compensate for excessive financial burdens on individual cantons due to
geo-topographic or socio-demographic factors;
d. encourage inter-cantonal cooperation on burden equalization;
e. maintain the tax competitiveness of the cantons by national and interna-
tional comparison.
3. 
The funds for the equalization of financial resources shall be provided by those
cantons with a higher level of resources and by the Confederation. The pay-
ments made by those cantons with a higher level of resources shall amount to
a minimum of two-thirds and a maximum of 80 per cent of the payments made
by the Confederation.

Source: https://www.admin.ch/opc/en/classified-compilation/19995395/index.html.

The constitutional amendment on equalization (article 135 Cst.) and

the ‘re-assignment of functions between the federal and cantonal tiers’
were voted on in 2004 and accepted by 23 cantons,4 and by 64 per cent of
the voters. It came into effect on 1 January 2008 together with the federal
law of 12 October 2003 on equalization and the reassignment of functions
between the Confederation and the cantons, thereby fulfilling the consti-
tutional amendment.5
The new system comprises of three components: (1) revenue equali-
zation; (2) expenditure needs equalization – the latter divided in two
equal parts, one taking into account socio-demographic, the other geo-
topographic variables; and (3) a transition fund.
Box 8.1 presents article 135 of the Federal Constitution related to
equalization. And based on the 2003 federal law, Figure 8.1 presents the
actual architecture of the Swiss equalization policy at the federal-cantonal
level.

8.3.2 Revenue Equalization

The constitutional objectives of revenue equalization are to: (1) reduce

the differences in financial capacity among the cantons; and (2)

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 144 Intergovernmental transfers in federations

Confederation

2423 million CHF 718 million CHF 198 million CHF

revenue equalization expenditure needs equalization transition fund

vertical horizontal vertical vertical horizontal

4074 1651 359 359 297 99

millions CHF millions CHF millions CHF millions CHF millions CHF millions CHF

cantons cantons in
cantons with geo- socio-
with high need of all other
low financial topographic demographic
financial transitory cantons
capacity variables variables
capacity adjustment

AG, AI, AR, BS, GE, NW, AI, AR, BE, BE, BS, GE, BE, FR, GL, AG, AI, AR,
BE, BL, FR, OW, SZ, ZG, FR, GL, GR, JU, SH, SO, JU, LU, NE BL, BS, GE,
GL, GR, JU, ZH JU, LU, NE, TI, VD, VS, GR, NW,
LU, NE, SG, NW, OW, ZH OW, SG, SH,
SH, SO, TG, SG, SZ, TG, SO, SZ, TG,
TI, UR, VD, TI, UR, VD, TI, UR, VD,
VS VS VS, ZG, ZH

Note: AG: Aargau; AI: Appenzell Innerrhoden; AR: Appenzell Ausserrhoden; BE: Bern;
BL: Basel-Landschaft; BS: Basel-Stadt; FR: Fribourg; GE: Genève; GL: Glarus; GR:
Graubünden; JU: Jura; LU: Luzern; NE: Neuchâtel; NW: Nidwalden; OW: Obwalden; SG:
Sankt-Gallen; SH: Schaffhausen; SO: Solothurn; SZ: Schwyz; TG: Thurgau; TI: Ticino;
UR: Uri; VD: Vaud; VS: Valais; ZG: Zug; ZH: Zürich.

Source: Authors, adapted from FFA, https://www.efv.admin.ch/efv/fr/home/themen/finanz​

ausgleich/zahlen.html, access date 9 March 2019.

Figure 8.1 Fiscal equalization, Switzerland, 2018, million CHF

­ uarantee cantons a minimum level of financial resources. Article 6 of

g
the 2003 implementation law fixed this minimum level at 85 per cent of
the average per capita resource after revenue equalization. The result is
expressed in the cantonal indices of financial capacities (average at 100
per cent).
Revenue equalization combines vertical and horizontal transfer pay-
ments. The federal contribution corresponds to approximately 13 per cent
of the federal direct tax yield. This is in line with the spirit of the 1992
reform of the first equalization system.6 During the 1992 reforms, the
federal contribution is not provided for in the Constitution or the law.
With the enactment of the 2008 equalization law, the federal parliament
is mandated to decide the federal contribution to revenue equalization for
four years. Within these four years, the total amount (contributions of the

YILMAZ_9781789900842_t.indd 144 16/12/2019 10:44

 Revenue and expenditure needs equalization ­145

Confederation and the cantons) is indexed to an average annual growth

rate of direct taxation (article 5 of the law). For the 2018 reform, the
contributions of the seven cantons with a ‘resource potential’ higher than
the average correspond to 68 per cent of the federal allotment – that is just
above the minimum threshold of two-thirds written in article 135 of the
Federal Constitution.
The cantons’ financial capacities or ‘resource potential’ are measured
in the form of a representative tax system (RTS) based on four taxes: (1)
personal income tax; (2) wealth tax; (3) corporate profit tax; and (4) profit
tax on holding, domicile and mix companies.
Seven cantons with financial capacity higher than the national average
contribute to the revenue equalization pool out of their general budget
(that is, horizontal revenue equalization) in addition to the contribution
of the Confederation (that is, vertical revenue equalization). Conversely,
19 cantons with financial capacity lower than average obtain benefits
from the equalization fund. The distribution formula, calculated per
capita, is strictly proportional. The outcomes of the 2018 reforms
are summarized in Table 8.4. ‘Cantonal contributions’ correspond to
horizontal revenue equalization, while the amount of vertical revenue
equalization supported by the federal government is equal to the dif-
ference between the total contributions paid (4074 millions CHF) and
the horizontal contributions (1651 millions CHF). The equalization
performance is measured in terms of the differences in the cantonal
indices of financial capacity before and after equalization. The required
minimum threshold of 85 per cent has been respected for the fourth
consecutive year in 2018, with a top 88.3 per cent reached in the cantons
Uri, Valais and Jura.

8.3.3 Expenditure Needs Equalization

The constitutional objective of expenditure needs equalization is to

compensate for excessive financial burdens on individual cantons resulting
from geo-topographical or socio-demographic factors. Ex ante, three
questions should be answered: (1) Which functions/tasks should be subject
to equalization based on the definition of need (5 minimum level of
service, observed level including political preferences)? (2) What are the
suitable determinants/explanatory variables? (3) Should ‘low need’ cantons
participate in financing the equalization fund?
In the Swiss context, expenditure needs equalization is exclusively verti-
cal (Figure 8.1).7 The theoretical argument is that with horizontal equaliza-
tion beneficiaries of services in low-costs-low-needs jurisdictions accept a
tax-price supplement (that is, more expensive public services) in order to

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 146 Intergovernmental transfers in federations

Table 8.4 Revenue equalization in the cantons (2018)

Canton Index of Financial Beneficiary Canton Cantonal

Capacity Before and After in CHF Contributions
Equalization in CHF
Before After Difference Total Per Total Per
capita capita
Zürich 120.2 116.0 24.2 0 0 525 847 071 367
Bern 75.2 88.9 13.7 1 201 650 040 1 196 0 0
Luzern 89.5 93.2 3.7 126 654 780 324 0 0
Uri 68.2 88.3 20.1 63 296 476 1 748 0 0
Schwyz 172.1 157.0 215.1 0 0 199 037 438 1 310
Obwalden 102.4 101.9 20.5 0 0 1 587 890 43
Nidwalden 159.7 147.2 212.5 0 0 45 615 981 1 085
Glarus 71.2 88.5 17.3 60 261 578 1 502 0 0
Zug 244.1 214.0 230.1 0 0 311 423 696 2 618
Fribourg 79.5 89.8 10.3 264 763 179 893 0 0
Solothurn 74.6 88.9 14.3 324 380 883 1 237 0 0
Basel-Stadt 149.7 139.3 210.4 0 0 172 968 585 902
Basel-Landschaft 96.5 97.2 0.7 16 767 941 60 0 0
Schaffhausen 93.0 95.0 2.0 13 618 648 172 0 0
Appenzell 85.6 91.6 6.0 28 162 452 523 0 0
Ausserrhoden
Appenzell 85.2 91.5 6.3 8 577 481 542 0 0
Innerrhoden
Sankt Gallen 79.2 89.7 10.5 451 072 450 915 0 0
Graubünden 83.2 90.8 7.6 133 867 315 660 0 0
Aargau 85.3 91.5 6.2 342 773 344 538 0 0
Thurgau 79.0 89.7 10.7 241 513 997 927 0 0
Ticino 97.4 97.8 0.4 13 333 153 38 0 0
Vaud 99.6 99.7 0.1 1 442 779 2 0 0
Valais 66.8 88.3 21.5 620 152 410 1 864 0 0
Neuchâtel 94.3 95.7 1.4 22 680 399 128 0 0
Genève 146.1 136.5 29.6 0 0 394 228 249 837
Jura 65.9 88.3 22.4 139 098 196 1 938 0 0
Total 100.0 100.0 0.0 4 074 067 501 1 650 708 910

Source: Author, from FFA, https://www.efv.admin.ch/efv/fr/home/themen/finanzausgleich/

zahlen.htm, access date 25 March 2019.

subsidize public services in high-costs-high-needs jurisdictions: this would

distort the relative tax prices of subnational public services and result in
allocative inefficiency and wrong incentives in deciding service levels.
The practical arguments pertain to uncertainty about the government
functions to be included in the equalization basket as well as the absence
of solid and verifiable statistical information about differences in costs/

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 Revenue and expenditure needs equalization ­147

needs of the selected functions (Federal Council, 2001). In order to cir-

cumvent these difficulties, the equalization programme is based on selected
socio-demographic and topo-geographic determinants and explanatory
variables which are deemed to express, respectively quantify, differences in
cantonal needs. Table 8.5 summarizes this approach.
In Table 8.5, the weights in italics, which are situated in the last column
relating to the needs categories, are a result of an intense bargaining
between the Confederation and the cantons. First, the equalization
funds attributed to geo-topographic and socio-demographic needs were
partitioned in half (Figure 8.1) even though about 84 per cent of the
population live in urban areas (geographically, the ‘plateau suisse’,
which represents 41 per cent of the national territory, is distinct from
the mountainous areas: Jura, Prealpes and Alpes). Second, the weights
given to the geo-topographic variables were negotiated with the cantons
before the federal vote in 2004 (Federal Council, 2001) after which they
were written in the 2007 implementation decree. Third, the two-thirds/
one-third partition of the amount attributed to the socio-demographic
and urban areas variables were also negotiated. Fourth and finally, the
weights attributed to each determinant in parts (1) and (2) of the socio-
demographic category in Table 8.5 were computed with the principal
component analysis (PCA) technique. These weights are updated yearly.
The expenditure needs equalization calculations for 2018 are presented
in Table 8.6.

8.3.4 The Transition Fund

A transition fund was established in order to support financially weak

cantons in transitioning from the old system to the new fiscal equalization
system. In 2000, a financial simulation of the new revenue equalization
estimated that eight cantons would suffer losses in revenue transfers. This
was politically unacceptable and the affected cantons strongly protested. A
new ad hoc fund was then invented so that the whole project would not be
jeopardized (Dafflon, 2004).
The transitory fund is only of benefit to those cantons with a resource
index lower than 100 with the introduction of the new revenue equaliza-
tion scheme in 2008. If, subsequently, a canton’s index of financial
capacity increases to over 100, the canton will be pushed out of the fund
and there is no return back. If a canton faces a decrease in its financial
capacity and passes under the 100 mark, it will not get any payment either.
So, the number of beneficiary cantons should decrease over time. The
Confederation finances two-thirds of this compensation, and the remain-
der comes from the cantons (based on their population sizes). The initial

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 148 Intergovernmental transfers in federations

Table 8.5 System of expenditure needs equalization, 2018

Needs categories Objective Determinant Explanatory variable Weight*

Geo-topographic Compensate for Altitude % of population 0.330
excessive financial living above 800 m.
burdens due to alt.
geo-topographical Remoteness % of productive land 0.330
factors, mainly . 1080 m. alt.
in the Alps and Smallness Population density 0.165
mountainous Population in 0.165
regions commune with less
than 200 residents
Socio- (1) Compensate For 2/3
demographic for excessive Poverty % beneficiaries 0.55**
financial burdens of social aid to
of individual population
cantons due Old age % of aged . 80 to 0.27**
to some population
characteristics Foreigners % of foreigners of 0.44**
of the resident (not including population
population those from
neighbouring
countries)
(2) Problems For 1/3
specific to Public security Population size of 0.47**
agglomeration and order the municipalities
and urban areas Urban traffic, Number of 0.49**
congestion employments
costs, (equivalent full-time
job places) and
resident population
in proportion to
urban surface
Commuters, Number of 0.34**
urban public employments in
transportation proportion to
resident population
Transition fund Facilitate the Difference Difference paid in proportion to
transition from between the available fund. If for one canton
the old (pre-2008) old and new the difference reduces, the
to the new (2008) system in its compensation is also reduced in
system so that first year of proportion. The total available
beneficiary introduction fund is further reduced by 5% a
cantons in the old year from 2016 onwards
system receive
at least the same
amount in the
new system

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 Revenue and expenditure needs equalization ­149

Table 8.5 (continued)

Notes:
* Weights: fixed (arts 32 and 39).
** Calculation according to the principal component analysis (arts 35 and 37).

Source: Author, adapted from federal ordinance of 11 November 2007 on revenue

equalization and the compensation of excessive financial burden of the cantons, https://www.
admin.ch/opc/fr/classified-compilation/20071271/index.html, access date 14 April 2019.

Table 8.6 Expenditure needs equalization in the cantons, 2018, in CHF

Geo-topographic Socio-demographic Urban areas

Index Beneficiary Index Beneficiary Index Beneficiary
Zürich 32 0 0.17 15 929 418 6.250 65 117 655
Bern 125 27 010 038 0.20 12 530 321 1.620 0
Luzern 81 6 087 983 20.48 0 1.480 0
Uri 274 11 544 271 20.79 0 0.070 0
Schwyz 160 6 725 582 21.03 0 0.440 0
Obwalden 204 6 253 820 21.01 0 0.100 0
Nidwalden 97 1 257 137 21.24 0 0.210 0
Glarus 151 5 331 790 20.13 0 0.370 0
Zug 67 0 20.27 0 1.520 0
Fribourg 133 8 895 845 20.30 0 0.630 0
Solothurn 42 0 0.23 3 886 535 0.480 0
Basel-Stadt 12 0 2.74 33 137 831 11.550 18 306 193
Basel-Landschaft 32 0 20.03 0 0.900 0
Schaffhausen 41 0 0.25 1 250 353 0.890 0
Appenzell 357 19 206 007 20.66 0 0.150 0
Ausserrhoden
Appenzell 409 8 261 698 21.04 0 0.000 0
Innerrhoden
Sankt Gallen 84 1 878 595 20.46 0 1.130 0
Graubünden 451 136 826 831 20.54 0 0.450 0
Aargau 34 0 20.70 0 0.460 0
Thurgau 59 3 885 043 20.93 0 0.420 0
Ticino 98 14 241 864 0.81 17 978 771 1.080 0
Vaud 91 67 687 1.32 64 414 012 2.120 3 636 461
Valais 283 73 343 364 0.28 5 935 792 0.330 0
Neuchâtel 247 23 361 591 1.30 14 563 925 1.068 0
Genève 23 0 2.27 69 387 134 8.617 32 584 693
Jura 165 4 755 858 0.06 275 911 0.102 0
Total 100 358 935 004 239 290 003 119 645 001

Source: Authors, from FFA, https://www.efv.admin.ch/efv/fr/home/themen/finanzausgle​

ich/zahlen.htm, access date 14 April 2019.

YILMAZ_9781789900842_t.indd 149 16/12/2019 10:44

 150 Intergovernmental transfers in federations

amount fixed in 2008 was 430 million CHF, which was financed by the
Confederation (287 million CHF) and the cantons (143 million CHF). It
has been reduced by 5 per cent each year since 2016. In 2018, the contribu-
tions were reduced to 297 million CHF, indicated by Table 8.7.

Table 8.7 Transition fund, 2018, in CHF

Cantonal Cantons Net benefit

contributions beneficiary
Zürich 16 760 670 0
Bern 13 077 544 44 314 461 31 236 917
Luzern 4 741 614 20 138 259 15 396 645
Uri 475 311 0
Schwyz 1 754 716 0
Obwalden 441 586 0
Nidwalden 506 482 0
Glarus 526 132 6 943 444 6 417 312
Zug 1 347 339 0
Fribourg 3 255 796 116 688 025 113 432 229
Solothurn 3 330 464 0
Basel-Stadt 2 642 180 0
Bâle-Landschaft 3 529 277 0
Schaffhausen 1 005 998 0
Appenzell Ausserrhoden 732 973 0
Appenzell Innerrhoden 200 891 0
Sankt Gallen 6 156 013 0
Graubünden 2 588 864 0
Aargau 7 421 412 0
Thurgau 3 122 485 0
Tessin 4 214 666 0
Vaud 8 624 064 0
Valais 3 748 313 0
Neuchâtel 2 287 622 92 507 817 90 220 195
Genève 5 604 492 0
Jura 926 905 16 479 421 15 552 516
Total I 99 023 809 297 071 427 272 255 814
Confederation 198 047 618
Total II 297 071 427
Economies of the beneficiary 24 815 613
cantons
Net contribution of the cantons 74 208 618

Source: Author, from FFA, https://www.efv.admin.ch/efv/fr/home/themen/finanzausgleich/

zahlen.htm, access date 14 April 2019.

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 Revenue and expenditure needs equalization ­151

8.4 PERFORMANCE ANALYSIS

According to the equalization law (article 18), the federal government must
evaluate the performance of the equalization system and its effect on the
reduction of disparities between the cantons every four years. The federal
legislation describes, in detail, the objectives, items and instruments of this
evaluation.8 Three reports have been published for the periods of 2008–11,
2012–15 and 2016–19. The main conclusions of the third report (Federal
Council, 2018a) are discussed below.

8.4.1 Revenue Equalization

Since 2014, the revenue equalization component has achieved better results
than the targeted objective for each canton which aims to attain a tax
potential that corresponds to the minimal threshold of 85 per cent of the
national average after equalization (Federal Council, 2014: 9). Cantons
contributing to the revenue equalization scheme soon claimed that the 85
per cent initial target should be respected and their contribution reduced
in consequence. After lengthy and contentious debates at the federal level
and between the cantons, the federal government proposed that, from
2022, the revenue equalization legal target be increased from 85 to 86.5 per
cent. This is intended to fortify solidarity between the cantons9 – which
in fact disregards the claim of some contributing cantons maintaining
the 85 per cent target. However, this new target will, de facto, lead to a
reduction of the revenue equalization fund, because, in 2018, the lowest
index of financial capacity was 88.3 per cent in three cantons (Jura, Uri
and Valais – see Table 8.4). The reduction is estimated at 280 million CHF,
which corresponds to 6.8 per cent of the 2018 endowment to the fund
(Confederation and cantons).

8.4.2 The 2019 Reform10

The difference of 280 million CHF will not be returned to the cantons or
saved by the Confederation. According to the federal government, half
the amount should be used to increase the socio-demographic expenditure
needs equalization (80 million CHF in 2021, 140 million each year there-
after). The other half should serve, for a transitory period of five years, to
increase revenue equalization for the cantons with an index of financial
capacity below 100 points.11 After this period of time, this amount will
serve to reduce the contributions of the cantons with a capacity index
higher than 100. The Conference of the Cantons and the Council of States
adopted this proposal in December 2018. The finance commission of the

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 152 Intergovernmental transfers in federations

National Council examined the proposal on 5 March, this year. It has

adopted the changes in revenue equalization but did not accept that only
the socio-demographic part of expenditure needs equalization will benefit
from the increased dotation. It proposed – with a short majority of three
votes – to maintain a strict parity between the two categories: both will be
endowed with 40 million CHF in 2021 and 70 million CHF thereafter. This
last proposal and the entire reform were accepted in the two Councils in
the final vote held in 21 June 2019.

8.4.3 Expenditure Needs Equalization

For expenditure needs equalization, the performance evaluation is an

elusive concept. The difficulties are multiple. Firstly, the formulation of the
efficiency target ‘compensate for excessive financial burdens’ written in the
law is rather vague since neither the determinants nor the explanatory vari-
ables (see Table 8.5) express a causal relation to specific public functions
and expenditure items. Questions relating to the functions considered, how
one can estimate the burden and when this burden is considered excessive
also remain unanswered. Secondly, several explanatory variables, such
as ‘altitude’, ‘remoteness’ and ‘surface of urban areas’, do not register
significant variations from one calculation to the next. Thirdly, the weights
in the distribution formula are for some negotiated and fixed in the law and
for others obtained through principal component analysis (PCA) – two
parallel systems which can be questioned. And finally, since the functions
in need of equalization are not specified and the transfers from and to the
cantons are written in their general budget, it is impossible to assess the
equalizing performance in functional terms. The before and after equaliza-
tion positions of the cantons is simply measured in financial terms per
capita (Federal Council, 2018b: 36–41).

8.4.4 Geo-Topographic Determinants

First, the proportion (one-half) of equalization payments attributed to

the geo-topographic category is politically fixed and written in the law.
Second, the explanatory variables (Table 8.5) are not dynamic in the short
and medium term:12 two 33 per cent weights are attributed to altitude –
which does not change over time – so it has no further impact after being
first introduced in the formula – and does not mirror the burden that
topographic conditions and a dispersed population place on public expen-
ditures (Frey, 2001). Third, smallness defined as ‘communes with less than
200 inhabitants’ is no longer adequate in view of the policies encouraging
voluntary mergers of communes in many cantons (Dafflon, 2013).

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 Revenue and expenditure needs equalization ­153

The rigidity of the geo-topographic needs equalization is simply due to

the fact that, beyond political decisions taken to address this equalization
component, the statistical indicators which are suitable to evaluate the
need differences are rare. The presently used indicators were accepted for
want of better.
At the cantonal level, the amounts received under the heading of geo-
topographic equalization fall in the general budget of the recipient cantons
without being earmarked to any specific public function and expenditure.
The strongest criticism, coming from cantonal political parties and lobby
groups, is that the attribution of equal funds to geo-topographic and socio-
demographic needs equalization is not acceptable owing to the territorial
distribution of the population (15 per cent rural, 85 per cent urban): more
should be given to the urban population. But a modification would be
considered an affront to the mountain cantons and a serious lack of con-
federal solidarity. Political acceptance replaces the causality that economic
logic requires between functional needs and the explanatory variables.

8.4.5 Socio-Demographic Determinants

The socio-demographic component of the expenditure equalization scheme

would compensate for the ‘excessive burden due to some characteristics of
the population’. Yet, just as the geo-topographic component, neither the
functions nor the delimitation of ‘excessive burden’ are explicitly defined
in the law or the explicative reports. However, determinants and variables
in Table 8.5 give some information about the arguments. The first part
(two-thirds of the amount) relates to the concept of ‘A-cities’ (in German:
Arme, Alte, Ausländer, Arbeitlose). It relates to categorical characteristics
of the population in towns – poverty, old age, foreigners, unemployed
– which require specific care and may result in additional public expendi-
tures (Frey, 1996). The second part (one-third of the amount) addresses
additional specific problems of city centres in urban agglomeration, such
as public order and security, and traffic congestion. A comparison of the
weights resulting from PCA (Table 8.3) with the proportions of the related
functional expenditures in the cantons and the communes gives the figures
shown in Table 8.8.
The results of the third performance evaluation were in general well
received for both categories of expenditure needs equalization. There was
no operational proposal for changing the determinants, the variables or
the weights (Table 8.5). The only recurrent demand of the urban regions
was to allocate more funds to the socio-economic category than the strict
equality between the two categories (359 millions CHF each, Figure
8.1). But, this has been strongly rejected by the beneficiary mountainous

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 154 Intergovernmental transfers in federations

Table 8.8 Comparing CPA weights and PPE, 2016

Determinant Component Principal Weight in Proportion

Analysis (CPA) weight of Public Expenditures
(as in Table 8.5, last (PPE), 2016,
column, but for 2016) cantons and communes
Poverty: 29 32
Disabled 18
Families and children 10
Unemployed 4
Old age 15 14
Foreigners (incl. refugees) 22 27
Public order and security 12 15
Public transport 22 12
Total 100 100

Source: Author, Table 8.5 and FFA, www.efv.admin.ch > documentation > statistique
financière > Rapport > tous les fichiers; updated on 6 September 2018, access date 25
March 2019.

c­antons and, also, by the finance commission of the National Council

more recently (decision of 5 March 2019).13

8.5 CONCLUDING COMMENTS

This chapter demonstrates that a national equalization policy that jux-

taposes revenue equalization and expenditure needs/costs equalization is
feasible, though it faces numerous political and technical problems. With
the discussions covered in the conceptual issues section of this volume, we
can draw the following conclusions from the Swiss equalization system:
A first lesson emerges from this case study, which confirms the approach
presented in Chapter 4 of this volume: some subnational government units
dispose of financial resources above national average (per capita) when, at
the same time, expenditure needs or costs are higher than the national aver-
age. Table 8.9 illustrates this ambivalent situation in the Swiss case. Aside
from the transition fund to which all cantons contribute, one sees that six
out of seven cantons contributing to revenue equalization benefit either
from the geo-topographic equalization (Schwyz, Obwalden, Nidwalden) or
from the socio-demographic equalization (Zürich, Basel-Stadt, Genève).
Zug is the only canton which contributes to revenue equalization but does
not obtain financial aid. Moreover, Zürich, Basel-Stadt and Genève also
benefit from equalization reserved for urban areas.

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 Revenue and expenditure needs equalization ­155

Table 8.9 Cantonal benefit (B) or contribution (C) to equalization 2018

Canton Revenue Excessive burden Transition

fund
Topo- Socio- Urban
geographic demographic areas
B C B B B B C
Zürich C B B C
Bern B B B C
Luzern B B B C
Uri B B C
Schwyz C B C
Obwalden C B C
Nidwalden C B C
Glarus B B B C
Zug C C
Fribourg B B C
Solothurn B B C
Basel-Stadt C B B C
Basel-Landschaft B C
Schaffhausen B B C
Appenzell B B C
Ausserrhoden
Appenzell B B C
Innerrhoden
Sankt Gallen B B C
Graubünden B B C
Aargau B C
Thurgau B B C
Tessin B B B C
Vaud B B B B C
Valais B B B C
Neuchâtel B B B B C
Genève C B B C
Jura B B B B C

Source: Author, based on https://www.efv.admin.ch/efv/fr/home/themen/finanzausgleich/

z​ahlen.html.

Revenue disparities are approximated with an adapted RTS which includes

four items of the federal direct taxation standardized at the cantonal level.
The inclusion of other cantonal direct taxes or revenues from natural
resources – water concession in the Alps cantons – and from the cantons’
participation in public enterprises – was again recently suggested and
disregarded.14

YILMAZ_9781789900842_t.indd 155 16/12/2019 10:44

 156 Intergovernmental transfers in federations

The vertical-horizontal combination for revenue equalization reinforced

the inter-cantonal solidarity since the federation is not the only contribu-
tor, but seven cantons with a financial capacity higher than the average
also contribute. In the future, cantons with above-average-capacity will
contribute exactly to two-thirds of the federal payment (Federal Council,
2018b).
The exclusively vertical funding of the ‘excess burden’ equalization
corresponds to the economic logic that relative tax prices of cantonal
functions should not be influenced through equalization (Dafflon, 2007).
In the equalization of ‘excess burden’, the geo-topographic indicators are
not adequate since they are (1) static and (2) do not approximate specific
functions, needs or costs in the mountain cantons (Frey, 2001). Because of
the lack of better variables, decision makers choose to resort to political
convenience. The socio-demographic variables are more plausibly related
to cantonal functions, but miss important domains, such as expenditure
disparities in compulsory education. Experiments in intra-cantonal equali-
zation demonstrate that better targeted indicators are available (Dafflon
and Mischler, 2007; Rühli et al., 2013; Dafflon, 2015b).
Historically, at almost all stages of the process, the weights and equal-
izing formulas have been fiercely debated since they directly influence the
results. Rational choices prevailed in the weights given to the four taxes
taken into account for revenue equalization (in proportion of each tax
yield in the total). For the socio-demographic indicators (Table 8.5) and
supposing one could link the explanatory variables to specific functional
expenditures, according weights to the proportion of cantonal and com-
munal functional public expenditures would likely give results different
from those obtained with PCA. For example, the weight for foreigners is
underestimated in PCA (22 per cent) compared to PPE (27 per cent), and
inversely for public transportation in urban (PCA 22 per cent, PPE 12
per cent). In the absence of detailed calculation per canton, and the non-
allocation of transfers to specific functional expenditures, it is difficult to
assess whether these differences are really important and significant.
Finally, the total amount of equalization is explained from a historical
perspective and traced to the change of the system in 2008. The objective
at the time was not to increase the equalization fund, but to reform the
scheme for more transparency and more efficiency. The fund allocated to
equalization in the new system was the continuation of the existing situa-
tion. Yet, the growth rate of the future funds allocated to revenue equaliza-
tion should correspond to the growth rate of the referred four federal
direct taxes. As compared to revenue equalization, the funds earmarked
to expenditure needs equalization have been continuously decreasing in
relative terms, from 22 per cent to 18 per cent. But in both cases, the growth

YILMAZ_9781789900842_t.indd 156 16/12/2019 10:44

 Revenue and expenditure needs equalization ­157

rate of the funds allocated to revenue equalization and to expenditure

needs equalization do not essentially follow the present legal requirement
(Table 8.A1). The future reform modifies this situation with a mechanism
of automatic adjustment. For revenue equalization, the total funding must
correspond to the objective of an 86.5 per cent financial capacity index in
the poorest canton, with a federal contribution equal to 150 per cent of the
contributions of the cantons with financial capacity indices higher than
100 points. The federal contribution to the expenditure needs equalization
will correspond to the 2019 amount and will be adjusted yearly to the
Swiss consumption price index (Federal Council, 2018a: 214–16).
In sum, the architecture of the Swiss fiscal equalization mirrors and
answers all the core questions that are developed in Chapter 4 of this
volume. However, in the absence of sufficient factors of causality (which
explanatory variables for which functions, how to evaluate needs and costs
that create ‘excessive’ burden), and where several schemes provide pos-
sible answers, the implemented solutions most frequently mirror political
compromises. In such situations, the institutional architecture of Swiss
federalism shows that the political answers are in the general interest of the
cantons and are not exploited by cantonal politicians to gain local votes.
The Conference of the Cantons must propose solutions that are acceptable
for themselves and for the federal parliament. The process is severe enough
to eliminate local egoism.

NOTES

* Thanks to Alain Schönenberger, Paul Bernd Span, Serdar Yilmaz and two anonymous
peer reviewers for their comments and suggestions on an earlier version of this chapter.
1. Communes are local government units, the lowest political tier. There were 3021 com-
munes in 1990, 2899 in 2000 (-122), 2596 in 2010 (-303) and 2212 in 2019 (-384). The
number of communes per canton varies between three in the cantons of Glarus, which
has 40,000 inhabitants, and Basel-Stadt with 194,000 inhabitants, to 346 communes in
the canton of Bern which has more than 1 million population. In several cantons, the
merger of communes is a fundamental territorial reform that has accelerated since the
early 2000s and will continue. See Dafflon (2013).
2. The cantonal resident population varies from 1.5 million in canton Zürich to 16,000 in
Appenzell Innerrhoden. The average size of population per commune is 3669 inhabit-
ants nationwide; it varies between 13,861 in Jura and 64,847 in Basel-Stadt as of 19
December 2018. Source: Federal Statistical Office, accessed 25 March 2019 at https://
www.agvchapp.bfs.admin.ch/fr/state/query.
3. Regarding compulsory school education (from the age of 4 to 15) the cantons must agree
(harmonize) the following issues: the school entry age, compulsory school attendance,
duration and objectives of education levels, the transition from one level to another, rec-
ognition of qualifications, harmonization of school programmes, teachers’ qualification.
Where harmonization of school education is not achieved by horizontal coordination,
the Confederation (i.e. central government) shall issue regulations to achieve such
harmonization (art. 62 al. 4 Cst.). The cantons’ answer to this c­ onstitutional rule on

YILMAZ_9781789900842_t.indd 157 16/12/2019 10:44

 158 Intergovernmental transfers in federations

harmonization was the ‘concordat HarmoS’, decided by the Conference of the Cantonal
Ministers of Education on 14 June 2007 (accessed 25 March 2019 at http://www.edk.
ch-. domaines d’activité -. HarmoS, only in French or German).
4. It was rejected by Nidwalden, Schwyz and Zug – three of the seven contributing cantons.
5. It is interesting to note that the federal parliament adopted on 3 October 2003 the law
on fiscal equalization and the reassignment of functions between the Confederation and
the cantons on equalization before the popular vote on the constitutional amendment
(28 November 2004). The reason is that cantons and voters wanted to know the con-
tours of the new equalization policy, which was to replace the one introduced in 1959.
The 2003 federal law was subject to facultative referendum, which never took place. In
2004, the voter turnout for the constitutional amendment was 40 per cent.
6. The history of the Federal Direct Tax (FDT) sharing with the cantons can be summa-
rized as follows. Since 1934, the cantons received a share of the FDT in compensation
that the Confederation was allowed to tax income and profit in order to finance the
national defence. In 1940, the cantonal share was fixed at 30 per cent of the federal tax
yield for each canton according to the tax revenues collected in the canton. In 1959, with
the introduction of the first equalization scheme, the cantons agreed that one-sixth of
this share (5 per cent) be allocated to revenue equalization. It went up to 7.5 per cent
in 1980 and 13 per cent from 1992 to 2007 (each canton still received 17 per cent of the
FDT revenues collected within the canton).
7. We do not discuss here the pros and cons about whether expenditure needs/costs
equalization should be vertical only. The theoretical debate is still on; however, the
trend in theory and practice is to view vertical transfers as preferable for equalizing
costs and needs; and to view horizontal ‘Robin Hood’ solidarity as unsuitable for this
purpose (Lotz, 1997; Dafflon, 2007). Färber and Otter (2003) collected information on
equalization systems at the local level in Austria, Flanders (Belgium), Denmark, France,
Germany, Italy, Russia, Spain, Switzerland and the United Kingdom. Needs/costs
equalization, if it exists, is nowhere horizontal.
8. Ordonnance sur la péréquation financière et la compensation des charges (OPFCC) du
7 novembre 2007.
9. Proposition of the Conference of the Cantons in Message concernant la modification
de la loi fédérale sur la péréquation financière et la compensation des charges du 28
septembre 2018, accessed 25 March 2019 at https://www.admin.ch/opc/fr/federal-ga​
zette/2018/6607.pdf, pages 6616–17.
10. Federal Parliament, accessed 14 April 2019 at https://www.parlament.ch/fr/ratsbetrieb/
suche-curia-vista/geschaeft?AffairId=20180075.
11. The cantons with an index of financial capacity lower than 100 (national average) would
receive 80 million in 2021, 200 million in 2022, 160 million in 2023, 120 million in 2024
and 80 million in 2025. The amount varies for years 2002 to 2024 in order to compensate
for the reform of the business taxation (see note 9 above). The distribution will be made
on the basis of the resident population of the canton and not according to the revenue
equalization formula. As a result, the cantons with the lowest capacity indices will
receive much less than they would with the formula.
12. In the 2016–19 Report (Federal Council, 2018a: 39 and 80 – our translation): ‘This is
not surprising when one knows that in the past years, the two determinants related to
altitude needed not be up-dated . . . whereas the indicator of remoteness registered only
minor changes . . . These indicators are structural and stable and will not vary in the
near future’.
13. Federal Parliament, accessed 14 April 2019 at https://www.parlament.ch/fr/ratsbetrieb/
suche-curia-vista/geschaeft?AffairId=20180075.
14. Recommendation of the Finance commission of the National Council, 7 March 2019:
‘large majority’ for the non-inclusion of revenues from water concession; 10 votes for and
14 against taking into account the yields of cantonal participations in public enterprises,
cantonal banks and similar institutions. Federal Parliament, accessed 14 April 2019 at
https://www.parlament.ch/fr/ratsbetrieb/suche-curia-vista/geschaeft?AffairId=20180075.

YILMAZ_9781789900842_t.indd 158 16/12/2019 10:44

 Revenue and expenditure needs equalization ­159

REFERENCES

Ahmad, E., ed., 1997, Financing Decentralized Expenditures: An International

Comparison of Grants, Edward Elgar Publishing, Cheltenham, UK and
Northampton, MA, USA.
Boadway, R. and A. Shah, eds, 2007, Intergovernmental Fiscal Transfers, Principles
and Practice, Public Sector Governance and Accountability Series, The World
Bank, Washington, DC.
Conference of the Cantonal Ministers of Education, 2007, Harmos, http://www.
edk.ch.
Dafflon, B., 2004, ‘Federal-Cantonal Equalisation in Switzerland: An Overview
of the Reform in Progress’, Public Finance and Management, Symposium Fiscal
Federalism, vol. 4 no. 4.
Dafflon, B., 2007, ‘Fiscal Capacity Equalization in Horizontal Fiscal Equalization
Programs’, in Boadway and Shah, op. cit., pp. 361–99.
Dafflon, B., 2013, ‘Voluntary Amalgamation of Local Governments: The Swiss
Debate in the European Context’, in Lago-Peñas and Martinez-Vazquez, op. cit.,
pp. 189–220.
Dafflon, B., 2015a, ‘Swiss Fiscal Federalism: New Roads after the Reform of the
Constitution’, in Pola, op. cit., pp. 91–112.
Dafflon, B., 2015b, Analyse de performance de la péréquation intercommunale dans
le canton de Fribourg, accessed at https://www.fr.ch/sommaire/perequation-fina​
nciere-intercommunale.
Dafflon, B. and M. Della Santa, 1995, Fédéralisme et solidarité, Etude de la péré-
quation en Suisse, PIFF, Institute of Federalism Fribourg.
Dafflon, B. and P. Mischler, 2007, Réforme de la péréquation intercommunale dans le
canton de Fribourg, accessed at https://www.fr.ch/sommaire/perequation-financiere​
-intercommunale.
Färber, G. and N. Otter, eds, 2003, ‘Reforms of Local Fiscal Equalisation
in Europe’, Speyerer Forschungsberichte, Nr. 232, Forschungsinstitut für
Öffentliche Verwaltung, Deutsche Hochschule für Verwaltungswissenschaften,
Speyer, Germany.
Federal Council, 2001, Message 01.074 concernant la Réforme de la péréquation
financière et de la répartition des tâches entre la Confédération et les cantons
(RPT), 14 November, Berne, accessed 25 March 2019 at https://www.admin.ch/
opc/fr/federal-gazette/2002/2155.pdf.
Federal Council, 2014, Rapport sur l’évaluation de l’efficacité 2012–2015 de la
péréquation financière entre la Confédération et les cantons, Berne, accessed 25
March 2019 at www.news.admin.ch > péréquation financière > Rapport.
Federal Council, 2018a, Rapport sur l’évaluation de l’efficacité 2016–2019 de la
péréquation financière entre la Confédération et les cantons, Berne, accessed 25
March 2019 at https://www.efv.admin.ch/efv/fr/home/themen/finanzausgleich/wir​
ksamkeitsberichte.html.
Federal Council, 2018b, Message concernant la modification de la loi fédérale
sur la péréquation financière et la compensation des charges du 28 septembre
2018, accessed 25 March 2019 at https://www.admin.ch/opc/fr/federal-gazette​
/2018/6607.pdf.
Federal Finance Administration (FFA), 2017, ‘Péréquation financière 2018 entre la
Confédération et les cantons’, Berne, June.

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 160 Intergovernmental transfers in federations

Frey, R.L., 1996, Stadt: Lebens- und Wirtschaftsraum. Eine ökonomische Analyse,
Vdf, Hochschulverlag AG an der ETH Zürich.
Frey, R.L., 2001, ‘Analyse de l’objectif et de l’efficacité de la nouvelle péréquation
financière’, Wirtschaftswissenschaftliches Zentrum WWZ der Universität Basel.
Frey, R.L., B. Dafflon, C. Jeanrenaud and A. Meier, 1994, Le péréquation financière
entre la Confédération et les cantons. Expertise relative aux aides financières et
indemnités de la Confédération en faveur des cantons, Berne, Administration
fédérale des finances et Conférence des Directeurs cantonaux des finances.
Lago-Peñas, S. and J. Martinez-Vazquez, eds, 2013, The Challenge of Local
Government Size: Theoretical Perspectives, International Experience and Policy
Reform, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA,
USA.
Lotz, J.R., 1997, ‘Denmark and Other Scandinavian Countries: Equalization and
Grants’, in Ahmad, op. cit., pp. 184–212.
Pola, G., ed., 2015, Principles and Practices of Fiscal Autonomy, Experiences,
Debates and Prospects, Federalism Studies, Ashgate, Farnham UK and
Burlington USA, and Éupolis Lombardia.
Rühli, L., M. Frey and R.L. Frey, 2013, Irrgarten Finanzausgleich: Wege zu mehr
Effizienz bei der interkommunalen Solidarität, Avenir Suisse, Zürich.

YILMAZ_9781789900842_t.indd 160 16/12/2019 10:44

 Revenue and expenditure needs equalization ­161

APPENDIX
250.0
240.0 before
230.0 after
220.0
210.0
200.0
190.0
180.0
170.0
160.0
150.0
140.0
130.0
120.0
110.0
100.0
90.0
80.0
70.0
60.0
50.0
Zoug
Schwyz
Nidwald
Bâle-Ville
Genève
Zurich
Obwald
Vaud
Tessin
Bâle-Campagne
Neuchâtel
Schaffhouse
Lucerne
Appenzell Rh.-Ext.
Argovie
Appenzell Rh.-Int.
Grisons
Fribourg
St-Gall
Thurgovie
Berne
Soleure
Glaris
Uri
Valais
Jura
Sources: Authors, Table 8.4; Federal Council (2018: 71).

Figure 8A.1 Cantonal indices of financial capacity before and after

revenue equalization, 2018

YILMAZ_9781789900842_t.indd 161 16/12/2019 10:44

 Table 8A.1 Evolution of equalization funds, 2008–2018, in 1000 CHF

Year Revenue equalization Expenditure needs equalization

YILMAZ_9781789900842_t.indd 162
Vertical Horizontal Total Ratio H/V Growth rate Payment Ratio EN/R Growth rate
(%) 1 (%) 2 (%)
op. ref. FP op. ref. CPI
2008 1 798 569 1 258 998 3 057 567 70 682 216 22
2009 1 861 854 1 315 027 3 176 881 71 3.9 3.5 702 000 22 2.9 20.5
2010 1 961 872 1 406 130 3 368 002 72 6.0 5.3 694 980 21 21.0 0.7
2011 2 100 592 1 532 643 3 633 235 73 7.9 7.2 704 710 19 1.4 0.2
2012 2 131 868 1 461 057 3 592 925 69 21.1 22.4 737 624 21
2013 2 196 465 1 500 219 3 696 684 68 2.9 3.0 730 248 20 21.0 20.2
2014 2 220 010 1 507 952 3 727 962 68 0.8 1.1 725 866 19 20.6 0.0

162
2015 2 273 025 1 552 285 3 825 310 68 2.6 2.4 725 866 19 0.0 21.2
2016 2 300 683 1 752 308 4 052 991 76 6.0 5.5 717 881 18
2017 2 350 133 1 598 592 3 948 725 68 22.6 2.1 715 010 18 20.4 0.5
2018 2 423 359 1 650 709 4 074 068 68 3.2 3.1 718 870 18 0.5 1.0

Notes:
Growth rate 1: op.: effective rate of growth of the total amount of revenue equalization/ref. FP: according to art. 6 of the 2003 federal law, the
effective growth rate of the federal vertical amount corresponds to the rate of growth of the fiscal potential (FP) of the cantons mentioned in this
column. The op. growth rate for the total amount is lower because the ratio horizontal/vertical equalization is decreasing. In the future, it will be
fixed at 66 2/3 per cent.
Growth rate 2: according to art. 9 of the 2003 law, the amount of expenditure needs equalization is fixed by the federal parliament on the first year
of each four-year period. The annual growth rates thereafter for the second, third and fourth years of the period correspond to the annual increase
in the consumers’ price index (CPI). From comparison between the column op. and ref. CPI, this is not quite respected in practice.

Source: Federal Council, 2014 and 2018a; price index, https://www.bfs.admin.ch/bfs/fr/home/statistiques/prix/indice-prix-consommation/resultats-

ipc.assetdetail.7626789.html, access date 14 April 2019.

16/12/2019 10:44
 9. 
Intergovernmental fiscal relations in
Australia
Bob Searle

9.1 
THE STRUCTURE OF GOVERNMENT IN
AUSTRALIA

There are three tiers of government in Australia: the Commonwealth,

the states1 and about 550 local governments. The six states each have
independent legal status and the Commonwealth could be seen as ‘their
child’ as it was formed from six British colonies which became the states.
The two territories exist as a result of Commonwealth legislation and the
federal government limits their legislative capacity. Local government
exists under state legislation and has no constitutional status. All states
and the Northern Territory have local government, but the Australian
Capital Territory operates without a local government structure. There
are also parts of other states – South Australia and New South Wales
in particular – where no local government exists. Like the states, local
governments vary greatly in population, area and the extent of their
urbanization.
The separation of powers between the Commonwealth and the states
is determined by the Australian Constitution (Section 51) which leaves all
unspecified functions to the states: they are responsible for all the major
services to individuals: education, health, welfare, transport, police and
so on. The distribution of responsibilities has only been changed twice
since 1900 when the federation was established under an Act of the British
Parliament:

●● In 1946, to allow the Commonwealth to make social security pay-

ments to individuals; and
●● In 1967, to allow it to make laws specific to indigenous Australians.

In addition to what is specified, however, Section 96 of the Constitution

gives the Commonwealth the power to ‘grant financial assistance to any
state on such terms and conditions as the Parliament thinks fit’. This

163

YILMAZ_9781789900842_t.indd 163 16/12/2019 10:44

 164 Intergovernmental transfers in federations

chapter will show the extent to which the Commonwealth has used Section
96 to widen its influence on public services.

9.2 VERTICAL FISCAL IMBALANCE IN AUSTRALIA

The distribution of expenditure responsibilities and revenue capacities

results in a large vertical fiscal imbalance (VFI) with the states relying on
the Commonwealth for a substantial proportion of their revenue. There is
also some VFI that local government needs to be funded for: a much more
important issue for rural localities than it is for urban councils.
There has never been a structured attempt to overcome the central/state
VFI through a rationalization of mandates. Governments have agreed sev-
eral times to permanently transfer responsibility for specific services to the
Commonwealth, but these have not resulted in constitutional change. On
the revenue side, there have also been adjustments (driven by legal decisions
or agreements between governments) but these have generally resulted in
the abolition of state taxes and an increase in VFI. The last major example
of this was the July 2000 tax reforms under which the scrapping of a
number of state taxes made room for the Commonwealth to introduce
its Goods and Services Tax (GST). The result was to reduce states’ tax
collections without making any change to their responsibility for public
expenditure: substantially increasing VFI. The biggest impact on VFI,
however, remains the moving of income tax collections from the states to
the Commonwealth during the 1940s to fund military e­ xpenditures, then
never returning it to the states.
What VFI looks like in 2017–18 is shown in Figure 9.1. It shows that
43 per cent of state expenditure is funded through transfers from the
Commonwealth. The local government sector also suffers from a VFI
disadvantage, but that tier represents only about 5 per cent of total
­government activity, while the states are close to 33 per cent. Overall, local
governments receive about half of their revenue from Commonwealth or
state grants, with about a third of that being from the Commonwealth.
It also appears that there has never been a serious discussion at govern-
ment level on the structure of the fiscal transfers that overcome the VFI.
Individual states have frequently stated their preference for greater use of
untied funding, but it has rarely resulted in any public discussion. The rela-
tionship between VFI, the funding mix and the maintenance of state fiscal
autonomy has been largely ignored, but there is much room for reform
in these areas. The size of the transfer and the pattern of tied and untied
grants have evolved through political and budgetary processes rather than
as a result of any structured approach to the issue. A truly cooperative

YILMAZ_9781789900842_t.indd 164 16/12/2019 10:44

 Intergovernmental fiscal relations in Australia ­165

250
Payments for
specific purpose or
Other expenses
Cwealth PSPs
200
payments
Welfare 43%
GST
Police and justice
150
Transport and
$ billion

communication Mining royalties

100
Health State own State taxes
source
revenue
50 57% Sales of goods and
Education services
Other revenue
0
State expenses by function State revenue by source

Source: Commonwealth Grants Commission, private correspondence.

Figure 9.1 Australia’s vertical fiscal imbalance, 2017–18

federalism would give much more power to the states and the issues men-
tioned here would be resolved by both tiers of government and individual
grants would be designed within agreed parameters. We will see later that
there is capacity within inter-government agreements to undertake reform
in these areas, but it has not been used.

9.3 
OVERCOMING THE VERTICAL FISCAL
IMBALANCE

Giving the states and local government sufficient funds to provide a

reasonable standard of services is currently achieved through a mixture of
tied and untied grants, as shown in Figure 9.2.

9.4 
THE COMMONWEALTH’S TIED GRANTS
SYSTEM

As shown, the Commonwealth classifies Specific Purpose Payments (SPPs)

to the states into five groups. This typology does not seem to serve any real
purpose and its removal may well improve transparency.

YILMAZ_9781789900842_t.indd 165 16/12/2019 10:44

 166 Intergovernmental transfers in federations

Commonwealth Government

State and territory 6.7% of GDP

governments 25.9% of Commonwealth
($126.8 bn) expenditure

Untied grants The GST revenue Tied grants

($68.2 bn) ($58.6 bn)

National National National National Quality

Specific Health Reform Partnership Housing and Schools
Purpose payments payments Homelessness payments
payments payments
($2.5 bn) ($21.2 bn) ($13.8 bn) ($1.5 bn) ($19.5 bn)

Including

Local government
($1.6 bn)

Untied grants Tied grants State governments

($1.2 bn) ($ 0.4 bn) (about $3.5 bn)

Sources: Commonwealth and State Budget Documents, 2018–19, author’s analysis.

Figure 9.2 Size and structure of payments made to overcome VFI: 2018–19

National Specific Purpose Payments

There are only two National SPPs. The first is based on an agreement with
the states and seeks to develop a vocational education and training system
to improve service quality and greater transparency for students, employ-
ers and governments; and encourage greater efficiency. The pool of funds
is varied each year by reference to a wage cost index and is distributed
among the states based on their populations.
The second relates to the recently created National Disability Insurance
Scheme (NDIS) under which the states have agreed to progressively hand
responsibility for helping people with disabilities, and their carers, to the
Commonwealth’s National Disability Insurance Agency. This scheme is

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 Intergovernmental fiscal relations in Australia ­167

still being rolled out and, when it reaches full state coverage in 2019–20, the
funding now flowing to the NDIS will become a Commonwealth budget-
funded activity: another change to the distribution of mandates without
change to the Constitution.

National Health Reform Payments

The National Health Reform Program seeks to improve health services

and the efficiency of their provision. Until at least 2019–20, the funding
will be linked to growth in public hospital activity and a national unit
price for each activity (said to be the ‘efficient’ price) determined by the
Independent Hospital Pricing Authority. The current agreement with the
states is that the Commonwealth will fund 45 per cent of the ‘efficient’
growth in activity-based services, with growth in total Commonwealth
funding capped at 6.5 per cent per year.2

National Housing and Homelessness Payments

The National Housing and Homelessness Agreement aims at improving

access to affordable, safe and sustainable housing, including the prevention
of homelessness. The Commonwealth funding is matched by the states and
is increased annually by a wage cost index. In the past, Australia has had
many ‘matching’ grant systems, but this has not led to efficiencies because
states have seen each dollar spent as only costing their budget 50 cents.

National Partnership Payments

National Partnership payments to the states are the key vehicle used
to facilitate Commonwealth-initiated reforms in the delivery of state
services. To the extent possible, the Commonwealth aligns payments under
National Partnerships with the achievement of milestones and makes
the transfer of funds after the states have achieved the goals specified in
relevant agreements. However, this does not place very stringent condi-
tions on the states and the SPPs do not seem to create real incentives for
states to change either service delivery or economic efficiency. As a result,
there must be some doubt about the extent to which central government
objectives are being met.
Numerically, these are the most common SPPs and are typically entered
into for a fixed period. There were at least 85 National Partnership
Programs funded in 2018–19, ranging from $3.7 bn for states’ roads infra-
structure to $200 000 for the development of a national fire danger rating
and communication system.

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 168 Intergovernmental transfers in federations

An interesting aspect of these payments has been the increasing

tendency by the federal government to fund small programmes that are
for works which relate to a single geographic area. An example of this is
a $10 m stadium to be funded in a provincial city, without any apparent
assessment of how that city’s need compares to other locations. Such
commitments are most frequently made during election campaigns and
illustrate the extent to which the Commonwealth is prepared to use Section
96 of the Constitution to extend its influence.

Quality Education Payments

The Quality Schools Program provides funding for all government and
non-government schools. It covers both recurrent and capital funding and
is aimed at influencing all aspects of school education. The growth rate
of the Quality Education payments pool relies on agreements between the
Commonwealth and the states.

Conclusions on SPPs to the States

SPPs are used only to influence service delivery: there is no attempt to use
them to increase or change the pattern of state revenue. The proliferation
of SPPs has been driven largely by a desire of federal governments to be
involved in areas of state responsibility for assumed political benefits. This
has greatly blurred governments’ responsibilities in the eyes of the public
and reform is needed to clarify mandates and reduce VFI to improve the
link between revenue-raising powers and expenditure responsibilities. The
conditions attached to SPPs do not often include efficiency objectives and
are not sufficiently linked to the benchmarking Report on Government
Services produced by the Productivity Commission and discussed else-
where in this volume.
The categorization of SPPs is a hangover from a simplification attempted
in 2009, under which there was to be only five SPPs, each distributed on an
equal per capita (EPC) basis, plus a small number of national payments.
This proposal, put forward by the Commonwealth and agreed to by the
states, was not proceeded with because Commonwealth sectoral ministers
and their departments would not relinquish their roles in the distribution
of funds for sectoral functions. The proposal to distribute the SPPs as
EPC grants was aimed, at least in part, at overcoming the duplication of
needs assessments by the functional Commonwealth departments and the
Commonwealth Grants Commission, an issue discussed in more detail later.
How the size of an individual SPP varies between years is determined
either by agreement with the states, by reference to population, by

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 Intergovernmental fiscal relations in Australia ­169

reference to a cost inflator, by a mixture of these factors, or by budget-

ary considerations of the Commonwealth Government. For the major
SPPs, growth factors are detailed in agreements, but for others, the basis
of growth is very difficult to find. A rationalization of this element of
intergovernmental fiscal relations would be beneficial.
The distribution of funding between the states also differs between SPPs
and there has been no systematic attempt to make these more uniform.
They are based either on written agreements with the recipients, acceptance
of offers made by Commonwealth sectoral ministries, or even a ‘historical
basis’ the reasoning for which is lost in time. Commonwealth departments
managing the SPPs would probably all claim to use relative needs in the
distribution, but there is no common Commonwealth position on how
this concept should be understood. The largest of the SPPs, health and
education, are very different in their structures and operating procedures,
but there is public discussion of them and press coverage on both the size
of the pool and the basis of funds distribution. Other SPPs get little if any
public attention and insufficient detail of the arrangements is provided in
annual budget documents. For these smaller grant programmes, the policy
objective is often unclear.
In its 2018–19 Budget, the Commonwealth notes that SPPs now ‘cover
most areas of state and local government activity, including health, educa-
tion, skills and workforce development, community services, housing,
indigenous affairs, infrastructure and the environment’.3 It is surprising
that the steady reduction in states’ autonomy has not been the subject
of political discussion, and it seems that the Commonwealth’s financial
dominance is a very large influence on state reactions to their loss of
autonomy: they cannot afford to create friction with the provider of funds.
What the current arrangements do is create much confusion in the minds
of the electorate and give both tiers of government capacity to blame the
other when deficiencies in service standards are identified.
It is no wonder that the recent Productivity Commission report,
discussed in the next chapter, recommended that the reform of federal
financial relations includes development of a well-delineated division of
responsibilities between the states and the Commonwealth. To this could
be added the need to clarify national policy objectives, the creation of
better links between SPPs and efficiency of service provision, and the need
to make bases of distribution between the states more transparent and
related to a philosophy under which intergovernmental fiscal relations is
being managed.

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 170 Intergovernmental transfers in federations

9.5 
COMMONWEALTH PAYMENTS FOR LOCAL
GOVERNMENT

Local government has no constitutional status in Australia and is a

construct of the states. State legislation determines both the expenditure
mandates and own-source revenues of local government. Local government
associations have called for both constitutional status and a clarification
and widening of mandates, but nothing has been done in either area. The
local government association in each state talks to its state government and,
together, they talk as one to the federal government. But because mandates
are a state issue and constitutional status is a national issue, there seems to
be enough confusion of roles for the Commonwealth and state governments
to make the prospect of real change unlikely. This is not a healthy position
for local government to operate in and reform would appear beneficial.
Although about a third of local government’s grant funding is received
from the Commonwealth, there has been no discussion between the
Commonwealth and the states, or local government associations, on the
mix of tied and untied funding that make up these transfers. The limited
mandates of local government, which is widely seen as being involved only
in roads, rates and rubbish, might support the move to less SPPs and a
greater use of untied funding.

Untied Funding

The untied Commonwealth grants to local government have existed for

45 years. They were initially based on principles of fiscal equalization
and managed by the Commonwealth Grants Commission. After a very
brief period, the basis of distribution was changed so as to introduce a
minimum payment and all councils were thus assured of a grant. At the
same time, the management of the distribution was given to State Grants
Commissions which have since developed individual bases of distribution.
These are said to be equity-based but now often show little influence of
generally accepted equalization principles.
Local government untied funding is made up of two components – a
general purpose component and a local roads component. Although based
on local road needs, funding attributed to the later component is totally
untied once the payments are received. The states’ shares of the local roads
component is based on shares that applied in 1991–92, at the time the
funding became untied. The general purpose component is the largest and
is distributed between the states on a per capita basis. The combined pool
is increased annually by reference to population increases and changes in
the consumer price index.

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 Intergovernmental fiscal relations in Australia ­171

In reality, the Commonwealth appears to show little interest in these

funds and probably sees the expense as being a political necessity that
gives federal politicians a capacity to become more involved with their
electorates on local issues. They were introduced at a time when there
was discussion by governments on the future structure of government in
Australia, but that discussion has long since ceased.

Tied Funding

There are only two SPPs that the Commonwealth classifies as being for
local government: one for local roads and one for drought relief in rural
areas. The local roads funding is for construction and maintenance projects
and is split between the states on the same basis as the roads component
of the untied funding discussed above. The distributions within states are
determined by the State Grants Commissions and the decisions on projects
to be funded are made by individual councils. Not all local councils receive
funding from this source.
The funds for drought relief provide employment for people whose
work opportunities have been affected by drought. Funding is provided to
drought-declared areas and the distribution of funds is based on assessed
need.

9.6 STATE PAYMENTS TO LOCAL GOVERNMENT

The states have always argued that they have no fiscal capacity to give large
grants to local councils. Available data for 2014–15 indicates that the total
state financial support to local government was about $3.4 bn, with nearly
half of that being in Queensland. Nearly half of the total state assistance
to local government in Australia is for local roads funding.
There is no detail available at the central level on how the states distrib-
ute their grant funds for local roads but it is probable that the relative needs
determined by the State Grants Commissions are applied.

9.7 
CONCLUSIONS ON VERTICAL FISCAL
IMBALANCE AND TIED GRANTS

VFI is relatively high in Australia. Its impact on states’ autonomy discour-

ages them from thinking more widely about how tax efforts are linked to
service standards; and confuses the public about how government mandates
in their federation are distributed. It encourages inefficient ­governance by

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 172 Intergovernmental transfers in federations

resulting in the central government becoming too-frequently involved in

what should be state or local government decisions. It could be said to have
changed the federal democracy designed in the Australian Constitution
without this change having been agreed to by the electorate.
In terms of tied grants, it is difficult to see that the classification of these
payments has any meaning and it is difficult to associate the conditions
attached to them as benefitting efficiency. The systems for determining
their size and distribution between states seem haphazard. There is much
to be done in overcoming these issues.

9.8 
UNTIED GRANTS, HORIZONTAL FISCAL
EQUALIZATION AND THE COMMONWEALTH
GRANTS COMMISSION

The Size of the Untied Grants Pool

When the principle of Horizontal Fiscal Equalization (HFE) of all six

states was first applied in 1981, the pool of untied funds made available
to achieve this objective was based on a pre-determined share of total
personal income tax collections. It was very quickly changed to a share
of total Commonwealth tax collections, then by a system under which
the level of ‘financial assistance grants was to be escalated annually in
accordance with movements in prices and a real growth factor’.4 The base
for these calculations was the tax sharing pool of 1984–85, the movement
in prices was to be the consumer price index and the growth factor was to
be 2 per cent.
In 2000, the pool of untied funds became attached to the newly intro-
duced GST. This still determines the size of the pool but it will change in
a small way for the period 2019–20 to 2026–27 when the Commonwealth
proposes to add between 1 and 1.5 per cent to the pool to overcome what it
sees as inequalities in the current distribution. Under the agreement made
when the GST was introduced,5 the tax rate was set at 10 per cent and this
can only be changed if a proposal has:

1. the unanimous support of the states and Territories;

2. the endorsement of the Commonwealth Government; and
3. 
the passage of relevant legislation by both Houses of the
Commonwealth Parliament.

Change had been made deliberately difficult and, at that time, politicians
from all governments considered that the GST had such growth potential

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 Intergovernmental fiscal relations in Australia ­173

that the rate of tax would probably never need changing. There was con-
siderable discussion on the breadth of the tax base and it was agreed that
it should not apply to foodstuff and essential services like education and
health. Changes to the tax base were made subject to the same rigorous
requirements as those applied to the tax rate.
Since 2000, there have been minor changes to the tax base but no
change to the tax rate. Individual states, politicians and commentators
have frequently argued for increases in the tax rate but there has never
been any move to test whether all states, the federal government and the
Commonwealth Parliament would support an increase.
The distribution of untied grants to the states is managed by the
Commonwealth Grants Commission (CGC). The Commission does not
have constitutional status but has existed since 1933. It was established
to give stability to the processes through which the Commonwealth was
providing untied funds to the states and as a result of a move by Western
Australia to secede from the Australian Federation.

The Objective of Equalization

The principle of HFE was expounded for the first time when the CGC
proposed, in its third report (1936), that:

special grants are justified when a State, through financial stress from any cause,
is unable efficiently to discharge its function . . . and should be determined by
the amount of help found necessary to make it possible for that State, by reason-
able effort, to function at a standard not appreciably below that of other States.6

The process would ensure the level of states’ services were not ‘appreciably’
different. It would not ensure they could be the same.
This application of ‘not appreciably different’ remained in place until
the 1980s when the CGC decided to avoid the judgement element involved
in deciding what was appreciably different by incorporating all drivers
of differences in fiscal capacity into its assessments. Judgement was still
necessary in many of the assessments, but the overarching judgement of
what appreciable meant had been avoided.
The states were complicit in this development. Their submissions to
CGC inquiries had argued about the detail in the calculation of assess-
ments rather than a judgement of an appreciable difference in overall
capacities. They each argued for the assessment of influences that were
beneficial to their position relative to others. They argued for more and
more elements to the algorithm. Many of these were accepted and the
Commission’s ‘black box’ grew in complexity.

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 174 Intergovernmental transfers in federations

In its 1993 Review, the Commission formally revised its definition of

equalization to replace the term ‘appreciably different’ with ‘the same’, thus
aligning it with how HFE was being implemented. The Commonwealth
accepted this change. The terms of reference for the following 1999 review
told the Commission the funding distribution:

Should enable each state to provide the average standard of State-type services,
assuming it does so at an average level of operational efficiency and makes the
average effort to raise revenue from its own sources.

It was this definition of HFE and its method of application that were
implicitly accepted by all parties when they signed the Intergovernmental
Agreement on the Reform of Commonwealth-State Financial Relations in
1999. It remained operational until 2010 but, by that time, suggestions
were being made for a less comprehensive interpretation of equalization.
In 2010, the Commission accepted some of the suggestions for simplifi-
cation and redefined the equalization objective as:

State governments should receive funding . . . such that, after allowing for
material factors affecting revenues and expenditures, each would have the
fiscal capacity to provide services and the associated infrastructure at the same
standard, if each made the same effort to raise revenue from its own sources and
operated at the same level of efficiency.7

The Commission then reduced the number of elements in its algorithm by

introducing a materiality test to their inclusion. This definition of HFE is
still in use. It is said to still result in ‘comprehensive’ equalization in that
all components of the states’ budgets are considered, even if some of them
are judged to no longer warrant a differential assessment, and immaterial
differences in capacity are excluded.
Some states continued to argue that the change made in 2010 was not
enough. As the revenue capacity of Western Australia grew with a boom
in exports of iron ore, this pressure increased, and the Commonwealth
initiated several inquiries into possible simplification to the HFE system.
The difficulty confronted each time was that no funds other than GST col-
lections were to be made available: gaining support for change from those
states that would suffer reduced funding was impossible.
This position of the federal government remained unchanged until after
the 2018 Productivity Commission Report into HFE8 discussed in the
next chapter. In July 2018, the Commonwealth proposed some changes
to untied funding to the states. The major changes proposed, but not yet
discussed or agreed to by the states, are that:

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 Intergovernmental fiscal relations in Australia ­175

1. 
The funding for Western Australia in each of the eight years after
2018–19 will be subject to a floor but other states will be subject to the
CGC’s HFE principles, although none of those states will be worse off
because of the change.
2. 
The Commonwealth will provide an extra $6.7 bn in untied grants over
the eight years to achieve the ‘no worse off’ position.
3. 
After 2026–27, any funding needed to get Western Australia up to the
minimum to which it is guaranteed will be at the expense of the other
states.

The federal government described the change as reinforcing and protecting

the ‘fair go’ system used to distribute the GST, and establishing a transi-
tion to a new HFE system over eight years. These claims, which are based
on an assumed level of HFE funding to which Western Australia will be
entitled in the long term, will create a system of one playing field for seven
states and a different playing field for the fiscally strongest state: Western
Australia. Only a week after the Commonwealth announced the proposed
change, the press were speculating that the mining companies were entering
their next boom and rapidly building new mines in Western Australia. It
may be that the Western Australian relative need based on HFE principles
will remain below the level now built into the Commonwealth’s proposal.
The government’s proposal also changes the dynamic of equalization
in two other ways. If there is a new mining boom, more of the financial
benefit of that boom will be kept by Western Australia and its capacity
to reduce taxes, increase employee wages or improve services beyond the
level of other states will be enhanced. It would be receiving GST funding
beyond the level indicated by HFE at a time when its revenue capacity
would be very high. Secondly, at present, any change in a state’s relative
share of SPPs changes its fiscal capacity and changes its share of GST, but
the introduction of a GST floor means an increase in its relative share of
SPPs would not reduce Western Australia’s untied grant. That is, it would
face no HFE consequences from the receipt of an abnormal increase in
SPP funding.
The federal government has claimed to have ‘protected the long-term
integrity of the HFE system, ensured it is fit for purpose and can continue
delivering on its objective’.9 In fact, it has moved away from Australia’s tra-
ditional HFE principles and proposed a two-tiered system of state service
provision capacity. Western Australia will, if the proposals are accepted by
the other states, be able to provide a better standard of services or lower
tax rates than the other states, perhaps in perpetuity.
A two-tiered system of ‘equalization’ is not unknown in intergovern-
mental financial relations. Indonesia, for example, gives Aceh and West

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 176 Intergovernmental transfers in federations

Papua extra funding but makes it clear that this is to maintain national
cohesion and because of the wealth those provinces contribute to the
national economy. Similarly, it is not unknown for nations to leave some of
the revenue derived from minerals in the province of origin, as in Canada
for example, but this is usually accompanied by a statement giving this as
the reason for the pattern of funds distribution.
One benefit in these developments is that the Commonwealth
Government has, for the first time, decided what it wants to achieve
through the HFE system, and what price it is prepared to pay to achieve
that objective. For 85 years, it has let the CGC, often in consultation with
the states, decide what HFE meant and how it was to be implemented.
This led to grant recipients focusing on the numerical calculation of their
positions rather than the wider question of the ‘acceptable’ degree of
equalization. Particularly since 2000 when untied grants ceased to have
any impact on its budget, the Commonwealth had shown relatively little
interest in either the size of the GST pool or the way it was distributed.
These were matters for the states.
Although the government’s solution to Western Australia’s complaints
of inequalities in the GST distribution is different from that proposed by
the Productivity Commission, that Commission is undoubtedly correct in
having recommended that:

●● the Commonwealth Government should set a revised objective of

HFE;10 and
●● the Commonwealth Treasury should provide public input into the
CGC’s five-yearly review process.11

9.9 THE IMPLEMENTATION OF HFE

HFE in Australia is, at its most simple, shown to be:

G 5 E 2 R 2 O (9.1)

where:
G is a state’s requirement for untied assistance;
E is the expenses it would incur if it provided average levels of services at
average levels of efficiency;
R is the revenue it would raise if it applied average tax policies to its
revenue bases; and
O is its revenue from SPPs that relate to functions in the assessment
budget.

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 Intergovernmental fiscal relations in Australia ­177

In arriving at its quantification of each of the E, R and O components,

the CGC has made many decisions on how HFE was to be approached.
We now discuss the changes since 2010 that could be said to have changed
the concept of HFE.

The Breadth and Categorization of Assessments

In Australia, there has never been any serious thought given to whether or not
HFE should be limited by excluding either side of states’ budgets. The 1936
definition included both revenue capacity and service delivery in its formula-
tion and that has continued to be accepted. The question remains, however,
about how to define the revenue sources and services that are to be assessed.
After the late 1970s, the way the CGC defined the revenue sources
and services it assessed changed as the quest for precision changed. The
definition of individual services got more specific as the assessment detail
increased. The number of separate services assessed in 1978 was 19, but
this slowly increased to 41 before being reduced to 14 in 2010. On the
revenue side, the 1978 assessments identified 16 different revenue sources.
This number rose to 21 but was reduced to 7 in 2010.
The 2010 changes made the assessments more manageable and, possibly,
more understandable. If the assessment category did not influence any
state’s grant by at least $100 per capita, it was subsumed elsewhere in the
assessment budget or assessed separately but by the EPC method, thus
ensuring it had no impact on the funding distribution.
On the question of revenue capacity, the issue of categorization has been
most obvious in the area of mining where the geographic distribution of
resources can result in an individual state dominating the average revenue
effort if different minerals are each assessed separately. On the other hand,
royalty rates and the measurement of revenue bases vary greatly between
minerals, which creates difficulties for an overall assessment of states’ rev-
enue capacity from minerals. The categorization of mining revenue sources
and the assessment of capacity in mining has been a perennial issue in
Australia, as elsewhere. Over the years, several approaches have been taken
but none has been found to be satisfactory in the long term. The recent
Productivity Commission report concluded that there was no obvious
approach that would mitigate the problem of policy non-neutrality that
besets the mining assessment.

The Detail in the Assessments

The Australian system has also seen large shifts in the level of detail within
the assessment of individual services. In this regard, the changes towards

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 178 Intergovernmental transfers in federations

simplification in 2010 were dramatic in the level of detail to which assess-

ments were made. The CGC decided that no disability, as they are called,
would be assessed unless it redistributed at least $10 per capita for any one
state.12 Taking education as the example, the structure of the assessments
and the disabilities assessed for each category in 1999 and 2010 are shown
in Table 9.1.
In total, the 2010 simplifications were the cause of fairly large changes
in the funds distribution.13 In line with the amended definition of HFE,
however, the results were considered to be an acceptable consequence of
simplification and could be supported equally to those resulting from the
previous more detailed procedures.

The Accuracy of Calculated Disability Factors

Before 2004, there was no consideration given of the level of confidence

that might be attached to individual disability factors being applied to the
assessment categories. In that year, the CGC decided that, for some assess-
ments, it should discount the calculated factors because it had insufficient
confidence in either the data being used or its relationship to differences in
state expenditure needs in the future.

The Contemporaneity of HFE Assessment

HFE assessments in Australia are always based on data that is at least

two years old. That is, the 2018–19 distribution is based on assessments
of states’ capacities for a period ending in 2016–17. This has been seen as
inevitable because there are no financial data available for 2017–18 and the
inclusion of a year based on estimated data has been avoided because of
the uncertainty it would bring into the calculations.
A regular discussion point, however, has been the length of the assess-
ment period and it has, over time, varied between three and five years. It
has been three years since 2010. The argument for a five-year period is
to give greater stability to the assessments, while the arguments for three
years centre on making them more contemporaneous. However, whenever
change is being considered, the states agree that HFE is achieved, over
time, when the circumstances of each year are given equal weight over time.

Frequency of Updating the HFE Calculations

In 1981,14 the CGC considered the frequency with which the basis of its
assessments should be reviewed and whether or not the calculations should
be updated between reviews. With the agreement of the states, it concluded

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 Table 9.1 The education assessments

1999 Assessments

YILMAZ_9781789900842_t.indd 179
Socio- Urbanization Administrative Input Dispersion Service Isolation Cross- National Other
demographic scale costs delivery border capital
composition scale

Education
Pre-schools * * * * * *
Government primary educ * * * * * * * *
Non-government primary * * *
educ
Government secondary educ * * * * * * * * * *

179
Non-government secondary * * * *
educ
Vocational education and * * * * * * *
training
Higher educ
Transport of rural school * *
children
2010 Assessments
Indigenous Socio- Age Non-state Wage costs Regional Service Cross-
status economic sector costs delivery border
Status scale
Schools education * * * * * * *
Post-secondary education * * * * * *

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 180 Intergovernmental transfers in federations

that there should be a five-yearly review of the methods used to determine

states’ HFE positions,15 and the calculations should be updated annually
between reviews to incorporate the latest available financial year and the
most recent data on which to base disability factors. The update process
supported the notion of equalization being achieved over time with each
state’s circumstances each year getting equal weighting over time.
Availability of data was not a consideration in whether updates would
be possible. The Australian Bureau of Statistics (ABS) produces popula-
tion, government finance data and a wide range of non-financial data on
an annual basis. A decision taken very early was that the CGC should use
data that was publicly available and derived from a central agency. The
CGC should not be collecting data or evaluating the accuracy of data
collected by reputable central agencies.

Coping with Changes to the Distributions

Undertaking five-yearly reviews of the states’ HFE positions can lead to

changes that are sufficiently large to be difficult for states to manage in
their annual budgets. In these circumstances, the practice has been to phase
in the changes to states’ relativities over time. This has sometimes been
proposed by the CGC but has, on other occasions, been the result of nego-
tiations between states and the Commonwealth during their considerations
of Commission recommendations. The transition period has usually been
either three or five years, depending on the size of the required change in
distribution.

Conclusions on Horizontal Fiscal Equalization Methodology

HFE has been in place in Australia since the late 1970s but the detail
in the calculations has changed over time. It is only in 2018 that the
Commonwealth Government seems to be taking an active role in specify-
ing what the HFE objective is. This development is well overdue and must
be beneficial to the Australian equalization system.
In terms of the calculation of states’ relative funding needs, the CGC
initially let the states drive the process. More recently, it has taken a more
proactive role and has set limits to the impact of individual factors when
deciding whether or not to include them in the calculations. Correctly, it
has argued that neither process can be shown to give a better result than
the other.
Many of the changes made over the last decade have been claimed to
make the process simpler and more easily understood. No doubt it is a
simpler calculation but whether it has improved understanding is not clear.

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 Intergovernmental fiscal relations in Australia ­181

The general understanding of the HFE process still appears to be very

limited but it could be that commentators simply like to emphasize the
disgruntled politicians’ position that ‘it is too hard to understand’. The
process can only benefit from the Commonwealth taking a more active
role, as recommended in the recent Productivity Commission report.

9.10 
THE INTERFACE BETWEEN TIED AND
UNTIED GRANTS
As mentioned earlier, the Commonwealth attempted, in 2009, to get all
SPPs distributed on an EPC basis. Inter alia, this was because the present
arrangements result in sectoral departments determining a needs-based
distribution of SPPs and then the CGC effectively doing it again when
it assesses relative needs for state services. This arises because the CGC
includes the services funded by the SPPs within its assessments, then
reduces each state’s need for untied funding by the value of the SPPs
received to fund those services.
The CGC’s process is consistent with the principle of HFE and is
accepted as such by the state treasuries, but it does result in some conflict
between HFE and other intergovernmental fiscal relations policies. It has
been criticized at both the federal and state level: the claim being that
agreed SPP distributions are overridden.
This principle of inclusion to treat SPPs was developed by the CGC in
the 1970s, without federal government guidance. By accepting CGC find-
ings since then, the government has implicitly accepted the Commission’s
position. On some occasions, the CGC has been given instructions not to
use inclusion for specified payments and to keep those state receipts and
the services they fund outside the assessments. Prior to the recent propos-
als on the level of HFE grants for Western Australia, the treatment of SPPs
was the only aspect of HFE methodology on which the CGC had been
given instruction.

9.11 
INSTITUTIONAL ARRANGEMENTS FOR
INTERGOVERNMENTAL FISCAL RELATIONS16

Council of Australian Governments

The Council of Australian Governments (COAG) is the peak intergovern-

mental forum in Australia. It is the key decision-making body with respect
to monitoring and implementation of the framework for federal financial

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 182 Intergovernmental transfers in federations

relations. COAG’s roles include initiating, developing, endorsing and

monitoring the implementation of policy reforms of national significance
which require cooperative action by all governments. The Council is
made up of the Prime Minister, the Premiers of the states and the Chief
Ministers of the territories. It meets at least annually.

COAG Council on Federal Financial Relations

The Commonwealth Treasurer is the chair of this Standing Council of

COAG which meets at least once each financial year. The treasurers of
the states and territories are the other members. Within a framework
determined by COAG, the Council considers matters relating to the
Intergovernmental Agreement on Federal Financial Relations (IGAFFR).
One of the Council’s responsibilities is to consider ongoing reform of
federal financial relations but it has not been active in this field.

The Commonwealth Grants Commission

The CGC was created by legislation in 1933. It is the key institution

in the HFE process but has no constitutional basis. It is a permanent
body comprised of between three and six members, including the chair.
Members can be either full-time or part-time and are initially appointed
for a five-year period, but appointments are renewable.
The process for selecting members of the Commission is not legislated
but has traditionally involved the states. Membership of the Commission is
a statutory position and the appointment is made by the Governor-General,
not the minister to which the Commission reports or the Prime Minister.

9.12 
THE INTERGOVERNMENTAL AGREEMENT
ON FEDERAL FINANCIAL RELATIONS

The IGAFFR came into effect in January 2009 and was ‘designed to be a
living document, with detailed arrangements set out in schedules that can
be updated as necessary, with the agreement of COAG’. It holds details
of things the parties have agreed to and a series of general aspirational
statements. It gives no idea of long-term intentions on the level of VFI, the
degree of autonomy to be available to the states, or what is meant by HFE.
New policy proposals by the Commonwealth, like the recent GST redis-
tribution in favour of Western Australia, are announced before they have
been discussed with the states. If that proposal is accepted, the agreement
will, presumably, be changed.

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 Intergovernmental fiscal relations in Australia ­183

When first agreed to, the IGAFFR was given much publicity in the
Commonwealth’s annual Budget Papers, but now it is mentioned only in
passing, or not at all.
In the 2016–17 Budget Paper No. 3, for example, we learnt that:

At the COAG meeting in April 2016, the Commonwealth and states agreed to
work together to develop options to share personal income tax revenue raised
and collected by the Commonwealth in exchange for reducing Commonwealth
payments for specific purposes.

This is a worthy aspiration, but there was no mention of the IGAFFR and
we have had no information since on what progress, if any, has been made.

9.13 CONCLUSION

Intergovernmental Fiscal Relations in Australia are dominated by

Commonwealth-State relations and these in turn are dominated by the
size of the VFI. VFI in favour of the Commonwealth has been the greatest
influence on what is done and how it is done, and the Commonwealth’s
movement into state (and local government) mandates has been enabled by
Section 96 of the Constitution.
Federal financial arrangements, especially in relation to the major SPPs,
are changed fairly frequently and the states therefore concentrate on the
short-term impacts of Commonwealth proposals. The COAG arrange-
ments are not working in a sufficiently broad way as to consider the big
issues in intergovernmental fiscal relations.
It appears that Australia might be a long time away from having any
real reform to its fiscal federalism. It is interesting to speculate, however,
how different Australian government and society might be if there was
a reassessment of mandates, revenue sources and levels of autonomy of
the three tiers of government; an overall philosophy on the size of VFI;
agreement on the mix of tied and untied grants used to overcome VFI;
greater government interest in the meaning and application of HFE; how
the pools of grant funding were changed annually; policy uniformity on
the basis of tied grants distributions; and agreed links between the tied
grant systems and the achievement of greater service delivery efficiencies.

NOTES

1. The term states covers the Australian Capital Territory and the Northern Territory
unless otherwise indicated.

YILMAZ_9781789900842_t.indd 183 16/12/2019 10:44

 184 Intergovernmental transfers in federations

2. These mentions of efficiency seem to be a mechanism for cost limitation by the

Commonwealth rather than a measure of the cost of activities performed at an average
or optimum level of efficiency.
3. Australian Budget Paper No. 3, 2018–19, Federal Financial Relations, p. 11.
4. Commonwealth of Australia, Budget Paper No. 7, Payments to or for the States, the
Northern Territory and Local Government Authorities, 1985–86, p. 15.
5. The Intergovernmental Agreement on the Reform of Commonwealth-State Financial
Relations, 1999.
6. CGC Third Report 1936, p. 75.
7. CGC Report on GST Revenue Sharing Relativities, 2010 Review, Main Report, p. 34.
8. Productivity Commission Inquiry Report, Horizontal Fiscal Equalisation, Australian
Government, 2018.
9. The Hon. Scott Morrison, Treasurer of the Commonwealth of Australia, Media
Release, 5 July 2018.
10. In its interim response, the federal government has said this should be done in consulta-
tion with the states.
11. The interim response accepted this, ‘where it would contribute additional value to the
CGC’.
12. This limit was increased to $30 per capita in 2015.
13. The CGC did not quantify the impact of individual changes. In total, however, the
changes redistributed over $725m, about 2 per cent of the pool.
14. CGC, Report on State Tax Sharing Entitlements, 1981.
15. The pattern of reviews coincides with the availability of new population data from
the five-yearly census.
16. More information on COAG, its Council and sub-committee is obtainable from feder-
alfinancialrelations.gov.au.

MAJOR REFERENCES

CGC (Commonwealth Grants Commission) (1936) Third Report, Melbourne.

CGC (1981) Report on State Tax Sharing Entitlements, 1981, Canberra.
CGC (2010) Report on GST Revenue Sharing Relativities, 2010 Review, Main
Report, Canberra.
Commonwealth of Australia (1999) The Intergovernmental Agreement on the
Reform of Commonwealth-State Financial Relations, 1999.
Commonwealth of Australia (2018) Budget Paper No. 3, 2018–19, Federal Financial
Relations, Canberra: Australian Government.
Council of Australian Governments website: federalfinancialrelations.gov.au.
Morrison, Scott (2018) Media Release, 5 July 2018.
Productivity Commission (2018) Horizontal Fiscal Equalisation, Report No. 88,
Canberra: Australian Government.

YILMAZ_9781789900842_t.indd 184 16/12/2019 10:44

 10. The economic impacts of horizontal
fiscal equalization as practised in
Australia
Jonathan Coppel

10.1 INTRODUCTION

Fiscal federal relations in Australia are unique in several respects. Australia

has close to the highest level of vertical fiscal imbalance of any federated
state, and its system of horizontal fiscal equalization (HFE) seeks to fully
equalize state and territories’ (hereafter states) fiscal capacities on both the
revenue and expenditure sides of the budget. The latter also takes account
of differences in the cost of supplying services.
This comprehensive approach to HFE, the institutional framework
used to determine the distribution of funds and the processes to ensure
accountability for how they are used are often portrayed by international
commentators as the ‘gold standard’. However, within Australia, HFE has
repeatedly been a point of contention in federal state relations. Fiscally
stronger states emphasize how the system may act as a disincentive to
policy reform, or to develop particular industries or projects. Fiscally
weaker states stress HFE’s role in promoting fiscal equality across the
Australian federation, especially given the inherent disadvantages some
states face in raising revenue or delivering services.
These concerns reached a nadir as the mining boom, concentrated in
Western Australia, elevated the extent of redistribution to an unprec-
edented high and saw Western Australia’s share of the goods and services
tax (GST) fall to a record low (Figure 10.1).1 Never before has there been
such a disparity in state relativities. It is against this backdrop that the
Australian Productivity Commission was asked in May 2017 to undertake
an inquiry into Australia’s system of HFE.2 This chapter examines how the
current HFE system impacts on state budget management and whether it
distorts public finance policy decisions. It also discusses the benchmarking
arrangements in place to ensure accountability and transparency between
levels of government.

185

YILMAZ_9781789900842_t.indd 185 16/12/2019 10:44

 186 Intergovernmental transfers in federations

6.0
5.0 NT
4.0
2.0
TAS

1.5
SA
ACT

1.0 QLD

NSW VIC

NT WA
0.5 becomes ACT
part of becomes GST
HFE part of HFE introduced Mining boom
system
0.0
2

8
–8

–8

–9

–9

–9

–0

–0

–1

–1

–1
81

85

89

93

97

01

05

09

13

17
19

19

19

19

19

20

20

20

20

20
NT: Northern Territory QLD: Queensland
TAS: Tasmania VIC: Victoria
SA: South Australia NSW: New South Wales
ACT: Australian Capital Territory WA: Western Australia

Source: Productivity Commission (2018).

Figure 10.1 The widening disparity in state per capita GST relativities

10.2 HOW DOES HFE WORK IN AUSTRALIA?

10.2.1 What Is HFE and Why Does It Exist?

Australia’s federal financial relations landscape is characterized by a

concentration of power at the Commonwealth level, comparatively lower
taxing powers of the states (mainly consisting of payroll taxes, mining
royalties, stamp duty and land tax) and a co-operative approach to federal-
ism with widespread joint government involvement.
A consequence of this landscape is both horizontal and vertical fiscal
imbalances. The latter refers to the fact that the Commonwealth govern-
ment raises revenues in excess of its spending responsibilities, while state
governments have insufficient revenue from their own sources to finance

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 The economic impacts of horizontal fiscal equalization ­187

their spending responsibilities. Australia has among the highest vertical

fiscal imbalance (VFI) in the world (Koutsogeorgopulou and Tuske, 2015),
with close to half state revenues coming from the Commonwealth.3
In this context, the primary rationale for HFE is to seek the equal fiscal
treatment of jurisdictions in the Australian federation, not interpersonal
equity. It involves the transfer of funds from the Commonwealth to the
states to offset differences in revenue‑raising capacities and in the use and
costs of providing services and infrastructure. Inevitably, this means there
is a tension between HFE and the incentive for states to use their own tax
bases (discussed in the next section).
This was a known risk in the earliest days of Australia’s federation and
nicely captured by Robert Garran, Australia’s ‘first public servant’, using
the following caricature:

We thank you for the offer of the cow, but we can’t milk, and so we answer
now – we answer with a loud resounding chorus: please keep the cow and do the
milking for us. (Garran, 1958, p.208)

10.2.2 The Practice of HFE in Australia4

The Commonwealth Grants Commission (CGC) recommends a distribu-

tion of GST revenue according to the following objective:

State governments should receive funding from the pool of goods and services
tax revenue such that, after allowing for material factors affecting revenues and
expenditures, each would have the fiscal capacity to provide services and the
associated infrastructure at the same standard, if each made the same effort to
raise revenue from its own sources and operated at the same level of efficiency.
(CGC, 2010, p.34)

This articulation of the HFE objective is noteworthy in several respects.

First, it applies to both revenues and expenditures. Second, allowing
for material factors affecting expenditures means taking into account
differences in the cost of supplying services across jurisdictions, not just
differences in their use. Third, the same fiscal standard implies equalizing
to the fiscally strongest state. The primacy of the fiscal equality objective
and equalization on both the expenditure and revenue side is unique to
Australia.
Australia’s institutional arrangements for determining the GST distribu-
tion are robust and independent. The CGC, an independent statutory
agency, is charged with developing, applying and periodically revising
the methodology used to calculate the distribution of the GST pool. The
CGC was established in 1933 and greatly reduced the politicization of

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 188 Intergovernmental transfers in federations

Remainder as EPC
Size of the equalization
Task = +
Fiscal capacity per capita

St te 1
St te 2
St te 3
St te 4
St te 5
e6

St te 1
St te 2
St te 3
St te 4
St te 5
e6

St te 1
St te 2
St te 3
St te 4
St te 5
e6

St te 1
St te 2
St te 3
St te 4
St te 5
e6
at

at

at

at
a
a
a
a
a

a
a
a
a
a

a
a
a
a
a

a
a
a
a
a
St

St

St

St
Initial fiscal 1. Bring states to 2. Bring all states to 3. Redistribute
capacity average the strongest

Source: Productivity Commission (2018).

Figure 10.2 Schema of the conceptual stages of the HFE process

Commonwealth state transfer decisions. It is well respected and trusted,

and its processes are consultative and transparent.
The CGC’s methodology is very complex and few people understand the
method in detail. This gives scope for vested interests to mislead, and that
in turn risks a loss of confidence in the system. Conceptually, however, the
CGC’s approach is straightforward and can be summarized in three steps
(Figure 10.2):

1. 
States with relatively low fiscal capacities are raised to the average
(pre-GST) fiscal capacity of all states;
2. 
all states are then raised to the capacity of the fiscally strongest state;
3. 
any remaining revenue from the GST pool is distributed to all states on
an equal per capita (EPC) basis.

After these equalization steps, all states are provided with the fiscal
capacity to provide the national average level of services. Due to the VFI
between the state and Commonwealth governments, even the fiscally
strongest state requires an EPC component ‘top up’ (step three) to be able
to provide the average level of services.
The size of the equalization task – that is, the share of the GST pool
not distributed on a per capita basis to achieve equalization – peaked in
2016–17 at 12–13 per cent (Figure 10.3). The increase in the equalization

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 The economic impacts of horizontal fiscal equalization ­189

14 Victoria fiscally NSW fiscally 10

strongest state strongest state WA fiscally strongest state
9
12
8
Per cent of GST pool

10 7
6
8

$ billion
5
6 4
4 3
2
2
1
0 0
2000–01 2005–06 2010–11 2015–16
Redistribution amount (RHS) Redistribution share of GST pool (LHS)

Source: Productivity Commission (2018).

Figure 10.3 Share of GST pool not distributed on a per capita basis

task reflects the increased disparity in the fiscal capacities of the states over
the past two decades (as also revealed in the unprecedented dispersion in
GST relativities).
Western Australia emerged as the fiscally strongest state about a decade
ago, and is expected to remain so for some years to come. This reflects the
mining boom and increased mineral production in the resource rich state.
Typically, the fiscally strongest state has been less of an outlier and one of
the two largest state economies, New South Wales (NSW) or Victoria. In
contrast, the small state economies, such as South Australia and Tasmania,
have consistently been assessed with a below average fiscal capacity.
The key factors affecting the redistribution of the GST are mining,
remoteness and regional costs and indigenous status. Moreover, it is
changes in these factors, rather than in the HFE methodology that mostly
account for the shifts between states’ fiscal capacities over time.

10.2.3 To What Extent Does HFE Achieve Fiscal Equalization?

In practice the CGC does not achieve perfect equalization. This is largely
due to conceptual considerations and data limitations needed to apply
the methodology. For example, not all activities are differentially assessed
because they cannot be reliably measured or have an immaterial impact
and are either discounted or assessed on an EPC basis. In 2016–17,

YILMAZ_9781789900842_t.indd 189 16/12/2019 10:44

 190 Intergovernmental transfers in federations

nearly 40 per cent of revenues and about 20 per cent of expenditures were
assessed on an EPC basis, or near EPC basis. Even still, Australia is recog-
nized internationally as unique in almost completely eliminating disparities
in fiscal capacity between states (OECD, 2013).
The Commonwealth is also a major provider of revenue to the states
through other channels than the GST distribution. They include Specific
Purpose Payments (SPPs) and National Partnership Payments (NPPs).
These payments are taken into account by the CGC in state fiscal capacity
assessments, either as part of state revenue, or as an offsetting reduction in
state expenditure needs.
Some payments, however, are excluded from fiscal capacity assess-
ments. The Treasurer, for example, can direct the CGC to ‘quarantine’ a
Commonwealth payment that supports a project with national or cross-
state benefits, such as national infrastructure. The Treasurer also has the
power to target particular needs or shortfalls of individual states that may
not be recognized in the CGC’s analysis. For example, controversy about
Western Australia’s low relativity following the mining investment boom
led to the state receiving quarantined funds for infrastructure.
Quarantined payments made to a state raise that state’s ‘effective
relativity’, enabling it to receive additional Commonwealth funds without
the consequence of a reduction in its relativity as calculated by the CGC.
The ability of the Commonwealth Treasurer to quarantine payments from
HFE reduces transparency and accountability for the delivery of govern-
ment services (discussed further in section 10.4) and adds an element of
unpredictability to Australia’s HFE system. In practice, only about 5 per
cent of Commonwealth payments are quarantined by the Treasurer.5
The CGC also has the discretion to discount payments by up to 50 per
cent from their fiscal capacity assessments. This is done in accordance with
the principles of HFE and is usually reserved for when the CGC is not
confident of the accuracy of their assessment.
Once all these payments are taken into account, the overall degree of
fiscal disparity between the states narrows. Nonetheless, the heavy lifting
with the redistribution is done by the GST distribution. Once it is factored
in, the revenue disparities in most states fall to near negligible differences
(Figure 10.4). The one exception is the Northern Territory, which raises
close to the average own source revenue per capita, but after the GST
distribution its revenue per capita is about 135 per cent higher than the
average. This is because the Australian system also takes expenditure needs
into account and the Northern Territory has both higher use and costs
of government service delivery, due mostly to its remoteness and large
indigenous population.

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 The economic impacts of horizontal fiscal equalization ­191

Revenue per capita relative to the average, per cent

–60 –40 –20 0 20 40 60 80 100 120 140 160

TAS

SA

VIC

NT

QLD

NSW

ACT Own source revenue

After SPPs and NPPs
WA After GST payments

Source: Productivity Commission calculations.

Figure 10.4 The overall redistributive effects of Commonwealth transfers,

2015–16

10.3 THE ECONOMIC IMPACTS OF HFE

This section considers the economic impacts of Australia’s system of

HFE. Section 10.3.1 examines the disincentives facing states to initiate
tax and expenditure reforms. Specific emphasis is given to mineral and
energy resources, where the potential impacts of HFE have been highly
contentious. Section 10.3.2 focuses on how HFE can alter how economic
fluctuations bear on state budget cycles.

10.3.1 Disincentives to Undertake Public Finance Reforms

The CGC’s methods for calculating GST shares to the states are intended
to be policy neutral – that is, GST shares should reflect structural dif-
ferences across states and should not be affected by an individual state’s
policy decisions, including the mixture of revenue sources that it chooses
to use. But because average state policy is determined by what states col-
lectively do, there is some tension with the principle of policy neutrality.
The tension between what states do and policy neutrality is inherent to
any system of HFE, in that any increase in a state’s fiscal capacity relative
to others will see it receive less in equalization payments. There is also a

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 192 Intergovernmental transfers in federations

debate between focusing solely on addressing the inherent advantages and

disadvantages in the fiscal capacity of the states and allowing some fiscal
reward for effort, risk taking and policy reform (fairness). In practice, these
tensions and hence concerns about incentives for inefficient policy choices
are more evident on the revenue side, with some large potential effects in
relation to major state tax reform and the taxation of minerals and energy.

State tax reform

By virtue of how the GST distribution formula works, state tax policy
reform can lead to a change in that state’s share of the GST through:

●● the average‑rate (‘Robin Hood’) effect – a higher tax rate increases

the national weighted‑average rate, which can either reduce GST
payments (for states with a relatively large share of the tax base) or
increase GST payments (for states with a relatively low share); and
●● the elasticity effect – a higher tax rate leads to a reduction in the
state’s own tax base, due to lower demand or the movement of
resources to other states. The state’s GST payments increase as it is
assessed as having lower revenue‑raising capacity.

The direction and size of these effects is not straightforward and depends
on where the state sits relative to the average. In general, where a state
changes its tax rate, the subsequent effect on the GST distribution will be
small. It will be larger for the larger states, as they have a bigger impact
on the national average tax rate. In the event of a state increasing one tax
rate and reducing another (for example, to make a reform revenue neutral),
there would be two average-rate effects to take into account.
A general measure of the effect of changes to revenue-raising effort on
GST payments can be calculated by examining the change in GST pay-
ments due to raising an extra $100 in revenue by a tax rate increase in any
state. Table 10.1 presents this measure for selected revenue assessments.
For most tax categories the estimates are less than 5 cents per dollar
change in own source revenue, and the median effect is close to 1 cent. The
main exception is iron ore royalties (discussed below), for which Western
Australia (WA) has a very large share of the revenue base. A $100 increase
in WA iron ore royalties raised by a higher royalty rate in WA would result
in an $87.9 decline in its GST distribution. Other states would benefit,
especially the large population states of NSW and Victoria (Table 10.1).
In contrast, policy changes that affect the tax base can have a sig-
nificant effect on the GST distribution. This is because changes to the
base mean changes to assessed revenue-raising capacity (vis‑à‑vis other
states). For example, if a state like Victoria (with 25 per cent of Australia’s

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 The economic impacts of horizontal fiscal equalization ­193

Table 10.1 Average‑rate effects per $100 revenue increase, 2016–17

Revenue category NSW VIC QLD WA SA TAS ACT NT

Insurance tax 22.6 1.9 0.7 0.3 20.5 0.4 0.1 20.1
Land tax on 27.5 23.7 5.6 20.2 3.5 1.2 0.8 0.3
 income-producing
property
Iron ore royalties 32.0 25.6 20.0 287.9 6.1 1.5 1.7 1.0
Taxes on heavy 5.3 0.8 21.3 25.2 20.2 20.3 1.3 20.3
vehicles
Payroll tax 22.9 1.3 2.1 23.1 1.9 0.8 20.1 20.2
Stamp duty on 210.4 21.5 1.5 5.3 3.4 1.0 0.0 0.6
property

Note: * Figures indicate the change in each state’s GST payments, in dollars, for a $100
increase in revenue raised by a tax‑rate increase in any state (the amount by which that
state’s tax rate needs to increase to raise the $100 in revenue will depend on the state),
assuming no change in the size of tax bases.

Source: Productivity Commission (2018).

­ opulation), expanded its tax base and therefore increased tax revenue by
p
$100, it would see $75 ($100 less its population share) of the additional
revenue redistributed to other states.
Taken together, there is little doubt that state tax reform disincentives
exist in principle. Whether such effects actually influence policy decisions
is harder to discern; decisions not to pursue reforms are impossible to
directly observe. Not surprisingly, there is widespread disagreement on the
occurrence and magnitude of disincentive effects and conclusive evidence
is scarce. Against this background and to illustrate how tax reforms can
influence a state’s GST payment, the Commission considered several
­stylized reform ‘cameos’.6
The cameos rest upon simple assumptions and share a number of
limitations. They assume that a state can fully offset its revenue or balance
its spending in the same year the reform is implemented. The analysis
does not consider the transition path for reform or any indirect effects
that might occur as a result of the policy change. Nor does it factor in any
long-term impact of the policy change in the state or how other states may
respond. Furthermore, the impact of the reform on a state tax base (the
elasticity effect) is by assumption only. Notwithstanding these simplifying
assumptions, the cameos remain useful for illustrative purposes.
The first cameo involves a state halving its average rate of stamp duty on
property and replacing the lost revenue with a new broad-based tax on all

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 194 Intergovernmental transfers in federations

residential land. While the direct impact is revenue neutral, the net effect
is a reduction in GST payments for any state that undertakes this reform
unilaterally. This is because the reforming state would be assessed as having
a stronger capacity to raise revenue from stamp duty because of the growth
in its assessed tax base, even though the reform would mean that it actually
now raises less revenue. Moreover, the land tax reform would also cause the
larger states to lose GST payments as they are assessed to have a stronger
capacity to raise revenue from land taxes.
The impacts on the GST distribution are much smaller in the case where all
states pursue the tax switch reform in parallel, as the national average stamp
duty rate would also fall by half (bringing down assessed revenue in all states).
Because no state would be a big outlier from average policy after multilateral
reform, some states would see a modest gain in GST payments, whereas
others would experience a reduction (depending on where each state stands
in relation to the average for each tax base). Hence, there can be a distinct
first-mover disadvantage among states intent on pursuing tax policy reform.
A second cameo illustrates what would happen if a state abolished
its insurance taxes. Every state would lose GST revenue from unilateral
reform of this kind because their tax base has increased (due to increased
demand for insurance) and because they are still assessed as having the
capacity to raise revenue through insurance taxes. However, the GST
impacts are small due to the small size of the insurance tax base (just over
$5 billion nationally in 2016–17). If all states were to multilaterally abolish
their insurance taxes the effect would be the same as if insurance taxes
were removed from the HFE methodology.
In summary, most state tax reforms would likely have limited impacts on
the GST distribution. However, despite the CGC’s aspiration and endeav-
our, Australia’s HFE system is not policy neutral. There are circumstances
where the effects of tax policy reform on the share of GST revenue flowing
to each state can be material – such as for a state undertaking large scale
tax reform – and act as a significant disincentive for states to implement
efficient tax policy. These incentives are exacerbated where the state is a
first mover on reform or where there is uncertainty about how significant
tax changes will be assessed by the CGC.

Mineral and energy resources

The potential for HFE to distort state policy is particularly striking for
some mineral and energy resources, as their extraction is very unevenly
distributed across states. For example, over 98 per cent of Australia’s iron
ore production is in WA. In such extreme situations, WA’s policy is average
state policy – and thus the mining assessment is not policy neutral because
that state’s own choices directly influence the level of GST payments it

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 The economic impacts of horizontal fiscal equalization ­195

receives. If WA raised royalties on iron ore, it would lose close to 90 per

cent of the additional revenues to other states.
Due to these outsized effects, some have argued that states have an
incentive to under-tax mineral rents or extract rents through other means.
For example, states could require mining companies to provide infrastruc-
ture and services directly to remote communities in exchange for paying
lower royalties (Ergas and Pincus, 2011, p.8; Pincus, 2011, p.17), or could
set low royalty rates and use other charges to extract rents from mining
companies (such as freight charges). Academics have suggested that HFE
is likely to be one of many factors driving the under‑taxation of mineral
rents by Australian states (Petchey, 2018, p.18).

Efficiency of service delivery

The potential for HFE to distort tax policy is much lower on the expendi-
ture side than it is on the revenue side. In principle, incentive effects could
arise because when the CGC assesses state expenditure needs, it considers
the cost of providing a service and the levels of service use.
In practice, however, where a state reduces or increases its average costs
for service delivery, it has very little impact on the GST distribution. An
additional dollar of expenditure in any state will move the national average
by less than 1 cent (analogous to the average-rate effect). As such, the cur-
rent HFE system is unlikely to materially distort state incentives to provide
public services cost-effectively.
However, where a state addresses its structural disadvantage and there-
fore affects the use of its services and infrastructure, its GST share would
move in line with the structural change, meaning the state would only
receive its population share of the fiscal benefits (analogous to the tax base
effect). This could create disincentives for states to address their structural
disadvantages, particularly if they would incur high costs to do so. To give
one example, the Productivity Commission has previously found that the
equalization of spending on natural disaster recovery, but not of disaster
mitigation expenses, biases states’ incentives to efficiently manage natural
disaster risks (Productivity Commission, 2014, p.33).
More generally, there are long‑running concerns that HFE leads to
grant dependency in the smaller states and a failure to pursue economic
development. Again, these in‑principle incentive effects are hard to sub-
stantiate with direct evidence.

10.3.2 How Does HFE Affect State Budget Management?

GST payments provide most states with a substantial share of their

overall revenue, ranging from 25 per cent in WA to nearly 70 per cent

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 196 Intergovernmental transfers in federations

in the Northern Territory in 2017–18. Hence, the HFE distribution has

considerable scope to influence states’ budget outcomes and management.
This section, therefore, focuses on how features of Australia’s HFE system
affect states’ ability to manage their budgets.

HFE can amplify state budget cycles

Two features of Australia’s HFE system act to limit the timeliness of GST
payments, potentially amplifying budget fluctuations at the state level.
First, relativities are averaged over three years (the assessment period).
Second, there is a two-year lag between the assessment period and the
year in which relativities apply (the application year), which is the result
of delays in data availability. This means that equalization payments for
the 2018–19 financial year are determined by states’ circumstances in the
financial years 2014–15 to 2016–17.
In turn, non-contemporaneity can flow through to a ‘mismatch’ between
states’ economic circumstances and GST payments in two ways. First,
when a state is experiencing a structural shift (so that its fiscal capacity is
growing – or declining – more rapidly than the change in the GST pool)
and second when a state is experiencing a sudden change in its fiscal capac-
ity (for example, an idiosyncratic shock).7
In these circumstances a state’s actual GST payments can differ substan-
tially from their contemporaneous GST requirements – the payments they
would receive if relativities reflected their circumstances in the application
year. With GST payments failing to respond to particularly rapid changes
in fiscal capacity, the GST distribution can be pro‑cyclical for individual
states – potentially amplifying the size and impact of economic fluctua-
tions. In practice, the value of the mismatch has generally been small rela-
tive to the states’ GST payments overall. WA’s recent experience with the
mining boom-induced shift in its fiscal capacity being a rare, but notable
exception.
From a policy perspective, the most appropriate response to a lack of
contemporaneity lies with the states themselves; offsetting cyclical influ-
ences on state budgets is not the primary objective of HFE. States borrow
and save to manage gaps between their GST payments and actual pay-
ments, as they already do for other sources of budget volatility. Moreover,
states are generally able to forecast the direction of changes in their GST
relativities. Indeed, some states argue that applying a three‑year moving
average to relativity calculations, plus a two‑year data lag, promotes
stability of GST payments and provides states with more certainty when
planning their budgets.

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 The economic impacts of horizontal fiscal equalization ­197

Volatility in equalization payments and budget planning

The counterpart to contemporaneity of equalization payments is volatil-
ity. As outlined above, greater contemporaneity of payments tends to be
accompanied by their greater volatility. Volatility, in turn, can contribute
to uncertainty in budgetary planning processes.
Other important influences of the HFE system on revenue volatility and
predictability include:

●● the size of the total GST pool – Australia’s national GST collection
determines the total amount of funding to be distributed to states.
Growth in the GST pool has ranged from 14 per cent in 2002–03
down to −3 per cent in 2008–09. In many years, changes in the size
of the pool have contributed more to changes in most states’ GST
payments than changes to populations and relativities combined.
●● revisions to data and the CGC’s methodology – because the data
used by the CGC are often revised following initial release, annual
relativities for an assessment year can vary materially across updates,
particularly given adjustments to states’ population shares. These
effects can be compounded by changes in the CGC’s methodology,
which is reviewed every five years.
●● judgements regarding the exclusion of Commonwealth payments –
both the Commonwealth Treasurer and the CGC have the ability to
determine whether specific Commonwealth payments are excluded
from the calculation of states’ relativities. These determinations are
unpredictable and can have significant impacts on state budgets,
particularly for smaller states (Brumby et al., 2012, p.70).

GST payments are relatively stable compared to other sources of state

government revenue. Over the past 16 years, the relative variation in GST
payments to the states from one year to the next has been smaller than for
other major sources of revenue (Figure 10.5). Moreover, in some cases
GST payments appear to partially offset fluctuations in other revenue
streams, dampening the volatility of overall state revenues.

10.4 
UNTIED GRANTS, ACCOUNTABILITY AND
BENCHMARKING

Ultimately, states are accountable to their electorates for how they use
HFE funds, not to the Commonwealth government. This is the basis for
why the distribution of GST funds from the Commonwealth to the states is
not tied, and for the more general move away from strict controls over how

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 198 Intergovernmental transfers in federations

60 40

35
50
30

Proportion of revenue (%)

Coefficient of variation

40
25

30 20

15
20
10
10
5

0 0
Interest Other Sales of Non-GST State GST
income revenue goods grants taxation payments
and services revenue
Average coefficient of variation, weighted by population (LHS)
Average proportion of state revenue, weighted by population (RHS)

Notes:
a The coefficient of variation is a measure of dispersion, showing the degree to which

values are spread above and below the mean, relative to the size of the mean itself. It takes
into account both positive and negative changes and is calculated by dividing the standard
deviation by the mean.
b Royalty income is included in ‘other revenue’. ‘State taxation revenue’ includes stamp/

transfer duty, land tax, insurance tax and vehicle licensing charges. ‘Current grants and
subsidies’ presented in the ABS Government Finance Statistics have been disaggregated into
‘Non-GST grants’ and ‘GST payments’.

Source: Productivity Commission (2018).

Figure 10.5 Year-on-year volatility of state revenue sources,a, b 2000–01 to

2015–16

federal transfers to the states are deployed. But to be effective it requires

a clear delineation of roles and responsibilities and finding a way to instil
accountability.
In this regard, Australia has never considered in a serious and
detailed manner the division of roles and responsibilities between the
Commonwealth and state governments, but it has been at the forefront of
experimentation with benchmarking as a tool to improve accountability
and service delivery in federal systems of government.
There are two broad approaches to intergovernmental b ­ enchmarking.

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 The economic impacts of horizontal fiscal equalization ­199

BOX 10.1 
EXPERIENCE WITH INTERGOVERNMENTAL
BENCHMARKING IN AUSTRALIA

In 1991 Heads of Government requested the Industry Commission (the predeces-

sor of the Productivity Commission) to benchmark Government Trading Enterprises
(GTEs) in the electricity, gas, water, transport and communication sectors. The
resulting series of reports, known as the ‘Red Books’, stimulated substantial
debates and reforms, including the privatization of many GTEs.
Following the success of the ‘Red Books’ Australian Governments recognized
the potential to apply a similar performance reporting regime to government-pro-
vided services. This led to the creation in 1993 of the Report on Government
Services, also known as RoGS, or as the ‘Blue Book’. RoGS is a leading example
of benchmarking in federal systems of government.
Its distinguishing feature is its collegial approach, with the Commonwealth
government playing a facilitative role, rather than a directive or coercive one.
RoGS governance arrangements also ensure buy-in through a genuine ‘Whole
of government’ approach. It is guided by a Steering Committee, comprising
senior representatives from central agencies from all governments who deter-
mine the performance monitoring framework and oversee publication of the
report.
It is the combination of top-down authority exercised by a Steering Committee
with bottom-up expertise contributed by line agencies which sets RoGS apart from
most other national reporting exercises. The Productivity Commission chairs the
Steering Committee and serves as an independent secretariat, compiling the data,
producing the report and ensuring a neutral assessment. The scope is comprehen-
sive, capturing some $250 billion in recurrent expenditures by governments,
equivalent to about two-thirds of the total.

The first is a top-down method where the federal government uses

benchmarking, much as a large business enterprise with its operating
units. The second approach is a bottom-up method. It is more col-
legiate and intended as a learning-oriented governance arrangement.
Both approaches are far from straightforward to implement. On the
continuum between the two approaches to intergovernmental bench-
marking Australia lies more firmly towards the bottom-up method.8 The
Productivity Commission has played a key role in intergovernmental
benchmarking for more than 25 years, making it an interesting case study
(Box 10.1). It is in effect an annual report card on governments’ perfor-
mance across an array of politically sensitive services. This makes it a key
accountability tool, as it receives extensive media coverage, academics
use the indicators in policy research and the community sector draws on
it for their advocacy.
But benchmarking is one instrument among others of accountability
within Australia’s system of federal state relations. While it plays a useful

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 200 Intergovernmental transfers in federations

role, accountability for how governments fulfil their roles and responsibili-
ties will inevitably remain blurred, given the high level of VFI in Australia.

10.5 SUMMING-UP

The Productivity Commission’s overall assessment found that Australia’s

HFE system is functioning reasonably well in regard to:

●● a high degree of fiscal equality: Australia is the only OECD country

that seeks to fully eliminate disparities in fiscal capacity for both rev-
enue and expenditure between subnational governments. It enables
all states to provide the average national level of services and mostly
adjusts for material structural disadvantages that are out of states’
control. The principle of fiscal equalization is strongly supported;
●● an independent process: the CGC, as an expert agency independent
from governments, is well placed to conduct the HFE distribution
process. It has well‑established processes that involve consultation
and regular methodology reviews. This helps to remove some of the
political melee around the distribution of GST; and
●● stability for state budgets: HFE results in reasonably stable GST pay-
ments and a level of predictability for most states regarding budget
outcomes.

However, there are deficiencies in a number of areas, which have become

particularly conspicuous recently. These include:

●● the system is not policy neutral: while most state tax reforms and
changes in state service delivery policies would have limited impacts
on the GST distribution, there are circumstances where distortions
are particularly pronounced for major tax reform exercises. These
disincentives are exacerbated where the state is a first mover on
reform or where there is uncertainty about how significant tax
changes will be assessed by the CGC. There is also a large potential
for HFE to discourage efficient taxation and extraction of some
mineral and energy resources. States that increase mineral produc-
tion or royalty rates will lose much of the additional revenue to
equalization due to the dominance of select minerals in particular
states.
●● too little weight is afforded to the importance of fairly rewarding
effort: because the system does not systematically provide for states
to retain a reasonable share of the fiscal dividends of their policy

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 The economic impacts of horizontal fiscal equalization ­201

efforts without them being ‘equalized away’ through lower GST

payments.
●● lack of transparency and accountability: the HFE system is fiendishly
complex. While this may not be a problem in itself, it can give scope
for vested interests to feed misinformation and undermine account-
ability for decisions and public confidence in the system.

The Commission’s final report proposed a package of changes to improve

the HFE system and to bolster trust and community confidence in the
system. They covered the need for:

●● a revised and clearer articulation of the objective of HFE to allow

the system to provide a better balance between fiscal equality and
efficiency;
●● improved governance arrangements to enhance transparency and
accountability through more robust decision-making frameworks
and stronger communication;
●● improving the way fiscal capacities are assessed through ‘in system’
changes (for example, higher materiality thresholds) to correct for
some of the equity and efficiency problems with the HFE system;
●● a different equalization standard that recognizes reward for policy
effort to unlock additional equity and efficiency benefits; and
●● broader reforms to federal financial relations, recognizing that there
is only so much an improved HFE system can deliver in isolation.

For an in-depth discussion of the rationale for, and assessment of these

changes, readers should refer to the Commission’s final report.

NOTES

1. A state’s tax share relativity is the ratio of a state’s per capita GST allocation to the
national average per capita GST distributed for a given year.
2. This chapter draws on the Australian Productivity Commission’s final report Horizontal
Fiscal Equalization, which can be downloaded from: https://www.pc.gov.au/inquiries/
completed/horizontal-fiscal-equalisation/report. The CGC also conducts an in-depth
Methodology Review every five years. The next review is underway and will be released in
2020.
3. VFI refers to the situation where the Commonwealth raises more revenue than it requires
for its own direct expenditure responsibilities, whereas states raise less revenue than they
require for their expenditure responsibilities.
4. For a more detailed exposition of Federal State Financial arrangements in Australia and
how HFE is implemented in Australia see Chapter 9 in this volume.
5. For a more detailed discussion of quarantined payments, see Appendix B of the
Productivity Commission’s final report on Horizontal Fiscal Equalization.

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 202 Intergovernmental transfers in federations

6. For a detailed and fuller discussion on the cameo analysis, including the caveats and
assumptions used, readers are referred to the Productivity Commission’s final report (PC,
2018, Appendix C).
7. Equalization will nevertheless respond over the longer term to structural change in states’
fiscal capacities. In contrast, no state can escape the fiscal consequences of a collective
downturn in the economy’s fiscal position; HFE would not be able to offset all states’
declines in their other revenues (non-GST).
8. For a more detailed exposition on the rationale and approaches to benchmarking in
federations, see PC and Forum of Federations (2012).

REFERENCES

Brumby, J., Carter, B. and Greiner, N. (2012). GST Distribution Review, Final
Report, Australian Government, Canberra.
CGC (Commonwealth Grants Commission) (2010). Volume 1: Main Report,
Report on GST Revenue Sharing Relativities: 2010 Review, Canberra.
Ergas, H. and Pincus, J. (2011). ‘Reflections on fiscal equalisation in Australia:
Submission to the GST Distribution Review’, Issues Paper, Canberra.
Garran, R. (1958). Prosper the Commonwealth, Angus and Robertson, Sydney.
Koutsogeorgopulou, V. and Tuske, A. (2015). Federal-State Relations in Australia,
OECD Working Paper, No. 1198, Paris.
OECD (Organisation for Economic Co-operation and Development) (2013).
Fiscal Federalism 2014: Making Decentralisation Work, Paris.
PC (2018). Horizontal Fiscal Equalisation, Report no. 88, Canberra.
PC and Forum of Federations (2012). Benchmarking in Federal Systems, Roundtable
proceedings, Melbourne, 19–20 December 2010, eds A. Fenna and F. Knüpling,
Canberra.
Petchey, J.D. (2018). ‘Inter-regional transfers and the induced under-taxation of
economic rents’, Regional Studies, 52 (2), 1–11.
Pincus, J. (2011). ‘Examining horizontal fiscal equalisation in Australia’, Research
Paper No. 2011-25, University of Adelaide School of Economics, Adelaide.
Productivity Commission (PC) (2014). Natural Disaster Funding Arrangements,
Report no. 74, Canberra.

YILMAZ_9781789900842_t.indd 202 16/12/2019 10:44

 PART III

Intergovernmental Transfers in Evolving

Federations

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 11. Intergovernmental fiscal transfers
and performance grants in Brazil
Deborah L. Wetzel and Lorena Viñuela

11.1 INTRODUCTION

Brazil is one of the world’s largest federal countries. It has a population

of about 209 million and is highly urbanized with some 85.4 per cent of
the population living in urban areas. Its gross domestic product (GDP)
per capita in 2017 was US$10,720.1 It is a country of great size, resources
and diversity – from the relatively wealthy Southeast, to the agricultural
heartland of the Centre-West, to the less developed North and Northeast,
and the sparsely populated North-West Amazon. The size and complexity
of the country have led to diverse approaches to intergovernmental finance
over the decades.
Since the Constitution of 1988, the Brazilian government has operated
in a highly decentralized way. Brazil has 26 states plus the Federal District
of Brasilia, which serves as the capital, and over 5,500 municipalities. The
1988 Constitution establishes municipalities as full federation members
with the same autonomy and sovereignty as the states. With this status,
municipalities are not subordinated to the states or any other jurisdictions
such as metropolitan areas. This has important implications for the system
of transfers as both shared taxes and transfers may move directly from
the federal level to states or municipalities, or from the state level to the
municipal governments. In other words, not all transfers to municipalities
pass through state governments.
This chapter provides an overview of Brazil’s system of intergovernmen-
tal transfers and three cases of performance-based transfers. The first is
the Bolsa Família programme that provides grants directly to beneficiaries
and to both states and municipalities for administering one of the largest
social protection programmes. The other two include the performance-
based transfers from the Ceará and Rio de Janeiro states to municipalities
in the education and water and health sectors respectively. In the case of
Ceará, the state has adopted a conditional revenue-sharing mechanism to
allocate the proceeds of the state value added tax (VAT) to municipalities

204

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 Intergovernmental fiscal transfers and performance grants in Brazil ­205

that meet performance targets in basic education and water. Rio de Janeiro
has similarly implemented transfers to municipal hospitals that seek to
encourage better service provision and improve economies of scale and
inter-municipal cooperation.
Brazil’s variety of experiences with different types of transfers at the
subnational level provide interesting lessons and ideas for other countries.
The approaches used suggest a mechanism to align subnational actions
with goals. They also help strengthen accountability and a focus on out-
comes that could be relevant for other federal systems.

11.2 
EVOLUTION AND SPECIAL FEATURES OF
BRAZIL’S FEDERAL SYSTEM

Over the decades, Brazil has undergone several cycles of centralization and
decentralization. The choice of a federal design can be traced to the need
to mitigate centrifugal forces and threats to territorial integrity that have
been present since colonial times. Alternating civil and military govern-
ments changed the distribution of authority across levels of government
but states have always played a strong role, being initially responsible
for the provision of all basic services and collecting their own revenues.
State-based politics and elites continue to be influential in determining
intergovernmental policies.
Democratization after the last military dictatorship led to the introduc-
tion of a high degree of decentralization. The 1988 Constitution made
the 27 states, including the Federal District, and 5,560 municipalities2
equal members of the Union with relative financial independence and
significant service delivery responsibilities. The devolution process also
led to a marked ‘municipalization’. The devolution of resources and
responsibilities to subnational governments was less the result of a clear
decentralization plan but instead was driven by political pressure and a
strong reaction to the military regime. The assignment of revenues was
not accompanied by a clear distribution of the responsibilities for public
service provision across levels of government or matching of needs with
revenue sources (Rezende 1995).
Fiscal decentralization was most extensive in the 1990s with the
full implementation of revenue and expenditure assignment changes
introduced by the new Constitution. By 1995, states and municipalities
accounted for 45 per cent of public expenditure and 42 per cent of revenue.
This implied a 30 per cent increase from the level observed a decade before.
Until the early 2000s, the fiscal behaviour and indebtedness of state and
municipal governments in Brazil were a major source of macroeconomic

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 206 Intergovernmental transfers in federations

instability in Brazil. Expansionary fiscal policies and a lack of effective

controls on indebtedness resulted in subnational debt crises and bailouts in
1989, 1993 and 1997. In 1997, the Federal Government assumed the debts
of 25 of the 27 states that were unable to service their debt – an amount
equivalent to about 13 per cent of GDP. About 90 per cent of the states’
debt was restructured, so as to be paid off in 30 years at a favourable inter-
est rate while a small part was forgiven.
As part of the last bailout agreement, the Federal Government simul-
taneously negotiated several structural adjustment and reform measures
with the states. These measures included privatization, restrictions on
incurring new debt, limits on spending and targets on fiscal performance.
Conditions were included in annual Programmes of Fiscal Adjustment
(PAFs). In 2000, the controls on subnational fiscal performance were
further strengthened by the adoption of the Fiscal Responsibility Law (Lei
de Responsabilidade Fiscal or LRF). The LRF institutionalized fiscal dis-
cipline at all levels of government, incorporating hard budget constraints
into a single unified framework. It explicitly prohibited debt refinancing
operations between different levels of government making future bailouts
more difficult but failed to include a subnational bankruptcy provision.
Since this agreement, subnational spending as a share of total spending
stabilized at about 35 per cent.
Despite the success of the LRF in curbing the growth of subnational
debt, moral hazard issues still remain in the system, as evidenced by the
buildup of debt by some states in more recent years and the destabilizing
impact of the recession that began in 2014. There is a group of states with
large and burdensome debts to the Federal Government, mostly states
from the more developed South and Southeast regions, although the
majority have relatively low levels of debt.
In addition to the usual complexities of designing and implementing the
technical aspects of the intergovernmental system, the Brazilian political
system adds to the challenges of striking and sustaining credible com-
mitments on fiscal discipline and government policies. Brazil’s electoral
institutions and party financing favour the representation and inclusion
of a variety of political and regional interests. The open-list proportional
representation system, combined with large districts (each state is one dis-
trict), allows political parties with relatively few national votes to gain seats
in the national legislature. Parties specialize in specific regions or states and
make alliances to compete strategically in local elections. In some cases,
electoral alliances at the subnational level differ from the national ones.
Party financing rules disproportionately benefit small parties.
The nature of elections and representation in a context of com-
paratively strong federalism generates a high number of veto players in

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 Intergovernmental fiscal transfers and performance grants in Brazil ­207

the ­policymaking process. The open-list electoral system erodes party

discipline, while the state-based organization of political competition
makes gathering support for reforms that limit subnational autonomy
or affect state interests quite difficult. At the same time, decentralization
has increased the opportunities for subnational party leaders to control
patronage resources independently from national leaders and offered
more opportunities for smaller parties. The extensive responsibilities of
subnational governments in many areas create partially autonomous
arenas for policy action. The multiplicity of entry points increases the
success chances of special interests and reduces incentives for countrywide
collective action and comprehensive policy reform.
Fragmentation across levels of government and parties makes it difficult
for decision makers to put national interests above regional, local or even
particular interests. For members of Congress, the focus is on building
support and raising money for future campaigns. Such efforts lead policy-
makers to concentrate on very local interests and ensure that allocations
benefit campaign contributors (Alston and Mueller 2006; Samuels 2002).
Over time, earmarking of expenditures has been built into the system to
respond to these pressures; however, this complicates the implementation
of policies at all levels. Moreover, coherent national policies require all
levels of government to cooperate in their implementation given the
decentralization of responsibilities and resources.
Unbalanced political representation, combined with the widely different
economic interests of states, complicate economic and political reform,
especially around matters related to fiscal federalism. Small states have
significant influence and their support is needed to pass reforms. Brazil
has one of the highest levels of malapportionment, or divergent ratios of
voters to representatives, in the world. The current rules overrepresent the
sparsely populated and less developed North and underrepresent populous
and affluent states in the Southeast.3 These divergent rates of representa-
tion make small states attractive coalition partners and often translate into
distortions in the distribution of transfers, especially in the cases where
small states are not also poor.
Governors have a powerful influence in the Senate, more so than in most
federations around the world; they also have a strong sway over representa-
tives of the Lower House. Through their ability to allocate resources and
posts, state governors have considerable power to determine the future of
deputies, who are expected to support the incumbent governor and the
state (Abrucio 1994; Hagopian 1996; Samuels and Abrucio 2000; Samuels
2003). As a result, state-level factors, in particular the control of public jobs
and campaign financing, drive congressional elections. Rather than seek
re-election, many legislators aspire to positions in their state or ­municipal

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 208 Intergovernmental transfers in federations

governments. Decentralization has increased the attractiveness of subna-

tional posts. Because of the importance of governors in determining the
future of representatives, presidents need to negotiate regularly with them.
All of these factors limit the design and effective implementation of any
improvements to the system of intergovernmental finance in Brazil.

11.3 INTERGOVERNMENTAL FISCAL RELATIONS

In recent years, Brazil’s tax revenue as a share of GDP has ranged between
32 and 36 per cent of GDP. However, the distribution of revenue across the
three levels of government reflects a complex set of assigned and shared
taxes. The bulk of taxes – about 70 per cent – are levied at the federal
level. However, the states also raise one-quarter of taxes at their level.
Municipalities raise only 6 per cent of total taxes (Figure 11.1).
Taxes assigned to the federal level include personal income (IRPF),
which at about 6 per cent of GDP is the second largest source of revenue;
corporate profits tax (IRPJ); industrial products tax (IPI), tax on financial
operations (IDF), tax on fuels (CIDE), rural property tax (ITR), tax on
imports (II) and the payroll tax to fund social security (see Figure 11.2).
Brazilian states have more tax autonomy than their counterparts in
other federations. The states’ primary source of revenue comes from the

100% 5.8%
21.1%
80% 25.3%

26.6%
60% Federal
States
40% Municipalities
68.9%
52.4%
20%

0%
Tax Collection Available Revenues

Note: The figure for the Federal Government includes social contributions.

Source: Secretária do Tesouro Nacional.

Figure 11.1 Tax collection versus tax revenue sharing by levels of

government, 2012

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 Intergovernmental fiscal transfers and performance grants in Brazil ­209

VAT (Imposto sobre Circulação de Mercadorias e Serviços – ICMS),

representing the largest revenue source in the country at about 7–10 per
cent of GDP. States are also assigned the personal property tax (IPVA)
and taxes on donations and inheritances (ITCMD). A distinctive feature
of the Brazilian system is that the states also have obligations to share taxes
with the municipalities – 25 per cent of the ICMS and IPVA taxes. The
ICMS is shared under a rule in which three-quarters is based on derivation
and one-quarter can be defined by the state. The IPVA is shared among
municipalities based on the number of registered vehicles.
Municipalities are assigned taxes on consumption of services (ISS), the
property tax (IPTU) and the tax on property transfer (ITBI). Figure 11.2
also indicates which taxes are shared with lower levels of government, for

Personal
Property Transaction Business Miscellaneous
Income

PIS/COFINS Social Security

II
Federal ITR IPI CSLL IRPF
IOF
CIDE IRPJ

IPI

CIDE
State IPVA IRPJ IRPF
ICMS

ITCMD

IPTU ISS

ITR ITBI
Municipal IRPJ IRPF
IPI
IPVA
CIDE

ICMS

Note: Vertical lines represent sharing of taxes between different levels of government.
Social Integration Program or Programa de Integração Social (PIS), Personal Contribution
to Social Security or Personal Contribuição Social para o Financiamento da Seguridade
Social (COFINS), Social Tax on Net Profits or Contribuição Social sobre o Lucro Líquido
(CSLL), and Imposto sobre Operações de Crédito (IOF).

Source: Araujo and Barroso (2014).

Figure 11.2 Brazil’s tax assignment across levels of government

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 210 Intergovernmental transfers in federations

Federal
• 21.5% of IPI and IR - FPE
• 7.5% of IPI, to exporter states (FPEX)
• 21.75% of CID • 23.5% of IPI and IR - FPE
• 30% of IOF-ouro • 2.5% of IPI, to municipalities in
• 60% of Salario Educaçāo exporter states (FPEX)
• 3% of IPI and IR to Regional Funds • 50% of ITR
(FNO, FNE, FCO) • 70% of IOF-ouro
• 40–50% of Royalties • 7.25% of CID
• 30–40% of Royalties
States

• 25% ICMS
• 50% IPVA

Municipalities

Note: See paragraphs 18–20 for definition of acronyms.

Source: Blanco et al. (2007); Araujo and Barroso (2014); Secretária do Tesouro Nacional.

Figure 11.3 Revenue shared by tax (percentage)

example, the Federal Government automatically shares the rural property

tax with the state level and the states automatically share 25 per cent of the
ICMS with municipalities. These shares are set out in Figure 11.3.
Revenues from royalties also need to be considered in the system of tax
sharing and transfers. Two taxes are levied on oil production – a royalty
rate that varies between 5 and 10 per cent and a special participation rate
up to 40 per cent charges on net production value. In most cases, producing
states are entitled to 26.25 per cent of the royalties and 40 per cent of the
special funds. Non-producing states receive collectively only 1.75 per cent
of the royalties collected.
This system has created additional gaps between producing and non-
producing states. The primary beneficiary of oil revenue has been Rio
de Janeiro. While subsoil natural resources belong to the Union, the
legislation dating to the 1980s granted states and municipalities about 60
per cent of royalty revenue. In 1997, the Petroleum Act kept the essential
features of the decentralized oil revenue-sharing structure favourable to
the few offshore states. A new law passed in 2012, expected to generate
major redistribution of resources away from producers and help finance
education and health mandates, has not yet become effective because of
the opposition of the producing states and municipalities.

YILMAZ_9781789900842_t.indd 210 16/12/2019 10:44

 Intergovernmental fiscal transfers and performance grants in Brazil ­211

The assignment of ICMS to the states has led to a complex system that
has lent itself to a harmful competition through exemptions to attract
investors – the so-called ‘fiscal wars’. The efficiency of tax administration
at the state and municipal level remains generally low, whereas compliance
costs to taxpayers continue to be very significant.
On the expenditure side, assignments and responsibilities are much more
blurred, especially in certain areas, such as health and education, where each
level of government has some responsibilities. In recent years, overall general
government expenditure as a share of GDP has hovered around 38 per cent
in Brazil. About 53 per cent of current spending is by states and municipali-
ties, and they also account for about 68 per cent of personnel expenditure.
States and municipalities are responsible for the provision of services,
including education, health, sanitation and security (see Figures 11.4 and
11.5). They also play a considerable role in the implementation and financ-
ing of programmes that complement federal social protection programmes.

Sanitation
Transport
2%
Urbanization 4%
Education
5%
19%

Legislative and
Administration
10%

Social Security
Special
and Assistance
charges
13%
16%

Other
15%
Health
16%

Source: OECD (2017).

Figure 11.4 State expenditure by function (percentage)

YILMAZ_9781789900842_t.indd 211 16/12/2019 10:44

 212 Intergovernmental transfers in federations

Sanitation
Transport
3%
3%

Urbanization Education
12% 25%

Legislative and
Administration
14%
Special
charges
4%

Social Security
and Assistance
9%

Other
7% Health
23%

Source: OECD (2017).

Figure 11.5 Municipal expenditure by function (percentage)

States allocate approximately 35 per cent of their expenditure to education

and health, while these sectors represent close to half of the municipal
outlays.
Capital expenditure is highly decentralized in Brazil. States and munici-
palities execute approximately 40 per cent of total public investment. If
state-owned enterprises are excluded, they represent approximately 76 per
cent of total public investment (Mendes and Viñuela 2017). While state
and municipal governments play an important role in public investment,
they face challenges in effectively managing capital projects and meeting
infrastructure gaps.
The evolution of the Brazilian federal framework has translated into siz-
able vertical imbalances. While the 1988 Constitution devolved functions
and increased transfers from the federal level to states and municipalities
and from states to municipalities, it did not fully match expenditure
responsibilities and revenues.

YILMAZ_9781789900842_t.indd 212 16/12/2019 10:44

 Intergovernmental fiscal transfers and performance grants in Brazil ­213

Over time, the Federal Government reduced the percentages of taxes

automatically shared and shifted more to revenues that were pooled and
shared based on a formula. The Social Emergency Fund (Fundo Social
de Emergencia or FSE) created in 1993 removed 20 per cent of taxes
automatically shared. The FSE was later transformed into the Fiscal
Stabilization Fund (Fundo de Estabilização Fiscal or FEF) designed to
address short-term fiscal crises during the 1990s. The share of automatic,
non-earmarked transfers, of which the majority is contributed by the Fund
of State Participation (Fundo de Participação Estadual or FPE), fell sub-
stantially during the 2000s. Incremental changes reinforced the clawback
over resources, while discretionary transfers multiplied.
Approximately a third of subnational expenditure is financed through
transfers, yet there is a wide variation across states in the level of depend-
ence on transfers. About half of the states finance between 50 and 80
per cent of their expenditure from transfers. There is a strong distinction
between paying and receiving states and small states receive substantial
transfers per capita (Rodden 2015).
Disparities in the ability to deliver services are significant at both state
and municipal levels. Through the transfer system, the Federal Government
takes most of the responsibility for equalization. The revenue-sharing
mechanisms noted above are highly procyclical and only partially address
regional disparities. There are two key transfer mechanisms with hori-
zontal equalization objectives, namely – the Fund for State Participation
(FPE) and the Fund of Participation for Municipalities (FPM) (Table
11.1). The FPE is funded with revenue from the federal income tax and
the tax on industrialized products (21.5 per cent of the total from each).
The FPM is funded with 24.5 per cent of the same taxes. These transfers
are distributed through a simple formula based on per capita income and
population criterion.
The FPE and FPM have some equalizing effects because they collect
taxes from regions with higher fiscal capacity and distribute a part of
the funds to the less developed regions. But the distribution is based on
population and income per capita rather than a more precise specifica-
tion of the amount of resources required to meet similar service delivery
across all governments at the same level. Moreover, the population and
income per capita indicators are outdated further limiting equaliza-
tion. During this time, the Centre-West has grown much faster than
the Northeast and can no longer be considered poor. Also, while the
redistribution is still progressive, the thinly populated states of Acre,
Amapá, Roraima and Tocantins receive more than twice the per capita
FPE transfers compared to the Northeast states with a lower human
development index (HDI).

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 214 Intergovernmental transfers in federations

Table 11.1 Intergovernmental transfers by type, 2006–16

Government Levels TOTAL Federal Federal to States to

to States Municipalities Municipalities
Type Transfer Percentage of GDP
Equalization FPE 1.2 1.2
FPM 1.3 1.3
Origin Based ICMS 1.7 1.7
Unconditional

Devolutionary
IPVA 0.2 0.2
ITR 0.001 0.001
IPI – FPEX 0.1 0.1
ICMS – Exp 0.1 0.1
Compen.
Royalties 0.5 0.3 0.2
Matching FUNDEF/ 1.3 0.3 0.4 0.6
 FUNDEB
Earmarked

(Education)
SUS (Health) 1.0 0.4 0.6
Non-matching Voluntary Grants 0.4 0.2 0.2
CIDE (Transport) 0.1 0.1 0.0
Other

Regional Dev. FNO/FNE/FCO 0.2

Funds
Total 8.2 2.7 2.8 2.5

Notes: FUNDEF/FUNDEB: National Fund for the Development of Education; SUS:

Sistema Único de Saúde.

Source: Updated from Blanco et al. (2008); calculations based on Secretária do Tesouro
Nacional data.

The FPM distribution rules are more equalizing for capital cities than
for small municipalities. State capitals receive 10 per cent of the FPM
resources, while non-capital municipalities receive 86.4 per cent. The
remaining 3.6 per cent is distributed among the most populous municipali-
ties. The allocation to state capitals is determined using population and per
capita income. However, the allocation to non-capital municipalities is
determined exclusively on the basis of population. A minimum allocation
is given according to population ranges. The minimum allocation strongly
favours small municipalities regardless of their per capita income, which
weakens equalization objectives and encourages municipalities to split.

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 Intergovernmental fiscal transfers and performance grants in Brazil ­215

The FPM benefits very small municipalities. Per capita FPM transfers to
municipalities with fewer than 5,000 inhabitants are five times greater than
those to municipalities with more than 50,000 inhabitants.
The system also includes regional development funds that seek to reduce
economic disparities. The 1988 Constitution established that 3 per cent of
the income and product taxes would finance three regional development
funds for the development of Centre-West, Northeast and North (Fundo
do Financiamento do Centro Oeste or FCO, Fundo do Financiamento
do Nordeste or FNE and Fundo de Financiamento do Norte or FNO).
However, there is limited evidence that these funds have been effective in
achieving their goals.
Earmarked transfers have become increasingly important over the
last two decades. Most of them are matching grants for the health and
education sectors, such as the National Health System (SUS) and National
Fund for the Development of Education (FUNDEF/FUNDEB) and are
distributed according to the number of beneficiaries to ensure a minimal
level of spending (Table 11.1). These funds are financed by the Federal
Government, states and municipalities. Non-matching grants account
for 0.5 per cent of GDP, comprising mainly voluntary grants that are
executed through agreements between the Federal Government and states
and municipalities. In general, these agreements are part of federal pro-
grammes delegated to lower levels of government, while CIDE is directed
to road transportation sector investments.
The FUNDEF/FUNDEB4 programme provides matching transfers
to subsidize education expenditures by lower levels of government. The
Federal Government defines regional minimum levels of expenditures
per student, which vary according to region, grade and location (urban/
rural). State governments and municipalities contribute 20 per cent of their
current revenues to a common pool, which is then distributed according
to the number of students in the respective state and municipality and the
minimum level of expenditures specified by the Federal Government. If
the resources of the pool are not enough to cover the minimum expendi-
ture per student, the Federal Government makes up the difference. While
the federal contributions can be considered equalizing, the minimum
level of expenditures specified by the Federal Government is quite low
and regional disparities in expenditure per capita still persist. The more
developed South and Southeast regions have a considerably higher level of
education expenditure per student than the other regions given the much
larger size of their tax base.
The national health system (Unified Health System or SUS) has promoted
convergence in health per capita expenditures and better coverage of basic
care. SUS is also managed and executed by all three levels of government.

YILMAZ_9781789900842_t.indd 215 16/12/2019 10:44

 216 Intergovernmental transfers in federations

In general, municipalities are responsible for basic health: ­prevention,

ambulatory procedures and low-complexity hospital procedures. States
and large municipalities carry out more complex hospital treatments. The
Federal Government is responsible for defining the health policy and the
coordination and regulation of the SUS. It also provides direct payments
to private health services providers and executes certain activities directly.
States and municipalities are required to contribute to the system with 15
per cent and 12 per cent of their current revenues, respectively. The Federal
Government supplements these to reach a minimum level of expenditure.5
While SUS promotes regional equalization, the quality of the services and
access to secondary and complex services continue to vary substantially
and are still strongly correlated with economic development.
Overall, municipal governments seem to be the main beneficiaries of the
system of intergovernmental transfers. Transfers from the federal and state
governments to municipalities are equivalent to 5.3 per cent of GDP. The
right panel of Figure 11.1 shows that the system provides municipalities
with a share of resources (21.1 per cent) that far exceeds what they collect
in taxes (5.8 per cent).
An unintended effect of the transfer system was the multiplication
of municipalities. Between 1988 and 2007, the number of municipalities
in Brazil increased from 4,491 to 5,560. The majority of these have a
population below 150,000 people. This increase has been attributed largely
to the incentives created by the rules governing the distribution of FPM
unconditional transfers. As municipalities received a generous minimum
per municipality, if a municipality split into two, it increased the total
transfer received by the former municipality. The rules governing the dis-
tribution of the ICMS and royalties also contributed to the proliferation of
municipalities. If economic activity is generally concentrated in a district
of the municipality, there were strong incentives for this district to break
away and form its own municipality, thereby increasing its revenues per
capita at the expense of the rest of the former municipality.

11.4 
EXPERIMENTING WITH PERFORMANCE
GRANTS AT THE FEDERAL LEVEL: BOLSA
FAMÍLIA

In addition to the traditional systems of shared taxes, conditional and

unconditional transfers, Brazil has experimented with other types of
performance-based grants. Along with Mexico, Brazil was one of the early
experimenters with conditional cash transfers directly to citizens. The
conditional cash transfer approach in Brazil proved to be highly effective.

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 Intergovernmental fiscal transfers and performance grants in Brazil ­217

The Bolsa Família Programme (BFP) has been implemented by the

Federal Government since 2003 with the goal of combatting hunger, food
insecurity and poverty, as well as supporting access to key services for the
poor. About a quarter of the Brazilian population is enrolled in the pro-
gramme with 99.7 per cent of municipalities participating. Bolsa Família
targets the poor and extreme poor.
The Ministry for Social Development (MDS) is responsible for the
programme, defines the eligibility criteria and authorizes payments to
families in return for meeting specific criteria. The programme focuses on
families as beneficiaries (those with monthly per capita incomes lower than
R$154.00) and provides variable benefits according to the family com-
position prioritizing children and adolescents. Programme requirements
include mandatory school attendance (85 per cent of the time for children
6–15 years old and 75 per cent for those 16–17 years old), mandatory
immunization for children aged 7 and under, regular medical check-ups
for mothers and children and mandatory prenatal and postnatal care for
pregnant and new mothers.
Beneficiaries are entered in a unified registry (Cadastro Único) and the
programme makes direct payments to beneficiaries through a bank card.
These two innovations proved to be quite important to the success of the
programme. The unified registry was implemented in an inclusive way with
the government undertaking extensive outreach campaigns, as opposed
to more traditional approaches in which beneficiaries must seek out a
government official. This created a positive dynamic in which the poor –
often excluded – saw the BFP as making them a part of society. The direct
payments from central government to beneficiaries through a bank card
removed the passing of resources through several hands before it arrived
at the intended beneficiaries, so it helped to keep the system transparent
and clean.
The management responsibilities of the programme are shared among
states and municipalities and the Federal Government offers financial
incentives to comply with minimum service standards. MDS enters into
formal joint management agreements (Termos de Adesão) with each
municipality. These agreements follow a standard ‘template’ and serve
two key functions in establishing the overall framework for decentral-
ized implementation: (1) they clarify roles and responsibilities for the
implementation of the programme; and (2) they establish minimum
institutional standards for the programme’s operation at the municipal
level. Specifically, the agreements require that municipalities maintain a
local coordinator (local point-of-contact), register potential beneficiaries
in the Cadastro Único, monitor and consolidate information on compli-
ance with health and education conditionalities, and operate social control

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 218 Intergovernmental transfers in federations

councils (SCCs). These agreements also specify that municipalities agree

to prioritize BFP beneficiaries for other complementary services (literacy,
professional training, and income-generation programmes), as part of the
BFP’s role to ‘horizontally integrate’ social policy.
BFP has had a significant impact on poverty reduction – lifting over
20 million people (about 10 per cent of the population) out of poverty
between 2003 and 2014 – and improving health and education outcomes
of the children and adolescents that benefit from the programme. With a
budget equivalent to 0.5 per cent of the GDP, it helped reduce the infant
mortality rate caused by undernourishment by more than 50 per cent and
increased the pass rate of students in secondary education from 75.7 to
79.7 per cent (Campello and Neri 2013). Moreover, it played an important
role in promoting the dignity and autonomy of the poor. It also served as
an example of an effective conditional cash transfer programme that has
been a model for other countries around the world.

11.5 
STATES’ PERFORMANCE GRANTS AND
SUBNATIONAL INNOVATION

As noted above, states have discretion over the formula they use to allocate
a quarter of the state VAT that they transfer to municipalities. This is a
non-trivial amount given that the 1988 Constitution increased the share
allocated from states to municipalities to 25 per cent of the state ICMS.
Several states have experimented since with introducing performance
criteria. Some states have more recently changed their laws to condition
the distribution of the quarter of the state ICMS on performance indica-
tors as an incentive for better governance. The Federal Government is also
considering introducing performance criteria in the conditional transfers
that finance the adoption of full-time secondary education (escolas de
tempo integral).

Ceará

One successful case of the introduction of performance measures in the

allocation of grants is from the Northeast state of Ceará that has sup-
ported significant progress in improving access to and quality of municipal
services. Since the late 1980s, successive governments have reformed
Ceará’s public administration and invested heavily in social programmes.
These efforts have been reflected in economic growth, balanced public
finances, sustainable levels of indebtedness and significant improvements
in social welfare. Access to education and health services has improved

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 Intergovernmental fiscal transfers and performance grants in Brazil ­219

markedly over the past two decades, and there has also been significant
progress in the quality of service provision.
Building on earlier reforms, Ceará introduced numerous results-based
elements in the state management in the 2000s, including the adoption
of a strategic plan. The 2003 Strategic Plan sought to improve fiscal
space and modernize the state’s management practices, and focused on
four programmes: Working Ceará (Ceará Empreendedor); Ceará for a
Better Life (Ceará Vida Melhor); Integrated Ceará (Ceará Integração);
and Ceará at the Service of Citizenry (Ceará a Serviço do Cidadão). A
system of detailed indicators was developed to facilitate monitoring and
programme evaluation and a Committee for Results-based Management
and Fiscal Administration (Comitê de Gestão por Resultados e Gestão
Fiscal) was established to oversee the implementation of the state’s results
management model. The introduction in 2007 of an integrated Priority
Actions and Projects Monitoring system (Monitoramento de Ações e
Projetos Prioritários) strengthened the capacity of the state to monitor
strategic programmes.
Results criteria for allocating the ICMS share was introduced in 2007
in line with the new strategy and results-based management model. Since
1996, the state had used a formula to distribute a quarter of the shared
ICMS to close municipalities’ financing gaps in the education sector in
the following manner: (1) 5 per cent according to the ratio between the
municipality’s and the state’s population; (2) 12.5 per cent by the relation-
ship between the sum of municipal expenditure on the maintenance and
development of education and the municipal revenue from taxes and
constitutional federal and state transfers; and (3) 7.5 per cent equally
distributed among all municipalities. The additional resources did not,
however, result in improvements in key indicators of the quality of spend-
ing such as reductions in school evasion, improved grades in standardized
tests and reductions in age-grade distortion. The state then revised the
formula to distribute resources according to measures of the improve-
ments achieved in the quality of education, health and environmental
services. The discretionary portion is distributed as a weighted average of
indicators of performance in the areas of education (72 per cent), health
(20 per cent) and environment (8 per cent). In education, for example, the
formula rewards municipalities that improve enrolment, reduce repetition
rates and improve learning outcomes.
While there were many contributing factors, this approach had a positive
impact on student proficiency in the municipal education system and in
learning outcomes in the standardized Portuguese and mathematics tests.
Evaluations (Brandão 2014; Petterini and Irffi 2013) show statistically sig-
nificant positive results on enrolment and learning outcomes (Portuguese

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 220 Intergovernmental transfers in federations

and mathematics). The poorer municipalities in the state, which had

previously performed worse than the rest, also observed improvements
and began to converge with the state average. Importantly, there has been
no significant change in the magnitude of municipal expenditures – so the
approach is generating better results with similar resources.

Rio de Janeiro

Under the Brazilian health system, states are primarily responsible for
providing tertiary (hospital-level) healthcare but not all healthcare facilities
are run by states. Basic primary healthcare is the responsibility of munici-
pal governments. There are also hospitals owned by municipalities and
philanthropic organizations. To address dismal results in the health sector,
the State of Rio de Janeiro introduced performance grants in the late
2000s to complement other transfers to municipalities. Interventions were
guided by a new policy and strategic plan and involved the establishment
of monitoring of results and the training and recruitment of new staff.
Only hospitals located in municipalities with fewer than 110,000 resi-
dents were eligible. Rural municipalities without hospitals were also eligible
to receive grants, provided they referred patients to hospitals located in
other municipalities that belong to the programme.6
The Programme of Assistance to Hospitals of the Interior (Programa
de Apoio aos Hospitais do Interior Municipal – PAHI) grant consisted
of two parts: (1) a fixed component that was scaled according to the size
and characteristics of the hospital; and (2) a variable component based
on performance benchmarks. The state also implemented a monitoring
system (Sistema de Gestão de Metas e Indicadores de Saude or SIGMIS).
The conditional part of the grant included several performance targets
related to hospital management and the provision of services to patients
from other municipalities. Improvements in the hygiene standards and
disease management in municipal hospitals, as well as an increase in the
number of patients that had access to hospitals in nearby municipalities
and the number of intensive care beds available, were seen to be achieved
through the PAHI programme.
The Programme for Rural Hospitals provided results-based transfers
to municipalities to incentivize a greater quality of service delivery and
incentivize service provision across municipality boundaries to increase
economies of scale. The programme started as a pilot and was quickly
adopted by all municipalities.

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 Intergovernmental fiscal transfers and performance grants in Brazil ­221

11.6 CONCLUSIONS AND LESSONS

Brazil’s large and complex structure of government, combined with a

highly fragmented political system, has generated an intricate system of
tax sharing and fiscal transfers. Revenue assignments provide a significant
amount of automatic tax sharing built into the system, but discretion-
ary transfers are increasingly important. Expenditure responsibilities, as
in many countries, are overlapping. This structure has led – even after
automatic sharing of taxes – to vertical gaps among levels of government
and to differences in government provision of services to citizens across
governments in the country.
A rather unique feature of the system is the sovereignty of both states and
municipalities, which in turn has led to dual systems of equalization transfers
– with equalization transfers going from the federal level to states (FPE), as
well as from the federal level to municipalities (FPM). However, the failure
to update the key population indicators in the equalization formula suggests
that equalization lags behind the demographic and economic changes that
have occurred since the early 1990s. Royalties and specific targeted trans-
fers to regions have become mechanisms that complement the equalization
system for both financial and political purposes. Targeted conditional grants
are added in to ensure sufficient state and local spending on key priorities
such as education and health. The complexity of the system, combined with
the fragmented political system, is such that making incremental improve-
ments becomes quite difficult – whether it is to alter the tax sharing regime or
to adjust the design of transfers themselves. When all is added up, resources
shift to municipalities, but equalization is less effective across municipalities.
Despite the difficulty in making improvements to the transfer system
overall, the states have been innovative in applying results-based mecha-
nisms to the transfers they have some control over. The system in Ceará
demonstrates a case where tying the distribution of resources to the
achievement of key goals created the incentives that improved performance
for all localities, especially in education. In Rio, a system of incentive-based
transfers aimed to improve the allocation of resources in the health sector
and to support more effective use of both larger and rural hospitals.
The complexity of the system of transfers also likely played a role in the
development of Brazil’s best-known system of transfers – Bolsa Família
– the conditional cash transfer system in which the Federal Government
streamlined implementation by providing benefits directly to citizens,
drawing on technology to create a single registry for all participants and
drawing municipalities in to re-enforce accountability in the system. For
the equivalent of 0.5 per cent of GDP per year the programme achieved
very significant results and served as a model worldwide.

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 222 Intergovernmental transfers in federations

For all its complexities, the system of transfers in Brazil has been resil-
ient in the face of major internal and external shocks and has allowed one
of the world’s largest federations to continue to adapt and adjust.

NOTES

1. World Bank, World Development Indicators. Available at: https://databank.worldbank.

org/source/world-development-indicators, accessed in April 2019.
2. Of the 5,560 Brazilian municipalities, only 12 have more than 1 million inhabitants, 1,300
have fewer than 5,000 inhabitants, 2,700 have between 5,000 and 20,000 inhabitants,
1,300 have between 20,000 and 150,000 inhabitants and 132 have between 150,000 and 1
million.
3. In 1977, a reform introduced by the then military regime increased the number of seats
in the Lower House for the poorer and more sparsely populated states of the North
and Northeast. This precedent later influenced the design of the 1988 Constitution,
which introduced an even bigger shift in regional representation. A minimum of 8
and a maximum of 77 representatives to the Lower House favours states with smaller
populations. As a result, the North controls 15 per cent of seats with 8 per cent of the
population, while the Southeast has 43 per cent of the population but only a third of
seats. A representative of the more developed states needs 16 times the votes to be elected
than a less developed one (Samuels 2003).
4. Fund for Primary School Maintenance and Development and Teacher Training (Fundo
de Manutenção e Desenvolvimento do Ensino Fundamental e Valorização do Magistério
– FUNDEF) was created in 1996 and covered primary education (grades one to eight).
In 2006, the Fund for Maintenance and Development of Basic Education and Teacher
Training (Fundo de Manutenção e Desenvolvimento do Ensino Básico e Valorização do
Magistério – FUNDEB) replaced FUNDEF and extended its coverage to also include
day care, pre-school, secondary school and adult youth education.
5. The Constitutional Amendment No. 29 of 2000 defined the minimum level of health
expenditures to be financed by the Federal Government. It set the minimum expenditure
level for 2001 and specified that it be adjusted annually by the growth rate of nominal
GDP.
6. This rule removes a potentially perverse incentive for small municipalities to create their
own hospitals.

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Samuels, David (2003). Ambition, Federalism, and Legislative Politics in Brazil.
Cambridge: Cambridge University Press.
Samuels, David and Fernando L. Abrucio (2000). ‘Federalism and Democratic
Transition: The “New” Politics of the Governors in Brazil’. Publius 30 (2): 43–62.
Secretária do Tesouro Nacional (2019). ‘Boletim de Finanças dos Entes
Subnacionais’. Brasília.
World Bank (2008). ‘Brazil: Topics in Fiscal Federalism’. Report. Washington, DC:
World Bank.

YILMAZ_9781789900842_t.indd 223 16/12/2019 10:44

 12. I ntergovernmental fiscal transfer
system in Argentina: historical
evolution, current performance
and reform options to promote
efficiency, equity and transparency
Marco Larizza and Julian Folgar

12.1 
STRUCTURAL AND INSTITUTIONAL
FEATURES OF THE ARGENTINE
FEDERATION1

Argentina is a very unequal federation, with areas as rich as devel-

oped nations, and provinces as poor as low middle-income countries.
Heterogeneity across provinces in terms of income is very large. The poorest
province, Formosa, has a gross domestic product (GDP) per capita 7.4
times smaller than the richest oil producing province of Santa Cruz in the
Patagonia region (World Bank 2018a). In addition, Argentina is one of the
most decentralized countries in the world, with a growing share of spending
responsibilities transferred to the provinces. The combination of subnational
inequality and highly decentralized spending define a structural feature of
Argentina’s federation, in stark contrast with the historical experience of
OECD countries (see Figure 12.1). As the following sections will demon-
strate, the institutional arrangements and the need to provide homogeneous
services across heterogeneous provinces generate perverse expenditure and
revenue collection incentives, resulting in substantial fiscal challenges.
Argentina is a federal country comprising 23 provinces and the
autonomous federal capital City of Buenos Aires (Ciudad Autónoma de
Buenos Aires, CABA for its Spanish acronym).2 According to the 1853
Constitution, each province has its own constitution, generating different
institutional designs and administrative structures. The Argentinian federa-
tion grants a substantial degree of policymaking authority to the provinces,
but responsibilities are not always clearly defined. The federal government
has exclusive responsibility for defence, foreign affairs, immigration and

224

YILMAZ_9781789900842_t.indd 224 16/12/2019 10:44

 Intergovernmental fiscal transfer system in Argentina ­225

10
OECD Countries
Latin America
Regional Disparities (ratio regional max/min GDP pc)

9 Mexico

Peru
8
Argentina 2017
7 Colombia

Brasil
6 Chile
Argentina 1970
5

4
Portugal Czech Republic
3 Uruguay United Kingdom Germany
Ireland Italy Belgium
Hungary Poland
France United States
2 Greece Netherlands Austria
Spain Sweden
Slovak Republic Norway Finland
1 Israel

0
0 10 20 30 40 50 60
Fiscal Decentralization (% sub-national governments’ spending)

Note: The two data points for Argentina illustrate how the structural features of the
country’s federal system have become more pronounced over time. This is the combined
effect of policy interventions decentralizing responsibilities to provinces and constitutional
reforms creating new provinces, which in turn increased territorial disparities.

Sources: Authors’ own elaboration using data from Ministry of Treasury (Argentina),
OECD database and Cetrángolo and Goldschmit (2012).

Figure 12.1 Argentina’s federal system combines large regional

inequalities with highly decentralized expenditure patterns

international trade, currency and banking regulations. Provinces have

exclusive competences in the organization and delivery of local (municipal)
public services, while sharing responsibilities with national authorities for
social services such as education and health.3 However, the institutional and
regulatory framework is not always clear in articulating the constitutional
principle of concurrent responsibilities shared by the federal and the pro-
vincial governments. Provinces are in charge of executing national public
policies (such as social plans/welfare programmes), for which the national
government maintains significant regulatory powers. Moreover, according
to the constitution’s residual power clause, provinces reserve all powers not
explicitly delegated to the federal government and are responsible for defin-
ing municipalities’ powers within their territories.
In terms of revenues, a majority of them are collected at the national

YILMAZ_9781789900842_t.indd 225 16/12/2019 10:44

 226 Intergovernmental transfers in federations

level. To help fund subnational expenditures, a portion of national revenues

is redistributed back to provinces through an ‘automatic’ revenue sharing
scheme (‘Coparticipación Federal de Impuestos’ – CFI for its Spanish
acronym), and by discretionary transfers. As of 2018, overall transfers from
the federal government to subnational administrations reached 8.7 per
cent of GDP, of which 70 per cent (6.2 per cent of GDP) comes from the
CFI. The remaining 30 per cent comprises a sub-set of other ‘automatic’
transfers regulated by Special Laws (18 per cent of total transfers; 1.6 per
cent of GDP) and ‘non-automatic’ budgetary transfers (12 per cent of total
transfers; 1 per cent of GDP) (Figure 12.2). In practice, all ‘automatic’
transfers (CFI plus Special Laws) are referred as the ‘Co-participation
System’.4 As Figure 12.2 illustrates, intergovernmental transfers expanded
significantly since the early 2000s, growing from an average of 5 per cent of
GDP during the 1980s and the 1990s to about 9 per cent of GDP in 2017.
This was the combined effect of increasing relevance of non-automatic
transfers to provinces (financing both recurrent and capital spending) and
the increase in overall tax burden experienced during the 2000s.
10 30

9
25
8

Tax Burden as % GDP

20
Transfers as % GDP

5 15

4
10
3

2
5
1

0 0
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

CFI ‘Special Laws’ Non-Automatic Federal Tax Burden (RHA)

Note: Tax burden excludes social security contributions.

Source: Authors’ own elaboration based on data from the Ministry of Treasury.

Figure 12.2 Evolution of intergovernmental transfers and tax burden over

time, as percentage of GDP, 1983–2017

YILMAZ_9781789900842_t.indd 226 16/12/2019 10:44

 Intergovernmental fiscal transfer system in Argentina ­227

12.2 
HISTORY AND EVOLUTION OF ARGENTINA’S
INTERGOVERNMENTAL TRANSFER SYSTEM

The distribution of tax authority in Argentina has been subject to multiple

policy interventions over time, which account for the current configuration
of the intergovernmental transfer system. The 1853 Constitution assigned
the federal government exclusive authority over trade taxes (import and
export), while provinces kept exclusive authority on taxes on production
and consumption of specific goods. Trade duties, which represented the
lion’s share of federal government revenues (close to 60 per cent),5 were
strongly affected by the world economic crisis following the 1929 Great
Depression, forcing the central administration to expand its sources of
financing by reforming existing excise taxes and incorporating new taxes
collected by the federal branch and shared with the provinces.6 In 1935,
the federal revenue sharing CFI agreement was introduced, establishing
the obligation for the federal government to transfer to the provinces a
percentage of the total tax collection, compensating the provinces for their
decision to delegate tax revenue authority over crucial taxes to the federal
government. It was not until 1973, during the Lanusse military dictator-
ship,7 that a federal law (Law 20.221) was adopted to regulate the CFI
system. This new scheme set secondary distribution shares with dynamic
and egalitarian criteria. According to the law, the CFI was supposed to
be regulated and shares decided on a yearly basis for a period of transi-
tion. However, by the end of the transition period, and amidst the strong
macro-fiscal crisis, central and provincial authorities were unable to reach
an agreement on a new legal framework for the revenue sharing system.
This led to a 3-year period (1985–87) with bilateral and unilateral arrange-
ments for providing transfer resources to the provinces through ad hoc
arrangements. In 1988, following an election, a new regime was negotiated
with the federal and provincial governments under Law 23.548; this regime
is still in place today.8
The CFI history suggests that changes in the intergovernmental transfer
system have traditionally been driven by exogenous factors, including
the need to address macro-fiscal and financial crises originating at the
federal level. More specifically, most of the changes introduced in the
co-participation scheme (CFI) over the past 30 years have been designed
with the primary objective of covering the growing fiscal costs generated
by other policy reforms, including reforming the National Pension System
(see Box 12.1), rather than being driven by the objective of improving the
provision of public goods and services across the country.
The distribution of administrative functions has also been subject to
multiple policy interventions over time, producing a highly ­decentralized

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 228 Intergovernmental transfers in federations

BOX 12.1 POLICY REFORMS IN THE NATIONAL PENSION

SYSTEM AND THEIR IMPACT ON
INTERGOVERNMENTAL FISCAL TRANSFERS

The National Pension System (NPS) has been at the centre of the federalism
discussions in Argentina during the past 30 years. Argentina established a con-
tributory social security scheme, within which the public pay-as-you-go NPS was
the key pillar. The NPS covered most private sector employees, as well as federal
government civil servants. Since the early 1980s, the system started to run deficits
in a context of significant macroeconomic instability (ILO 2011).
A major reform to the NPS was passed during the 1990s, which generated
significant fiscal costs for the federal government. The policy reform was centred
around the creation of an individual voluntary private insurance pillar in the system.
Thus, while the public sector would continue to finance current pensioners, it would
stop receiving part of the contributions from active workers that decided to contrib-
ute to an individual capitalization account, managed by private insurance compa-
nies. Shifting from a unique pay-as-you-go public scheme to a mixed one was
expected to have large fiscal costs during the transition period (Cetrángolo and
Grushka 2004).
The need to cover the financial costs of the pension reform led to policy changes
in the intergovernmental transfer system, reducing transfers to the provinces. As
a first step, in 1992 the federal government applied a special deduction of 11 and
20 per cent to value added and income taxes, respectively, to finance the NPS.9
Later, provinces and federal government agreed to impose a 15 per cent deduction
to the common pool of funds to be shared between levels of government (‘masa
coparticipable’), to finance the NPS.10 One year later, to partially compensate the
fiscal costs for the provinces, the federal government agreed to absorb the provin-
cial pension systems (for provincial public servants) of those jurisdictions that
voluntarily decided to transfer them. Almost half of the provinces – 11 out of 24 –
signed the agreement to transfer their pensions system to the federal government
(Apella 2014).
In 2008, Argentina eliminated the private pillar of the NPS going back to a
unique pay-as-you-go public scheme. After this (re-)nationalization of the pension
system, provinces took legal actions against the federal government to stop special
deductions from the shared federal taxes to finance the NPS. By 2010, the prov-
inces’ share of those special deductions intended to finance the NPS (11 per cent
of value added tax (VAT), 20 per cent of income tax, 15 per cent of cumulative
funds to be shared), reached close to 2 per cent of GDP per year, on average. In
October 2015 the Supreme Court ruled in favour of three provinces (setting a
precedent), ordering the federal government to stop deducting the 15 per cent of
the shared funds (masa coparticipable). At the end of her mandate, former
President Cristina Kirchner issued a decree expanding the Supreme Court ruling
to all 24 provinces, for a significant fiscal cost to the upcoming federal administra-
tion. The decree was rescinded by President Macri in early 2016, reaching an
agreement with the provinces to gradually eliminate – over a 5-year period – the
special deductions.11

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 Intergovernmental fiscal transfer system in Argentina ­229

system with large vertical fiscal gaps. During the 1940s–70s, both dem-
ocratic and military governments tended to centralize administrative
responsibilities. However, starting from the late 1970s Argentina expe-
rienced a strong decentralization of responsibilities from the federal
government to the provinces in social sectors such as education and health,
without the corresponding devolution of revenue sources, to stabilize the
federal budget in the context of a significant fiscal crisis (Cetrángolo and
Gatto 2002).12 Since these decentralization reforms were motivated by
macro-fiscal considerations and emergency needs rather than by a strategic
vision on the devolution of administrative responsibilities to subnational
governments, they ended up with sub-optimal outcomes which impacted
the provision of basic public services (Becerra et al. 2003; Steinberg et al.
2011).
Following these decentralization efforts, provinces have become respon-
sible for a growing share of total spending over the past 50 years. However,
their revenue patterns have not substantially changed. In 2016, for exam-
ple, provinces collected only a small fraction of the revenues, up to about
20 per cent of the overall tax burden (including municipal revenues). In
2017, federal transfers from a common pool of national taxes, on average,
accounted for 46 per cent of total provincial revenues, reaching close
to 60 per cent – if non-automatic transfers are included. There is also a
large variation in the degree of fiscal dependency across provinces. There
are areas such as the City of Buenos Aires, which finances over 75 per
cent of its budget with own taxes, while less developed provinces (such
as Formosa, la Rioja, Catamarca, Corrientes, Santiago del Estero, Jujuy
and Chaco) receive between 80 and 90 per cent of their total revenue from
federal transfers (Figure 12.3).
Local taxes on average only cover a small share of the provincial budg-
ets. Provinces have the power to set their own tax rates,13 and concentrate
their tax collection effort in sales tax (Ingresos Brutos), a cascade tax with
strong distortive properties, which represents on average more than 72
per cent of own provincial tax revenue.14 In Santa Cruz, Misiones and
Neuquen, sales tax represents close to 90 per cent of provincial tax collec-
tion, while in Entre Rios and La Pampa it is around 60 per cent. To a lesser
extent, provinces also rely on property tax, automobile tax and stamp
duties. The most important federal taxes (VAT, income tax, trade taxes,
and so on) are collected at the central level.
Provincial budgets are dominated by recurrent expenditures for basic
public services, leaving a small fiscal space for capital investments/­
infrastructure spending. As Figure 12.4 shows, subnational governments
are mostly in charge of the provision of basic education, health, security
and urban services, while the federal government spends mainly on

YILMAZ_9781789900842_t.indd 229 16/12/2019 10:44

 Average Automatic (Tax sharing-CFI)
CABA Non-Automatic
Neuquén

YILMAZ_9781789900842_t.indd 230
Buenos Aires
Chubut
Mendoza
Santa Cruz
Tierra del Fuego
Córdoba
La Pampa
Río Negro
Santa Fe
Entre Ríos
Tucumán
San Juan

230
Misiones
Salta
San Luis
Catamarca
Corrientes
Chaco
Jujuy
Sgo del Estero
La Rioja
Formosa
0 10 20 30 40 50 60 70 80 90 100

Source: Authors’ own elaboration based on data from the Ministry of Treasury.

Figure 12.3 Federal transfers as percentage of total revenues, by province, 2017

16/12/2019 10:44
 Intergovernmental fiscal transfer system in Argentina ­231

100% 0% 1%
3% 5%
17% 12%
90% 18%
20%
80%
50%
70%

60% 72%

50% 63%
88%
40% 82%
75%
35%
30%

20%
25% 21%
10% 15%
0%
Education Health Pensions Debt Economic Urban
Service Services Services

Federal Provincial Municipalities

Source: Authors’ own elaboration based on data from the Ministry of Treasury.

Figure 12.4 Spending functions by level of government

­ ensions and healthcare for the elderly, debt services and, to a lesser
p
extent, on public universities. On average, provinces spend 50 per cent of
their budgets to cover the public sector wage bill. Moreover, when added
transfers to municipalities (automatic, and mainly used to pay municipal
wages), transfers to private educational institutions (subsidy to teachers’
salaries) and pension benefits, more than 75 per cent of provincial budgets
are accounted for by wage expenditure and/or social benefits. Similarly,
when sorting public expenditure by its functions, education, public admin-
istration, security and health services are responsible on average for more
than 70 per cent of provincial budgets.
While on average capital expenditure allocations are low, comparison
across provinces reveals interesting differences. Buenos Aires City, Santiago
del Estero, San Luis, Cordoba and San Juan spend more than 20 per cent
of their budgetary resources on capital expenditure. Whereas, half of the
24 provinces do not get to spend more than 8 per cent. Moreover, if those
spending are measured in per capita terms, differences spike, reflecting a

YILMAZ_9781789900842_t.indd 231 16/12/2019 10:44

 232 Intergovernmental transfers in federations

serious divergence in social equity. For instance, San Luis, the province that
spends the most in public investment per capita, devotes nine times more
than the Province of Buenos Aires.

12.3 
HOW POLITICS INFLUENCE POLICIES:
UNDERSTANDING THE POLITICAL
ECONOMY OF FISCAL FEDERALISM IN
ARGENTINA
The ‘rules of the political game’ play an important role in accounting for
the observed features of the Argentine fiscal federalism, and its historical
evolution over time. Argentina’s tax allocation and spending authorities
and its system of intergovernmental transfers do not correspond to equity
or efficiency economic criteria, and often provide perverse incentives and
obstacles for sound economic policies (Tommasi et al. 2001; Spiller and
Tommasi 2008). From a political economy perspective, some of these
features of Argentina’s fiscal federalism can be better understood as the
outcome of the ‘rules of the political game’. Indeed, the policy decisions
to centralize or decentralize revenues and functions were not the result of
planned policy decisions grounded in equity and efficiency considerations,
rather an outcome of macro-fiscal crisis at the federal level (as discussed
above), as well as a by-product of the power relationship between national
politicians and provincial governors (Eaton and Dickovick 2004; González
2013).
The history and evolution of co-participation law illustrates this point.
After the revenue sharing rule was introduced in 1935, powerful military
and civilian governments between the 1930s and 1950s were able to modify
the provisions of the law to reduce provincial shares and further centralize
functions and revenues (Pírez 1986). This changed in the early 1960s,
when governors mobilized and took advantage of weak presidencies to
push for larger transfers to provinces. A centralizing tendency emerged
again under the military rule starting in 1966, when governors and mayors
became military appointees and their weakened status facilitated the
military junta’s efforts to substantially cut federal transfers and further
centralize revenue and tax authority. It was only towards the end of the
Lanusse military rule (1973) that resources were decentralized again.
Interestingly, this reform was driven by the military’s effort to limit the
power of the new democratically elected president – as they were expecting
Peronist to win – and strengthen the role of conservative provinces in the
interior (González 2013: 11–13). These revenue decentralizing trends were
again reversed after the 1976 military coup, when the new military junta

YILMAZ_9781789900842_t.indd 232 16/12/2019 10:44

 Intergovernmental fiscal transfer system in Argentina ­233

(1976–83) reduced transfers to provincial governments while decentralizing

spending responsibilities in health and education services, as a way to deal
with its large fiscal deficit at the federal level (reaching more than 10 per
cent of GDP in 1976).
Several features of the ‘rules of the political game’ in Argentina do
not facilitate intergovernmental cooperation and tend to generate fiscal
policies that are economically inefficient. These features include – among
others – the dominant role of the president and governors in intergov-
ernmental relations and the related bargaining process that take place
between these actors, the lack of incentives among national legislators,
and the ability of the presidents to alter agreements through unilateral
actions (Tommasi et al. 2001: 183; Scartascini and Tommasi 2013). The
stark economic inequalities among provinces and the structural features
of Argentina’s federal system (vertical imbalance) imply that most prov-
inces are highly dependent on the national government to finance their
expenditures. In turn, presidents need to secure votes in the Congress to
implement economic policies. As a result, the policymaking process can
be in large part characterized as ‘deals’ or ‘exchanges’ between president
and governors (Spiller and Tommasi 2003, 2008), whereby governors grant
political support in exchange for policies benefitting their constituencies.
The governors’ political support is provided through the electoral channel
(by mobilizing votes during presidential elections); and the legislative
channel (by securing votes from provincial legislators for the president’s
policy agenda and projects in the House and the Senate). The dominance
of governors as key political actors in national politics and their ability
to control the careers of individual legislators allow them to secure short-
term benefits at the expense of long-term national interests, undermining
the role of the Congress as an institution.15 As Tommasi et al. (2001: 195)
put it, ‘intergovernmental relations have predominantly been much more
informal . . .’. Many changes to the CFI scheme have taken place either in
the president’s quarters or in ad hoc meetings between the president and
the governors.
Less developed and underpopulated ‘peripheral’ provinces have tra-
ditionally been the low hanging fruit in the construction of the ruling
coalitions between presidents and governors. While non-metropolitan,
‘peripheral’ provinces only account for about 30 per cent of the national
population, their political representation in the bicameral Congress far
exceeds their population, granting them a central role in the institutional
power structure and the coalition dynamics of the country’s major political
parties. According to a comparative study, Argentina’s Senate ranked high-
est in terms of territorial over-representation.16 This over-representation
also extends to the lower chamber of the Congress, the Chamber of

YILMAZ_9781789900842_t.indd 233 16/12/2019 10:44

 234 Intergovernmental transfers in federations

Deputies, where peripheral provinces, with 30 per cent of the population,

hold 52 per cent of the seats.17 Therefore non-metropolitan/peripheral
provinces have considerable political influence over national policymak-
ing, influencing the distribution of economic resources across provinces.
This in turn has contributed to create a fiscal transfer system that tends
to favour economically marginal but vote-rich provinces to ensure the
political survival of the national ruling coalition.18 A statistical analysis of
the electoral dynamics of market reform in Argentina between 1989 and
1995 illustrates this point, showing how the economic costs of structural
reforms were concentrated primarily on ‘metropolitan’ provinces, while
public spending and patronage continued in economically marginal but
politically over-represented peripheral provinces, to ensure support for the
governing party (Gibson and Calvo 2000).
The aggregate result of this historical process and political economy
dynamics is a vertical fiscal imbalance between federal and subnational
governments, which stands out as a distinctive feature of Argentina’s fiscal
federal system (see Figure 12.5).19 While other federal countries like Brazil,
Colombia and Mexico also show high levels of expenditures decentraliza-
tion, what makes Argentina an outlier is the high degree of vertical fiscal
imbalance, which is largely financed through the CFI and, to a lesser extent,
with non-automatic intergovernmental transfers (Tommasi et al. 2001).

45 Vertical Imbalance
Provinces' share on overall spending

40

35

30
and revenue

25

20 42.1

32.6 33.4
15

10 21.4

0
Revenue Expenditure Revenue Expenditure
1970 2015

Source: Authors’ own elaboration based on data from the Ministry of Treasury.

Figure 12.5 Vertical imbalance: provincial share of overall revenue

collection and public spending (1970–2015)

YILMAZ_9781789900842_t.indd 234 16/12/2019 10:44

 Intergovernmental fiscal transfer system in Argentina ­235

This is in part explained by the fact that the allocation of tax authority
and administrative functions/spending responsibilities – and the intergov-
ernmental transfer system underpinning both – do not correspond to any
economic criteria; nor does it reflect efficiency considerations. It is instead
largely driven by historical legacies, fiscal emergencies at the federal level
and the complex power relationships between the president and governors
across provinces. Moreover, both the composition and the magnitude of
the federal transfers has increased over time (see Figure 12.3), contributing
to what observers define as ‘federal fiscal labyrinth’ (Tommasi et al. 2001)
or ‘hybrid federation’ (González 2015a). Such complex networks of fiscal
federal relationships in Argentina create perverse incentives and multiple
obstacles to sound economic policies. The rest of the chapter will analyse
the effect of the intergovernmental fiscal transfer system in terms of
horizontal and vertical imbalances.

12.4 
CURRENT INTERGOVERNMENTAL FISCAL
TRANSFER SYSTEM IN ARGENTINA: AN
EMPIRICAL ANALYSIS20

The following sections of this chapter aim to empirically assess the extent
to which the Argentine transfer system effectively addresses the vertical
objective of income return (correcting vertical imbalances) as well as the
horizontal redistribution of income (correcting horizontal imbalances). As
illustrated in the previous section, the Argentine case concentrates the bulk
of its transfer system around the revenue sharing agreement (CFI plus
Special Laws), with the implication that two separate objectives usually
associated with intergovernmental fiscal transfer systems – namely, closing
the vertical fiscal gap (revenue sharing) and reducing the horizontal fiscal
gap – are mixed in the same instrument. In addition, given the substantial
lack of transparency in the management of resources at the provincial
level, it appears difficult to assess clearly to what extent some of the
transfers that are considered conditional are in fact obliging the recipient
governments to use the resources in a binding manner.

How Does the Argentine Transfer System Address the Vertical Imbalances
by Appropriate Parameters?

The existence of a transfer mechanism that manages to ‘return’ part of the

revenues to a given locality becomes essential to continue generating the
right incentives to mobilize revenues among subnational governments. To
assess the degree to which income is returned through the transfer system,

YILMAZ_9781789900842_t.indd 235 16/12/2019 10:44

 236 Intergovernmental transfers in federations

35
Share of Automatic Transfers to Provinces
Contribution to GDP
30

25

20

15

10

0
BUENOS AIRES
CABA
SANTA FE
CÓRDOBA
MENDOZA
NEUQUÉN
ENTRE RÍOS
CHUBUT
TUCUMÁN
SANTA CRUZ
SALTA
CHACO
RÍO NEGRO
MISIONES
SGO DEL ESTERO
CORRIENTES
SAN JUAN
JUJUY
SAN LUIS
TIERRA DEL FUEGO
LA PAMPA
CATAMARCA
FORMOSA
LA RIOJA
Source: Authors’ own elaborations based on data from Ministry of Treasury.

Figure 12.6 Contribution to GDP and percentage share of federal taxes

transfers, by province 2018

it is useful to compare it with the contribution of each province to the

aggregate income generation process. Using the latest available informa-
tion of the geographic Provincial GDP (2004), the analysis can provide
a good proxy variable of the territorial tax base on which the collection
of federal taxes falls. As Figure 12.6 illustrates, taken together the four
jurisdictions that contribute the most to the national GDP are also the
ones that receive the largest contribution from the total revenues trans-
ferred: Province of Buenos Aires (PBA), City of Buenos Aires (Ciudad
Autonoma de Buenos Aires – CABA), Santa Fe and Cordoba. However,
a closer look shows substantial variation among provinces. Specifically,
the difference between what the PBA and the CABA ‘contribute’ and
what they ‘receive’ implies that provinces with a low contribution to the
GDP receive more than what they contribute. Since 2017, following the

YILMAZ_9781789900842_t.indd 236 16/12/2019 10:44

 Intergovernmental fiscal transfer system in Argentina ­237

BOX 12.2 RECENT DEVELOPMENTS: THE 2017 FISCAL

PACTS AND FISCAL RESPONSIBILITY LAW

After reaching agreements with governors from 22 provinces (excluding San Luis
and La Pampa), in December 2017 the Congress passed a new Fiscal Pact (Law
27.429) to improve efficiency in subnational public finances and equity in intergov-
ernmental transfers.21 The agreement addresses part of the long-lasting fiscal
disputes between different levels of government in Argentina. Among the most
relevant topics of the agreement are the following:

a) Increasing transfers to PBA: a partial redesign of the revenue transfer system

to compensate for the historical erosion of the Province of Buenos Aires, where
56 per cent of the urban poor live;
b) Resolution of lawsuits against the federal government: the provinces will reach
an agreement with the federal government on their legal disputes and refrain
from initiating new legal actions regarding the tax sharing system (CFI). The
federal government issued a 10-year bond with an AR$5bn interest payment in
2018 and AR$12bn from 2019 onwards, distributed within all the provinces who
signed this agreement.
c) Gradual reduction of provincial distortive taxes: the provinces agreed to
gradually reduce distortive taxes by 1.5 percentage points of GDP (turnover
tax and stamp duties –Ingresos Brutos y Sellos) in 5 years. To compensate
for the revenue shortfall an increase of progressive real estate tax is expected.
In this context, a newly established Federal Agency of Property Valuation will
be in charge of assessing market values on properties across the country. As
a result, the Fiscal Pact points to a gradual shift of Argentina’s (subnational)
tax structure from a very distortive, procyclical and regressive composition
towards a more efficient, stable and progressive taxation.
d) Addendum to the Fiscal Pact (decentralization of spending in energy subsidies
to the provinces; increase in the base of shared taxes): in the context of the
International Monetary Fund (IMF) programme and the 2019 budget discus-
sions, the federal government agreed to decentralize some spending respon-
sibilities to provinces in order to meet 2019 fiscal targets. Congress passed an
addendum to the Fiscal Pact incorporating the commitment of the provinces
to be in charge of water, electricity and transport subsidies. To partially offset
this expansion, the government also expanded the base of some shared taxes
(e.g. VAT, income tax, wealth tax) that will bring additional financing to the
provinces.

Together with the Fiscal Pact, 22 provinces and the federal government agreed
on changes in the Fiscal Responsibility Law (FRL; Law 27.428), by putting in
place new fiscal rules. Containing the real growth of current spending and public
employment are at the core of these changes. Accordingly, recurrent primary
spending is set to increase below average inflation. Similarly, the annual change
in public employment cannot exceed demographic growth. Moreover, interest
payments cannot represent more than 15 per cent of recurrent net revenues
(excluding automatic transfers to municipalities). These fiscal rules are expected

YILMAZ_9781789900842_t.indd 237 16/12/2019 10:44

 238 Intergovernmental transfers in federations

to create more space to run countercyclical fiscal policy and/or increase public
investment in infrastructure. In addition, the FRL also incorporates institutional
requirements regarding transparency, accountability and forward fiscal planning,
among others.

Sources: Law 27.429/2017 and Law 27.428/2017.

reforms under the Fiscal Pacts (see Box 12.2), the share of resources that
each province receives from the common pool changed. Specifically, the
share that PBA receives is now higher (from 18 to 20 per cent), reducing
its vertical gap, while the rest of the provinces now receive a marginally
smaller share of the total.

How Does the Argentine Transfer System Address the Horizontal

Imbalances by Appropriate Parameters?

Looking at the equalization effects of the transfer system, interesting pat-

terns emerge. Ordering jurisdictions by their level of poverty (percentage
households with NBI (necesidades basicas insatisfechas – unmet basic
needs)) to capture social needs, a simple regression analysis shows that
the relationship with the transfers per capita received by each province is
very weak (Figures 12.7 to 12.10). In fact, provinces with very different
percentages of population share (such as Formosa and La Pampa) receive
similar levels of per capita transfers. Moreover, breaking down the differ-
ent pillars of transfers, data suggest that the set of automatic transfers
by Special Laws (18 per cent of the total) are those that present a greater
redistributive bias. On the other hand, the CFI regime itself (70 per cent of
the total) is the pillar with the least redistributive impact. Likewise, order-
ing jurisdictions by their level of wealth (GDP per capita) shows that even
smaller impact is observed.22
In 2018, there were jurisdictions such as the PBA, whose transfers
are considerably below what their level of wealth would indicate, or
Santa Cruz which, being one of the provinces with the highest level of
wealth per inhabitant, receive transfers per capita similar to provinces
such as Formosa or La Rioja, among the poorest ones. This deficiency
of the transfer system becomes especially relevant given the high
­territorial ­heterogeneity existing in the country, indicating the urgency to
introduce reforms to the current scheme to achieve greater redistributive
power.

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 Intergovernmental fiscal transfer system in Argentina ­239

12.5 
CONCLUSIONS: PRINCIPLES AND
GUIDELINES TO REFORM THE
INTERGOVERNMENTAL TRANSFER SYSTEM

As the analysis in this chapter has illustrated, in Argentina the transfer

system in general – and the CFI in particular – mix revenue sharing ele-
ments with equalization transfer elements since the secondary distribution
of funds is not based on purely ‘income return’ criteria, but on the basis
of formulas that include at least some criteria of need for expenditure
and/or funding capacity. Moreover, the distribution of resources from the
revenue sharing mechanisms (CFI) is made according to fixed coefficients
politically negotiated more than three decades ago. Consequently, given
that the transfer system in Argentina targets the objectives of devolution
and redistribution with the same instrument – namely, the CFI regime and
its Special Laws – in practice these effects play in the opposite direction
making the regime end up having weak or non-existent net ‘income return’
and redistributive effects. Finally, although Argentina has in practice a
pillar of non-automatic budgetary transfers, which could typically fulfil
the role of a pillar of conditional transfers to achieve specific sectoral
objectives, in practice the system fails to achieve this objective, as non-
automatic transfers have been traditionally used as a tool of political
bargaining and elite co-optation. A good transfer system is the one that
has a separate instrument for each objective to be pursued and a financing
system that is transparent and simple (Martinez-Vazquez and Searle 2007;
Martinez-Vazquez and Sepulveda 2011).
The complexity and lack of transparency of the transfer system in
Argentina raises the need for a comprehensive reform to simplify its
design and align it with international best practices to better achieve three
fundamental objectives: closing the vertical gap, closing the horizontal
gaps and promoting sectoral objectives. The study of the Argentine case
also highlights the priority need to provide the system with a greater
redistributive bias than the current one, given the high levels of territo-
rial heterogeneity that exist across provinces. The political environment
and the specific economic and social circumstances faced by the country
will in large part determine the scope and ambition of a reform path.
While a structural reform trajectory seems infeasible in the short run, it is
important to highlight a few aspects that any reform effort should take into
account, in light of historical experiences of other countries and emerging
international best practices (Schroeder and Smoke 2003), as well as taking
into consideration the specific challenges that Argentina faces given the
current macro-fiscal context:

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 240 Intergovernmental transfers in federations

100 y = 971.51x + 32095

Tierra del Fuego
R2 = 0.0830
90

80
Per Capita Transfers (ARS thous)

Catamarca

70 La Rioja Formosa

La Pampa
60 Santa Cruz
San Juan Chaco
San Luis
50 Santiago del
Jujuy
Estero
Entre Ríos
40 Río Negro Corrientes
Santa Fe Neuquén Misiones Salta
30 Córdoba Chubut Tucumán

CABA Mendoza
20

Buenos Aires
10

0
0 5 10 15 20 25 30
% NBI 2010

Source: Ministry of Treasury and INDEC.

Figure 12.7 Overall transfers and poverty –2018

80 y = 577.10x + 24795
R2 = 0.0460
Tierra del Fuego
70
Per Capita Transfers (ARS thous)

60 Catamarca

Formosa
50 La Pampa
La Rioja
San Luis
Santiago del
Santa Cruz San Juan
40 Estero
Chaco
Entre Ríos Jujuy
30 Río Negro Corrientes
Santa Fe Tucumán
Córdoba Neuquén Salta
Misiones
20 Chubut
CABA
Mendoza
10 Buenos Aires

0
0 5 10 15 20 25 30
% NBI 2010

Source: Ministry of Treasury and INDEC.

Figure 12.8 CFI transfers and poverty – 2018

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 Intergovernmental fiscal transfer system in Argentina ­241

16 y = 171.92x + 3387.5
R2 = 0.1044
14
La Rioja
Per Capita Transfers (ARS thous)

Tierra del Fuego

12

10 Jujuy

8 Catamarca
Formosa
Entre Ríos San Juan Misiones Chaco
La Pampa Neuquén
6 Salta
Santa Cruz
Santa Fe Mendoza Santiago del
4 CABA
Chubut Corrientes Estero
Córdoba Río Negro Tucumán

2 Buenos Aires
San Luis

0
0 5 10 15 20 25 30
% NBI 2010

Source: Ministry of Treasury and INDEC.

Figure 12.9 Non-automatic transfers and poverty – 2018

12
y = 222.49x + 3909.25
R2 = 0.3727
Tierra del Fuego Formosa
10 Catamarca
Santiago del
Per Capita Transfers (ARS thous)

La Rioja Estero
Santa Cruz Chaco
San Juan
8 Corrientes
La Pampa
Chubut Misiones
Neuquén Salta
Jujuy
San Luis Río Negro
Tucumán
6 Entre Ríos
Mendoza
Córdoba
Santa Fe
4
Buenos Aires

CABA
2

0
0 5 10 15 20 25 30
% NBI 2010

Source: Ministry of Treasury and INDEC.

Figure 12.10 Special laws’ transfers and poverty – 2018

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 242 Intergovernmental transfers in federations

1. 
Rethinking the size of the funds to be distributed, that is, the degree to
which the transfers are expected to close the aggregate vertical imbal-
ance, with a focus on improving efficiency and equity in the provision of
basic services, while defining a pension system that is fiscally sustainable
in the long run. As discussed in the chapter, the provinces received only
partial financing compensation to cover decentralized spending respon-
sibilities, leading to poor outcomes, more budget rigidity and crowding
out of provincial public investment in infrastructure, given the narrow
fiscal space. Given such deficiencies in the design of decentralized spend-
ing responsibilities in public health and basic, primary and secondary
public education, Argentina needs to rethink its aggregate approach
towards the provision of these services. A comprehensive discussion
on the way Argentina wants to ensure its basic service delivery, ideally
pointing to close horizontal gaps, needs to be a top priority while dis-
cussing any reform to the fiscal federalism. Furthermore, if the long-run
sustainability of the NPS is not defined (which may include structural
reform discussions), the door is open to future conflicts between levels
of government to fight for additional resources to postpone reforms.
Both discussions will largely determine the size of the vertical imbalance
that the intergovernmental transfer system will aim to close.
2. 
Providing the system with a priority redistributive bias to correct the
deep territorial inequalities in Argentina. An ideal federal scheme
should aim to promote fiscal autonomy of all subnational members
of the federation. However, the difference in income levels across
provinces in Argentina is higher than many other federal countries,
making it very difficult to provide similar levels of public services
across provinces without assistance from central government. A redis-
tributive bias in the fiscal transfer system would therefore take into
account the differences in fiscal capacity and spending needs across
provinces, helping to achieve a more equitable system where citizens
can have access to similar standards of public services, regardless of
the provinces where they reside.
3. 
Improving the transparency and reducing the complexity of the
system, adopting a ‘one objective/one instrument’ approach, in line
with international best practice. Argentina’s intergovernmental trans-
fer scheme stands out by being an extremely complex system, com-
monly referred to as a labyrinth. And despite having different pillars of
transfers (CFI, Special Laws and Non-automatic Transfers), the truth
is that neither of them follows a specific mandate, resulting in very
poor outcomes. Accordingly, reducing its complexity by unifying the
different transfers as much as possible will help improve the way the
system works, making it more transparent and coherent. In addition,

YILMAZ_9781789900842_t.indd 242 16/12/2019 10:44

 Intergovernmental fiscal transfer system in Argentina ­243

a simpler system will most likely help policymakers to think of better

reforms, since the implementation process should be simpler, too.
Furthermore, in order to achieve the most common goals of sharing
revenue collection (‘income return’ pillar), closing horizontal gaps (a
redistributive pillar) and financing pre-determined sectoral objectives,
the system would benefit from applying a specific instrument for each
proposed objective.
4. 
Strengthening fiscal rules by promoting cooperative behaviour across
levels of government and providing incentives to provinces to adopt
(and comply with) federal regulations. As indicated above, the need to
provide homogeneous services across heterogeneous provinces gener-
ates perverse expenditure and revenue collection incentives, resulting
in substantial fiscal challenges. Historically, the policy instruments
and processes used to negotiate these distributional tensions between
the national and provincial governments – including public transfers,
pensions, subsidies and taxation – have proven harmful to the nation
as a whole. Moreover, in many cases, the decision-making and imple-
mentation is decentralized to a variety of regulatory agencies, without
appropriate coordination mechanisms, leading to increased fragmen-
tation. There is therefore an urgent need to make federalism work
in Argentina by promoting a more cooperative behaviour in which
national, state and local governments cooperate to solve common
problems. While the institutional architecture that defines the nature
of fiscal federalism in Argentina is hard to change in the short term,
the Fiscal Pact recently signed on December 2017 by the federal gov-
ernment and by 22 out of 24 provinces is an important contribution to
this goal, suggesting there are opportunities to introduce incremental
improvements. Fiscal rules could be further strengthened by rolling
out federal guidelines on public financial management, to better moni-
tor expenditures and promote more efficient allocation of resources.
In this context, incentives could be provided for the provinces in the
form of results-based grant schemes and conditional transfers that
reward efficiency in public spending, prudent fiscal management as
well as compliance with federal guidelines, policy regulations and
jointly agreed reform priorities.

NOTES

1. This section is based on World Bank (2018a), which provides further elaboration of
the macro-fiscal challenges connected with the unequal structure of the Argentinian
federation.

YILMAZ_9781789900842_t.indd 243 16/12/2019 10:44

 244 Intergovernmental transfers in federations

2. When the constitution was signed in 1853, the Argentinian federation comprised 14
provinces. During subsequent administrative reforms in the 1950s and the 1990s, new
provinces were created, including Santa Cruz, Chubut, Formosa, Neuquen, Rio Negro,
Misiones, Chaco, La Pampa, CABA and Tierra del Fuego (Cetrángolo and Jiménez
2003).
3. The ‘shared’ responsibilities are not explicitly defined in the Constitution nor in
subsequent regulations. They are a result of informal arrangements which may also vary
across provinces.
4. ‘Automatic’ refers to tax revenues which are centrally collected by Administracion
Federal de Ingresos Publicos (AFIP) and transferred back to the provinces, according
to the percentage share as defined either in the CFI or through Special Laws. As such,
they are not part of the federal budget. ‘Non-automatic’ refers to budgetary transfers
and includes both discretionary transfers and programme-based and sectoral transfers.
5. See Porto (2003).
6. The Congress passed three laws: unification of excise taxes (12.139); sales tax (12.143)
and extension of a profit tax (12.147).
7. The dictatorship in power from 1966 to 1973, the so-called ‘Argentine Revolution’,
had three military presidents: Ongania (1966–70), Levingston (1970–71) and Lanusse
(1971–73).
8. For a review of the historical stages of the Coparticipacion in Argentina, see Cetrángolo
(2003), Porto (2003).
9. See Decree 879/92 and Law 23.966 for the income tax and VAT deductions, respectively.
10. See Law 24.130, also known as ‘Pacto Fiscal 1’.
11. See ‘Acuerdo Nacion-Provincias para el Nuevo Federalismo’: accessed 24 October 2019 at
https://www.argentina.gob.ar/interior/subsecretaria-de-relaciones-con-provincias/acu​e​
rdo-nacion-provincias.
12. The first decentralization process started in 1978. Laws 21.809 and 21.810 transferred
initial and primary public education, while Law 21.883 transferred 65 national hospitals
to the provinces. Later, in 1991, Law 24.061 continued to delegate federal responsi-
bilities to the provinces for hospitals and education institutions. For further details, see
Cetrángolo and Gatto (2002).
13. Most recently (December 2017), the Fiscal Pact included the commitment for the
participating provinces (22 out of 24) to set homogenous sales tax (Ingresos Brutos)
rates – by economic sectors – as well as gradually reduce (over a 5-year period) rates
for primary activities, following a precise schedule included in the Fiscal Responsibility
Law.
14. This calculation does not include royalties.
15. Due to the closed-list proportional electoral system, governors control the candidate
selection process and the nominations for congressional elections, to the point that
political careers of individual politicians are often structured and decided at the
provincial level. Consequently, ‘president need to negotiate not only electoral but also
legislative support with governors’ (González and Mamone 2015: 55). Moreover, given
that local party bosses have the incentives to remove individual legislators from high-
visibility positions, individual politicians have little incentives to build a long career in
Congress, invest in policymaking capabilities and acquire specific expertise (Jones et al.
2004; Jones and Hwang 2005).
16. For example, with a population of 12.6 million, Buenos Aires province is granted three
senators, the same number received by Tierra del Fuego, with a population of 59,000.
Thus, one vote in Tierra del Fuego is worth 214 votes in Buenos Aires.
17. Argentina has a bicameral Congress composed of the Senate (where each one of the 24
provinces has three senators) and the Chamber of Deputies, where each province has a
number of deputies proportional to its population, with a maximum of five deputies for
each province.
18. From the perspective of the president, it is in the peripheral provinces where votes can
be obtained at the lowest price possible. From the perspective of the governor, the flow

YILMAZ_9781789900842_t.indd 244 16/12/2019 10:44

 Intergovernmental fiscal transfer system in Argentina ­245

of income from the national government helps to secure resources to sustain the provi-
sion of jobs in the provincial bureaucracy and social welfare programmes. Moreover,
investing in less developed provinces is more attractive for presidents because governors
from these provinces tend to be weaker political challengers than governors from more
developed districts (González 2015a: 2).
19. See Tommasi et al. (2001) for a comparison of Argentine fiscal federalism to other
federations.
20. The analysis and data presented in this section draws upon the World Bank (2018b).
21. Dated 21 December 2017, published in the Official Gazette No.33782 of 2 January
2018. The two provinces that did not sign the agreement do not have to comply with
its commitments under the Fiscal Pact and the Fiscal Responsibility Law, but will not
receive its benefits either (authorization to issue debt, worst credit rating, and so on).
22. Multivariate regression tables are available from the authors upon request.

REFERENCES

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previsional argentino’, in R. Rofman (ed.), La protección social en Argentina. El
rol de las provincias. Buenos Aires, Banco Mundial, pp. 15–52.
Becerra, Marcelo, Sergio Espana and Ariel Fiszbein. 2003. ‘Enfoques sobre la
Eficiencia del Gasto en Educación Básica en la Argentina’. World Bank working
paper 6/03. Washington, DC: World Bank.
Cetrángolo, Oscar and Francisco Gatto. 2002. ‘Descentralización fiscal en argen-
tina: restricciones impuestas por un proceso mal orientado’, ILPES.
Cetrángolo, Oscar and Ariela Goldschmit. 2012. ‘Descentralización de los ser-
vicios públicos, cohesión territorial y afianzamiento de las democracias en
América Latina’, in A. Barcena and K. Acel (eds), ‘La política fiscal para el
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Cetrángolo, O. and C. Grushka. 2004. ‘Sistema previsional argentino: crisis, reforma
y crisis de la reforma’, Serie financiamiento del desarrollo No. 151, CEPAL,
Santiago de Chile.
Cetrángolo, Oscar and Juan Pablo Jiménez. 2003. ‘Las relaciones entre niveles de
gobierno en Argentina’, Revista de la CEPAL 84.
Eaton, Kent and J.T. Dickovick. 2004. ‘The politics of re-centralization in
Argentina and Brazil’, Latin American Research Review 39(1), 90–122.
Gennaioli, N., R. La Porta, F.L. De Silanes and A. Shleifer. 2014. ‘Growth in
regions’, Journal of Economic growth 19(3), 259–309.
Gibson, E.L. and E. Calvo. 2000. ‘Federalism and low-maintenance constituencies:
territorial dimensions of economic reform in Argentina’, Studies in Comparative
International Development 35(3), 32–55.
González, Lucas. 2013. ‘Tensions between centralization and decentralization
in the Argentine federation’, in John Kincaid, John Loughlin and Wilfried
Swenden (eds), Routledge Handbook on Federalism and Regionalism. London:
Routledge, pp. 471–80.
González, Lucas and I. Mamone. 2015. ‘Distributive politics in developing
federal democracies: compensating governors for their territorial support’, Latin
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ILO. 2011. ‘Encrucijadas en la seguridad social argentina: reformas, cobertura y

desafíos para el sistema de pensiones’ / Fabio Bertranou (et al.). 1ra. ed. Buenos
Aires: CEPAL y Oficina Internacional del Trabajo, 2012.
Jones, M.P. and W. Hwang. 2005. ‘Provincial party bosses: keystone of the Argentine
Congress’, in S. Levitsky and M.V. Murillo (eds), Argentine Democracy: The
Politics of Institutional Weakness. University Park, PA: The Pennsylvania State
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Jones, M., S. Saiegh, P. Spiller and M. Tommasi. 2007. ‘Congress, Political Careers and
the Provincial Connection’, in P. Spiller and M. Tommasi (eds), The Institutional
Foundations of Public Policy in Argentina. Cambridge: Cambridge University
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Ley 27.428. 2017. HONORABLE CONGRESO DE LA NACION
ARGENTINA 21-dic-2017, REGIMEN FEDERAL DE RESPONSABILIDAD
FISCAL Y BUENAS PRACTICAS DE GOBIERNO, Publicada en el Boletín
Oficial del 02-ene-2018 Número: 33782 Página: 25.
Ley 27.429. 2017. HONORABLE CONGRESO DE LA NACION ARGENTINA,
21-dic-2017, CONSENSO FISCAL, Publicada en el Boletín Oficial del 02-ene-
2018 Número: 33782 Página: 24.
Martinez-Vazquez, Jorge and Bob Searle (eds). 2007. Fiscal Equalization:
Challenges in the Design of Intergovernmental Transfers. New York: Springer.
Martinez-Vazquez, Jorge and Cristian Sepulveda. 2011. ‘Intergovernmental trans-
fers in Latin America: a policy reform perspective’. Working Paper Series,
International Studies Program, Andrew Young School of Policy Studies, Georgia
State University.
Pírez, Pedro. (1986). ‘La Coparticipación y Descentralización del Estado Nacional’,
Revista Mexicana de Sociología 48(4), 175–224.
Porto, A. 2003. ‘Etapas de la Coparticipación Federal de Impuestos’, Documento
de Federalismo Fiscal N°2, Buenos Aires, Universidad Nacional de La Plata,
Facultad de Ciencias Económicas, Departamento de Economía.
Scartascini, C., E. Stein and M. Tommasi. 2013. ‘Politi­cal institutions, intertempo-
ral cooperation, and the quality of public policies’, Journal of Applied Econo­mics
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Schroeder, Larry and Paul Smoke. 2003. ‘Intergovernmental fiscal transfers:
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(eds), Intergovernmental Fiscal Transfers in Asia: Current Practice and Challenges
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policy: transactions approach with application to Argentina’, Journal of Law,
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and policy outcomes in Argentina’, in E. Stein, M. Tommasi, P. Spiller and
C. Scartascini (eds), Poli­ cymaking in Latin America: How Politics Shapes
Po­licies, Harvard University David Rockefeller Center for Latin American
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territoriales en Argentina. Insumos para el planeamiento estratégico del sector
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Tommasi, M., S. Saiegh and P. Sanguinetti. 2001. ‘Fiscal federalism in Argentina:
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 Intergovernmental fiscal transfer system in Argentina ­247

World Bank. 2018a. Argentina Systematic Country Diagnostic. Washington, DC:

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YILMAZ_9781789900842_t.indd 247 16/12/2019 10:44

 13. Evolving role of the Finance
Commissions in India in the last 25
years*
Farah Zahir

13.1 INTRODUCTION

India has emerged in the twenty-first century as the largest democratic

federal polity and a global economic power inhabited by over a billion
people spread over 29 states and 7 Union territories (UTs). Below the
states in urban areas there are 96 municipal corporations, 1494 municipali-
ties and 2092 small municipalities. There are 247,033 rural local bodies or
Panchayats,1 of which 515 are at the district level, 5930 at the block level
and 240,588 at the village level. The devolution of power to the third tier
is, however, uneven among states and their participation in public service
delivery is marginal. India is a vast and diverse country, with its states
differing in size, socio-economic conditions and basic characteristics. In
2015/16, among the major states, the per capita National State Domestic
Product (NSDP) was the highest in Haryana at INR 162,034 (excluding a
small state, Goa, with NSDP per capita of INR 334,576) and the lowest
was in Bihar at INR 30,213. Interstate disparities are quite high in India
and they have increased over time. The per capita revenues vary with per
capita incomes due to variations in taxable capacity and effort among dif-
ferent states. Per capita transfers are higher in states with lower per capita
incomes, however, the intergovernmental transfer system is unable to fully
offset the revenue disabilities of the poorer states and more advanced and
well-off states spend significantly higher per capita expenditures compared
to the poorer states.

Genesis of Key Institutional Arrangements

Historically, India adopted a federal Constitution with strong unitary

features and progressed from a two-tiered federal structure to a three-
tiered structure in 1992. The 73rd and 74th Constitutional Amendments

248

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 Evolving role of the Finance Commissions in India ­249

provided constitutional sanctity to the rural and urban local bodies as the
third sphere of local self-governance in India. The centre-state relation-
ships in the pre-1992 period rested on principles largely defined under the
colonial rule of centralized governance. As a result, there was a strong
bias towards a unitary framework in the Constitution. Under the Indian
Constitution, many high-yielding taxes (productive taxes) are assigned
to the centre due to reasons provided in the Union List that the centre
is responsible for macroeconomic stabilization and redistribution. These
include the corporate and personal income taxes, customs duties, and
certain excise taxes (excluding those on alcoholic liquors, opium and other
narcotics). State governments are authorized to impose a limited Value
Added Tax (VAT) (and now Goods and Services Tax (GST)) as well as a
small tax on agricultural income. Local governments’ taxing powers are
largely confined to taxes on property.
The core arrangements with regard to the sharing of resources
and responsibilities are built into the Indian Constitution itself. The
Constitution defines the exclusive powers of the centre2 in the Union
List; exclusive powers of the states are specified in the state list (includ-
ing public order, police, public health, agriculture and others); and
those falling under the joint jurisdiction of both levels are placed in the
concurrent list (with the Union vested with overriding powers in subject
matters). This stands in sharp contrast to Canada, where the federal fiscal
relationships have evolved through a non-constitutional process, except
for the equalization transfers, which have a constitutional status. Most
arrangements derive from a series of negotiations between the two tiers of
government. Also, in countries like the United States (US) and Canada,
states have access to all broad tax bases including Sales Tax, while in
Australia the constitution postulates central government exclusive powers
to impose customs and excise duties and the judiciary have interpreted
this to include Sales Tax too.
The key institutional arrangement that guides the sharing of resources
between the various levels of government in India is entrusted to the
Finance Commission (FC). In addition, resource transfers also take
place through the Planning Commission3 and other central ministries.
Other institutions of importance in India are the National Development
Council and the Inter-State council. These institutions are comparable
with the Premiers’ or First Ministers’ Conference in Canada. In Australia,
the determination of the vertical share of resources to be transferred to
the states is not in the hands of the Commonwealth Grants Commission.
It gets determined automatically by the amount of revenues collected
under the GST supplemented by the special purpose grants that are in the
hands of the Commonwealth government. In India, the FC determines

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 250 Intergovernmental transfers in federations

a large part of the transfers in the form of tax devolution under a global
sharing arrangement (the divisible pool) and grants, requiring it to deter-
mine a significant part of the volume of the vertical transfers. The FC
transfers are supplemented by the Planning Commission4 grants and other
discretionary grants determined by the central government. The FC award
remains valid for a five-year period.

Core Mandate and Recent Developments

Since 1951, there have been 14 such Finance Commissions in India, the
Fifteenth Finance Commission (15th FC) was constituted in November
2017. The terms of reference (TOR)5 of the 15th FC is to make the recom-
mendations for the following:

●● the distribution between the Union and the States of the net
proceeds of taxes which are to be, or may be, divided between them
under Chapter I, Part XII of the Constitution and the allocation
between the states of the respective shares of such proceeds;
●● the principles which should govern the grants-in-aid of the revenues
of the states out of the Consolidated Fund of India and the sums to
be paid to the states by way of grants-in-aid of their revenues under
Article 275 of the Constitution for purposes other than those speci-
fied in the provisos to clause (1) of that Article; and
●● the measures needed to augment the Consolidated Fund of a State
to supplement the resources of the Panchayats and municipalities in
the state on the basis of the recommendations made by the FC of
the State.

Over the years the core mandate of the Commission has remained
unchanged, though it has been given the additional responsibility of exam-
ining various issues depending on the challenges faced by Indian public
finances from time to time. For instance, the Twelfth Finance Commission
(TwFC or 12th FC) evaluated the fiscal position of states and offered relief
to those that enacted their Fiscal Responsibility and Budget Management
(FRBM) laws. The Thirteenth (13th) and the Fourteenth (14th) FC
assessed the impact of GST on the economy. The 13th FC also incentiv-
ized states to increase forest cover by providing additional grants. In this
milieu, even the Fifteenth Finance Commission has been given some
additional responsibilities such as to: (i) review the impact of the 14th FC
recommendations on the fiscal position of the centre; (ii) review the debt
level of the centre and states, and recommend a roadmap; (iii) study the
impact of GST on the economy; and (iv) recommend performance-based

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 Evolving role of the Finance Commissions in India ­251

incentives for states based on their efforts to control population, promote

ease of doing business, and control expenditure on populist measures,
among others.
It needs to be noted that the importance of FCs in India not only lies in
shaping and recalibrating the Indian federalism from time to time but also
in keeping the country together with continuity even in the midst of the
worst macroeconomic crisis of 1991. The story of Indian federalism is one
of gradualism, resilience and change with continuity. In this context, the
various FCs have played an important role of serving as a glue in balancing
the intergovernmental relationships and fiscal transfers in a multilevel gov-
ernment system for ensuring provision of public services to over a billion
people. As Bagchi (2003) had noted ‘one cardinal reality that should never
be lost sight of is that federalism is the only possible form of government
for a polyglot country like India’.
This chapter traces the history of the FCs in India over the last two
and a half decades in shaping the intergovernmental transfer system in
India. The India case presents an interesting transition from a market
preserving federalism towards laboratory federalism in the light of the
recommendations made by the 14th FC. The chapter is organized as: (i)
market preserving federalism, economic reforms and the evolving role of
the FCs; (ii) the horizontal and vertical imbalances in the last 25 years; and
(iii) laboratory federalism and the 14th FC – a circumstantial aberration or
permanent change.

13.2 
MARKET PRESERVING FEDERALISM,
ECONOMIC REFORMS AND EVOLVING ROLE
OF FINANCE COMMISSIONS

In 1991, India experienced a balance-of-payments crisis which pushed

it to the verge of default on its external debt. The crisis followed an
acceleration in growth to 6 per cent in the second half of the 1980s; but
fiscal deficits bordering on 10 per cent of GDP during this period fed
into growing current account deficits. Fiscal deficits were financed in the
main by a combination of financial repression and external borrowing,
with relatively limited monetization to keep inflation low. As a result of
the ‘twin deficits’, public and external debt grew while reserves fell (Pinto
and Zahir, 2004a, 2004b, 2007). The year 1991 is regarded as a ‘watershed’
for the Indian economy as the macroeconomic stabilization and structural
adjustment initiated in this year constituted a fundamental break from
the past. The Indian government signalled a systemic shift to a more open
economy with greater reliance upon market forces, a larger role for the

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 252 Intergovernmental transfers in federations

private sector including foreign investment, and a restructuring of the role

of government (Ahluwalia, 2002a).
Under this new policy regime, economic growth combined with
economic efficiency became the objective function of the government.
However, the most persuasive objective of earlier decades emphasizing
poverty reduction was subsumed in the pursuit of growth on the grounds
that economic growth was both necessary and sufficient for improving the
living standards of the poor. With the change in the objective function of
the government, the 10th FC was asked (in addition to its core mandate)
by the Government of India to reflect upon issues of better fiscal manage-
ment and efficient use of resources by the government sector and public
enterprises. The 10th FC was set up at a time when the Indian economy
was opening up and there was a push as well as demand for greater federal-
ism in the country. Chelliah et al. (1992) had pointed out that the 10th FC
should be cognizant of the very changed economic and political context
while performing its task. The reason being the restructuring of the Indian
economy has brought radical changes in economic policies and the reform
programme so far initiated is backed by consensus of the political parties
and the citizens of India.
The 10th FC which was set up in 1992 made recommendations for
the period 1995–2000. This was the period which was marked by a
significant deterioration in the public finances of Indian states. Fiscal
transfers in federations as well as in India play several roles, such as
closing vertical imbalances, achieving redistribution goals, and insuring
states or UTs against macroeconomic shocks (IMF, 2017). The insurance
function is of two types – insurance against common shocks (may hit
all states and UTs simultaneously) and insurance against idiosyncratic
macroeconomic shocks (affect individual state/UT). Disentangling the
redistribution, stabilization, and risk sharing roles of fiscal transfers is
complicated in India as centre-state fiscal transfers are believed to affect
all roles simultaneously. The 10th FC thus had to carry out its remit in a
particularly difficult fiscal situation, more as a part of a policy trilemma of
shocks- stabilization-redistribution.
In the light of the changes in the economic policy which aimed at
liberalization, questions were raised whether the vertical imbalance had
increased or decreased. This debate was in the context that the shift to
a market driven economy altered the functions of both the central and
state government, while the constitutionally mandated functions remained
the same, the emphasis on various subject matters changed. It implied
that the state governments now enjoyed powers that, in the spirit of the
Constitution, they were meant to enjoy which earlier the central govern-
ment in its endeavour to implement centralized planning had prevented.

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 Evolving role of the Finance Commissions in India ­253

The environment within which the states in India operated had undergone
two phases of significant change: first, over the 1970s and 1980s with the
growth of regional political parties; and second, after 1991 with the central
government’s liberalization of the trade and investment regime. These
developments had allowed as well as required of the states a larger role in
determining their development paths and in attracting private investment
(Wes, 2007).
The growth experience of the 1990s showed that developed Indian
states with broad industrial bases and developed market institutions
and infrastructure had performed much better than those without them.
However, it was necessary to be mindful and not penalize those states
that performed more efficiently in the delivery of services or raised more
revenues relative to their tax bases. As a result, the situation demanded
that the intergovernmental transfer system ought to respond to the shifts
in economic policymaking. Post economic reforms, it became important
for FCs in India to establish a fine balance between equity and efficiency,
a system where fiscal disadvantage is taken care of, but fiscal imprudence
is effectively discouraged (Rangarajan, 2006). The fundamental change in
economic policy required both the central and the state governments to
face global competition and the market forces together in a coordinated
manner in the spirit of cooperative federalism.
The period following the economic reforms in India can be regarded as
a phase of ‘market preserving federalism’. The ‘ex ante’ policy framework
post 1991 was embedded in gradualism and careful articulation of eco-
nomic objectives, implying a clear definition of the goal and a deliberate
choice of extending the time taken to reach it, in order to ease the pain of
transition. The goals were often indicated only as a broad direction, with
the precise end point and the pace of transition left unstated to minimize
opposition – and possibly also to allow room to retreat if necessary. This
reduced politically divisive controversy, and enabled a consensus of sorts
to evolve, but it also meant that the consensus at each point represented
a compromise, with many interested groups joining only because they
believed that reforms would not go ‘too far’ (Ahluwalia, 2002a). The result
was a process of change, the emergence of an ex post policy framework,
that was not so much gradualist but fitful and opportunistic. In a nutshell,
the phase of market preserving federalism in India made the task of the
subsequent FCs more challenging. Despite the challenges, the contribu-
tion of later Commissions in rebalancing the centre-state relationships
in the context of liberalization of the Indian economy was significant as
explained in the following sections of the chapter.

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 254 Intergovernmental transfers in federations

13.3 
VERTICAL AND HORIZONTAL IMBALANCES
IN THE LAST 25 YEARS

According to Rangarajan and Srivastava (2011), in reviewing the inter se

distribution of the aggregate share of central tax revenues, the approach
of the FCs can be summarized in terms of three distinct phases. The three
phases are:

(i) Phase I: First (1952–57) to the Seventh (1979–84) FCs relied on dis-
tribution criteria which was distinct for income tax and union excise
duties, income tax sharing was mandatory while there was in-sharing
of union excise duty at the discretion of the centre;
(ii) Phase II: Eighth (1984–89) to the Tenth (1995–2000) FCs before the
implementation of the alternative scheme of devolution of central
taxes. Two noticeable changes during this phase were a move towards
unifying the formulae for the inter se distribution of both income
and union excise duties and secondly a portion of the union excise
duties was kept aside for distribution according to ‘assessed deficits’;
(iii) Phase III: Eleventh (2000–05) FC onwards, and a phase of full
convergence. This led to replacing four distinct sets of shares: (i)
portions of income tax and union excise duties subject to common
criteria; (ii) a portion of devolution against assessed deficits; (iii)
additional excise duties in lieu of sales tax on cotton, sugar and
tobacco; (iv) the grants in lieu of tax on railway passenger fares, by
only one set of shares under the global sharing agreement.

From the 11th to the most recent 14th FC, the overriding criteria under
the global sharing agreement was based on four factors: (i) vertical
transfers; (ii) equity; (iii) incentives for efficiency; (iv) cost disadvantages.
Another salient feature of the full convergence phase was that the
11th, 12th and 13th FCs were headed by economists with experience
in policymaking and the 14th was chaired by an administrator and a
distinguished economist. These appointments reflected the political
consensus in favour of economic reforms and acceptability of the
growing importance of partnership between the centre and the states on
economic development.

Measuring Vertical Imbalances

In India, the relationship of revenues relative to expenditure responsibili-

ties can be measured in terms of the four ratios as shown in Table 13.1.
P1 shows the pre-transfer excess or deficiency state wise and P2 shows the

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 Table 13.1 Measuring vertical imbalances in India (percentage)

Years P1 P2 C1 C2 Years P1 P2 C1 C2
Tenth FC: States in Crisis, Severe Resource Constraints Eleventh FC: Significant Fiscal Correction at the State Level

YILMAZ_9781789900842_t.indd 255
1995–96 50.4 19.5 36.9 42.1 2000–01 57.0 27.7 38.4 43.7
1996–97 54.4 20.4 34.7 39.6 2001–02 57.2 27.2 41.8 46.9
1997–98 54.7 21.3 35.7 41.8 2002–03 55.5 27.2 36.8 41.6
1998–99 57.5 30.3 40.4 45.1 2003–04 56.5 28.1 26.4 30.0
1999–2000 58.4 31.3 37.4 41.7 2004–05 54.9 22.6 24.3 27.6
Twelfth FC: Fiscal Consolidation both at the Centre and States Thirteenth FC: Constrained Fiscal Space for Inclusive Growth
2005–06 52.1 16.8 29.9 33.6 2010–11 51.6 14.5 34.0 39.2
2006–07 49.8 12.9 23.2 26.6 2011–12 50.2 13.7 41.6 48.3

255
2007–08 51.4 11.4 22.9 26.3 2012–13 46.9 13.7 37.3 42.8
2008–09 54.4 16.3 38.6 45.0 2013–14 48.2 15.6 34.5 39.5
2009–10 54.9 20.4 44.1 51.2 2014–15 51.9 16.9 33.6 42.1
Memo: Memo:
1990–91 57.9 22.8 40.9 52.4 2015–16 (RE) 56.7 20.2 33.2 40.4

Notes:
P1 is defined as states’ expenditure minus own revenues divided by states expenditure.
P2 is defined as ratio of states’ expenditure minus own revenues plus central transfers divided by states’ expenditure.
C1 is defined as centre’s expenditure inclusive of transfers minus centre’s gross revenue receipts divided by centre’s expenditure inclusive of transfers.
C2 is defined as centre’s expenditure net of transfers minus centre’s revenue net of transfers divided by centre’s expenditure net of transfers.
Expenditures are net of recoveries. Central expenditure and revenues net of transfers are derived by deducting grants as tax devolution is already
deducted in expenditure and revenue data.
RE refers to Revised Estimates.

Source: Indian Public Finance Statistics, 2016/17 and previous issues, Ministry of Finance, Government of India (GoI).

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 256 Intergovernmental transfers in federations

post-transfer uncovered gaps necessitating borrowing. The P1 ratio indi-

cates that over the last 25 years, on average more than half of the states’
expenditure remains uncovered from the states’ own revenues. However,
there have been changes in the Indian tax system with the introduction of
consumption-based VAT in 2005 replacing the Sales Tax and recently the
introduction of destination-based GST in 2017.6
The P1 ratio indicates that the state expenditures in India are far larger
than states’ own revenues. Also, states play a larger role in spending and
they bear more expenditure responsibilities as noted elsewhere in the chap-
ter. The P2 ratio indicates that after transfers there is still an uncovered
gap, although there is significant ‘correction’ of the vertical fiscal gap. In
1990/91, the year of the macroeconomic crisis, while P1 was 58 per cent (i.e.
states’ own revenues financed only 58 per cent of the states’ expenditure),
the P2 ratio at 23 per cent showed significant correction compared to the
P1 ratio, indicating post-central government transfers, the vertical fiscal
gap was reduced substantially but it did not disappear. Despite consider-
able correction, the uncovered expenditures of the states need to be met
as indicated by the positive sign, necessitating borrowings. Similarly, over
various FCs (Table 13.1), the P2 ratios showed significant correction in the
vertical fiscal gap compared to P1 ratios, albeit amidst different macroeco-
nomic conditions. The post-transfer imbalances increased sharply after
1997/98 given the deteriorating fiscal situation at the state level. During the
12th and 13th FC period a sharper correction is seen in the P2 ratios owing
to higher growth, buoyant revenues, better fiscal management in terms of
adherence to FRBM Act, 2003 at the state level.
The C1 ratio indicates that the central government is not in surplus
even prior to transfers. In comparison, the C2 ratio indicates the centre’s
own expenditures exceed its revenues (excluding transfers) by a large
margin. The positive sign of the C2 ratio shows that in the case of India,
the centre’s ‘fiscal space’ for development (productive) spending shrinks
further after it makes transfers to the states and the centre has to resort to
borrowings for meeting its own expenditure commitments.

Balancing Fiscal Policy in Full Convergence Phase

The adoption of the 80th Amendment Act, 2000 brought all central
taxes and duties (except those referred to in Articles 268 and 269, and the
surcharges and cesses) in the divisible pool to be shared between centre and
the states. The 11th FC fixed the share of states in the net proceeds of all
central taxes at 28 per cent for each of the five years starting from 2000/01
until 2004/05. It further recommended that 1.5 per cent of all shareable
union taxes and duties be allocated to the states separately, thus totalling

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 Evolving role of the Finance Commissions in India ­257

29.5 per cent of the net proceeds of all union taxes and duties. The recom-
mendations of the 11th and the 12th FCs covered the periods 2000–05 and
2005–10 respectively. In light of the economic reforms pursued since 1991,
the TOR of the two Commissions were expanded. They were additionally
asked to review the state of the finances of the centre and states and sug-
gest ways and means by which the government, collectively and separately,
may bring about a restructuring of the public finances so as to restore
budgetary balance and maintain macroeconomic stability.
Ravishankar et al. (2008) highlighted that the fiscal improvement
during 2000–06 was a result of three underlying factors, namely: (i) fiscal
correction efforts by the majority of states due to the 11th FC; (ii) a rise
in the share of central resources, especially to the poorer states, resulting
from the awards of the 11th and 12th FCs; and (iii) the acceleration of
economic growth in India since 2003/04. The fiscal deficit of all states
taken together declined from 4.7 per cent of GDP in 1999/00 to 3.2 per
cent in 2005/06. States’ deficit on current account (revenue deficit) for the
same period declined from 2.7 per cent of GDP to 0.5 per cent of GDP. A
close examination of the state specific performance revealed that poorer
and fiscally more dependent states had, in general, achieved stronger fiscal
correction than the high-income states. However, fiscal performance by
Indian states during 2000–06 had to be seen in the context of the historical
backdrop of the 1990s, a decade characterized by serious deterioration in
the fiscal position of all states that culminated in a fiscal crisis towards the
end of the 1990s.
Many states approached the 12th FC to increase the state’s share of cen-
tral taxes in the divisible pool from 29.5 per cent to at least 33 per cent. The
need for ramping up infrastructure spending was severely felt by the states
for ensuring access as well as improving provision of services to a large and
growing population base. In a more globalized and competitive environ-
ment, the importance of good infrastructure could not be ignored. Several
studies analysing India’s growth prospects identify infrastructure as among
the most important constraints to future rapid growth (Ahluwalia, 1998;
Krueger and Chinoy, 2002; World Bank, 2006). Thus, the TORs of the
12th FC were framed in a manner so that the Commission could provide a
way forward in finding a solution to the infrastructure gap story.
The 12th FC did not accede to the request of the states and instead
argued that grants provided a more effective mechanism for meeting the
equalization objective and increased the states’ share in central taxes by
only one percentage point to 30.5 per cent compared to the 11th FC.
However, the 12th FC made some path-breaking recommendations in
terms of strengthening the macroeconomic framework of the country
requesting the states to enact Fiscal Responsibility Legislations (FRLs),

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 258 Intergovernmental transfers in federations

which should, at a minimum, provide for: (i) eliminating current deficit

by 2008/09; (ii) reducing fiscal deficit to 3 per cent of GSDP (Gross State
Domestic Product) or its equivalent, defined as the ratio of interest pay-
ments to revenue receipts; (iii) bringing out annual reduction targets of
revenue and fiscal deficits; (iv) bringing out an annual statement giving
prospects for the state economy and related fiscal strategy; (iv) bringing
out special statements along with the budget giving in detail the number of
employees in government, public sector, and aided institutions and related
salaries; and (v) enacting the fiscal responsibility legislation, a necessary
precondition for availing debt relief.
In a nutshell, it can be concluded that the 12th FC did not reject in
totality the plea of the states for meeting their serious resource constraints
but used the FRLs to create the necessary fiscal space for capital spend-
ing by recommending the states to reach a ‘zero’ revenue deficit (current
account deficit). Linking debt relief to states to the enactment of FRLs/
FRBM similar to that of central government proved an excellent strategy
of restructuring the states’ public finances.
It needs to be noted that it was not possible to bridge the huge infra-
structure gap by vertical transfers alone. The overall strategy of increasing
infrastructure spending required complementary reforms, the enabling
environment for which was remarkably crafted in the 12th FC recommen-
dations. The task required both coordination and burden sharing between
the centre and states in terms of reducing their fiscal deficits and debt more
so, at the state level. Burden sharing is a two-way traffic, if states agreed
to reduce their debt burden, the centre had to step in to write off some of
the costly debt or replace the costly debt of the pre-1991 era with low cost
debt. The 12th FC responded to the states’ call for burden sharing and
agreed to provide debt relief through a combination of debt write-off and
debt restructuring. In fact, it encouraged the states to access the market for
future borrowings so that they rely less on the resource transfers from the
centre. In overall terms, the 12th FC recommended a less risky alternative
path for India by addressing the weaknesses in public finances and the
infrastructure gap simultaneously through an overhaul of public finances
rather than recommending a debt financed increase in infrastructure
spending given the vulnerability posed by the high debt-GDP ratio (as
depicted in Figure 13.1a–b).
The 13th FC was constituted against the backdrop of strong fiscal
correction and consolidation by most of the state governments. The major
recommendations of the 13th FC were: (i) the share of states in the net
proceeds of the shareable central taxes to be 32 per cent, 1.5 percentage
points higher than the recommendation of the 12th FC; (ii) the revenue
deficit to be progressively reduced and eliminated, followed by revenue

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 8 8

6 6

YILMAZ_9781789900842_t.indd 259
4 4
2 2
0 0
–2 –2

Per cent
Per cent
–4 –4
–6 r–g = 0 –6 r–g > 0
–8 –8
05/06

259
–10 –10
86/87 88/89 90/91 92/93 94/95 96/97 98/99 00/01 02/03 86/87 88/89 90/91 92/93 94/95 96/97 98/99 00/01 02/03 04/05

Debt impact of (r–g) Primary deficit r–g Debt impact of (r–g) Primary deficit r–g
a) b)

Note: The debt dynamics at the central government level deteriorated after the mid-1990s. After 1997/98, primary deficits reversed course and
started rising, while real interest rates converged to and then exceeded growth rates between 2000/01 and 2002/03. This then changed with the
pick-up in the growth after 2003/04. All this was possible through conscious policy and careful calibration of economic policy from time to time.
The role of the FCs in stabilizing the policies every five years through its additional mandates has been crucial.

Sources: a) Pinto and Zahir (2004a) for Figure 13.1a; b) Pinto et al. (2006) for Figure 13.1b. Data collected from Handbook of Statistics, Reserve
Bank of India, various budget documents, Ministry of Finance (GoI), author’s estimates.

Figure 13.1 Debt dynamics

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 260 Intergovernmental transfers in federations

surplus by 2013/14; (iii) the fiscal deficit to be reduced to 3 per cent of the
GDP by 2014/15; (iv) a target of 68 per cent of GDP for the combined debt
of the centre and states; (v) FRBM Act, 2003 to be amended to appropri-
ately reflect the nature of shocks which shall require targets relaxation; (vi)
both centre and states should conclude a ‘Grand Bargain’ to implement
the model GST; (vii) urged to reduce the number of Centrally Sponsored
Schemes (CSS); and (viii) states to address the problem of losses in the
power sector in a time-bound manner.
Chakraborty (2010), however, pointed out that the 13th FC’s recom-
mendation to increase the vertical share of tax devolution to states will
help, but its horizontal distribution formula leaves much to be desired.
The reason being: (i) its design is such that two of the four key indicators
are in conflict7 with each other; (ii) the Commission’s revised road map
for fiscal consolidation at the centre and the states, which recommends
state specific, year-wise, fiscal adjustment paths, not only limits the fiscal
manoeuvrability of states but also impinges on their fiscal autonomy. He
further concluded that the 13th FC has taken a narrow technocratic view
which emphasizes deficit fundamentalism.
In overall terms, the FCs in the full convergence phase played a crucial
role in balancing the centre-state relationship through a combination of
durable and meaningful reforms aimed at providing a strategic road map
that responded to the macroeconomic challenges faced by the centre and
state governments from time to time.

Horizontal Devolution (Sharing) Criteria

For ensuring horizontal equity various FCs used different criteria with
relative weights, in particular, the horizontal criteria were simplified after
the 10th FC. The 11th and 12th FCs were more inclined towards using a
unified formula for horizontal devolution. For determining the criteria and
the relative weights two basic principles of equity and fiscal efficiency were
emphasized by both Commissions. Equity implied, as a result of revenue
sharing, the resource deficiencies across the states are evened out. The 11th
FC was of the opinion that continuing with resource deficiency can create
perverse incentives or it can manifest a vested interest in maintaining a
status quo. It thus emphasized including a criterion for rewarding fiscal
efficiency.
Population has been a stable variable Commission after Commission for
determining the share of states in tax devolution – only the weights have
changed from time to time (Table 13.2). Area as a criterion was introduced
by the 10th FC and it served more as a proxy for cost of providing services.
For instance, states with large area and low population density had to incur

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 Evolving role of the Finance Commissions in India ­261

Table 13.2 Criteria and relative weights for determining inter se share of

states (Phase III) (percentage)

Parameter Finance Commissions

Tenth (1995–2000, Eleventh Twelfth Thirteenth Fourteenth
Alternative Scheme (2000–05) (2005–10) (2010–15) (2015–20)
of Devolution)
Population 1971 20.0 10.0 25.0 25.0 17.5
Adjusted Area 5.0 7.5 10.0 10.0 15.0
Income Distance/ 60.0 62.5 50.0 47.5 50.0
 Fiscal Capacity
Distancea
Fiscal Discipline 7.5 7.5 17.5
Tax Effort 10.0 5.0 7.5
Index of 5.0 7.5
 Infrastructure
Demographic 10.0
 Change 2011
Population
Forest Area 7.5
Total 100 100 100 100 100
Memo:
States’ Share in Income Tax: 77.5; 29.5c 30.5 32.0 42.0
 Divisible Pool of Union Excise: 47.5b
Central Taxes as (All Commodities)
Recommended
by FC

Notes:
a While computing the distance-based shares the 9th and the 10th FCs followed the practice

of measuring the distance of the per capita income of state from that of the highest per
capita income state. The 11th FC, however, changed this from a single high-income state
to an average of three high-income states (Punjab, Goa and Maharashtra) as a benchmark
from which distances were to be measured. The 12th more or less conformed to the 11th
FC practice. The 13th FC changed the estimation criteria (measured fiscal capacity in
terms of per capita taxable capacity), whereas the 14th FC reverted to the earlier method
of measuring fiscal capacity as the distance of actual per capita income of a state from the
state with the highest per capita income.
b Includes revenue deficit grants of 7.5 per cent.
c Of this, 1.5 per cent is on account of additional excise duties in lieu of sales tax on sugar,

textiles and tobacco.

Source: Report of the Finance Commission (10th–14th), Ministry of Finance,

Government of India.

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 262 Intergovernmental transfers in federations

heavy expenditure for providing basic administrative infrastructure. This

stands in sharp contrast to a state with an area of similar size but a high
density of population where costs of providing services are much lower.
The weights have varied from 5 per cent in the 10th FC to 15 per cent
in the 14th FC. Infrastructure played an important role in unbundling the
constraints to growth during the 10th, 11th and 12th FCs. However, the
12th FC dropped the infrastructure index from the horizontal formula
on the grounds that it was correlated with the income distance criteria.
In order to evolve a suitable structure of incentives in fiscal transfers, the
10th FC introduced ‘tax effort’ as a criterion for sharing the tax proceeds
with the states. The 11th FC went further and added ‘fiscal discipline’ as
a criterion. Tax effort together with fiscal discipline was given a weight of
12.5 per cent in the 11th FC which increased to 15 per cent by the 12th FC.
The 13th FC was of the view that there was a strong case to incentivize
states to follow fiscal prudence, particularly in the context of the need to
return to the path of fiscal correction. Accordingly, it assigned a weight of
17.5 per cent to fiscal discipline.
The 14th FC went further ahead and dropped both fiscal discipline and
tax effort criteria from the horizontal distribution formula. The 14th FC
introduced two new variables instead: (i) 2011 population; and (ii) forest
cover. The 2011 population criteria were aimed to capture the demographic
changes since 1971, both in terms of migration and age structure. The
Commission introduced forest cover since its TORs mandated the need to
balance management of the ecology and environment. The weightage of
area was enhanced to 15 per cent compared to 10 per cent in the 13th FC
and that of income distance increased to 50 per cent from 47.5 per cent in
the 13th FC.
While all states stand to gain in absolute terms due to greater devolution
by the 14th FC (as noted in the next section), the sharing pattern among
states had been affected by the change in the horizontal formula.8 The 14th
FC transfers had a more favourable impact on the states which were rela-
tively less developed having low per capita income such as Madhya Pradesh,
Odisha, Uttar Pradesh, Bihar, Chattisgarh, Jharkhand and West Bengal. In
all these states, the benefits of 14th FC transfers were in the range of 3–5
per cent of state income and the ratio of benefits to states’ own tax revenues
was also high, hence substantial increase in the spending capacities of these
states (Economic Survey, Government of India, 2014/15).

Grants-in-Aid

While the distribution of tax proceeds between the centre and states have
dominated the popular debates and discussions around the FCs in India,

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 Evolving role of the Finance Commissions in India ­263

the ‘Grants-in-Aid’ as a component of FCs has its own importance and

relevance. The size of the grants has varied from 7.7 per cent of total
transfers under the 7th FC to 26.1 per cent of total transfers under the
6th FC. In the full convergence phase, where the global sharing agreement
became increasingly important as a source of vertical devolution, the
share of grants in total transfers has been declining and in the 13th FC
it declined to 18 per cent of total transfers. However, the Grants-in-Aid
provided by various FCs included grants for meeting revenue deficit, dis-
aster relief, local bodies, sector specific schemes and state specific schemes.
The revenue deficit (current deficit) grants were provided to those states
which were projected to have a post-devolution non-plan revenue deficit
in any year. The 14th FC departed significantly from earlier FCs as it did
not recommend any grants for sector-specific and state-specific schemes.
The reason behind such a move was that these grants were not based on
any formula or any uniform principle and have thus been quite ad hoc in
nature. Also, it led to duplication of funding in many such schemes.

13.4 
LABORATORY FEDERALISM, 14TH FC: AN
ABERRATION OR A PERMANENT CHANGE?

India’s federal structure is witnessing a paradigm shift in the relationship

between the centre, states and local bodies. There are several reasons for
this shift:

●● The recent experimentation by the 14th FC of choosing a ‘big bang’

approach, compared to a ‘gradualist’ approach of the previous
FCs, of transferring huge sums of money (untied formula-based
transfers) to the states and local bodies has led to a perception that
states’ fiscal autonomy is substantially strengthened.
●● The number of CSS was brought down to 28 from 67 and the CSS
were restructured, and their funding pattern changed.
●● The ‘operative’ word used in the 14th FC report was a ‘trust-based
approach’ in the spirit of strengthening cooperative federalism.
●● The establishment of the GST council which has emerged as the
most significant body in fiscal federalism since independence.
●● Abolition of the Planning Commission in 2014, an extra-­
constitutional body that has been a source of important plan fund-
ing for states since 1950. With this also came the dismantling of the
National Development Council (NDC) which had been the guiding
force for the Planning Commission and served as an important
interlocutor between the states and the centre.

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 264 Intergovernmental transfers in federations

●● Discontinuation of the Plan and Non-Plan distinction while report-

ing expenditures in the budgets from 2017/18.
●● Establishment of a NITI (National Institution for Transforming
India) Aayog in 2015 replacing the erstwhile Planning Commission.
NITI has no mandate to control resources, it is a technical and
advisory body whose aim is to evaluate government programmes and
strategies for resource allocation. The NDC has been replaced by a
Governing Council that has the Prime Minister as the chairperson, a
vice chairperson, full-time members of NITI Aayog, chief ministers
of all states and so on.

The impact of some of the changes will unfold over time and it would
be premature to draw any conclusions in haste. However, what one can
convincingly examine is the impact of the changes due to the 14th FC as
the data for at least the first four years of the award are now available at
the aggregate level.

Laboratory Federalism

The 14th FC points to an interesting period in Indian federalism which one

may call ‘laboratory federalism’. It is a phase of experimentation in India
because some of the traditional and deeply entrenched institutions which
have been the fulcrum of economic policy for several decades have either
been dismantled or restructured. Federalism at work would now be based
on the results of the experimentation and the ‘technical progress’ in public
policy. The 14th FC can be viewed as one of the vehicles for bringing
desired changes in public policy in a somewhat loose sense. The changes
in policy were necessary given the abysmally low level of service provision
for the citizens in India due to state and local governments’ limited imple-
mentation capacity and their high dependency on central government’s
tied transfers. The schematic transfers in the form of CSS have left little
room for states and local governments to design and implement projects
that reflect local preferences.
The experience elsewhere in the world on schematic tied transfers is some-
what similar and there has been in India lately a greater push towards untied
transfers, more in the form of block grants. This is reminiscent of the stance
that the US contemplated in the 1990s. In the mid-90s, the US took a deci-
sion for shifting primary responsibility for poor relief back to the states. The
federal government replaced long-standing federal entitlement programmes,
which came both with detailed rules and generous matching grants to the
states, by a system of block grants with few strings attached.9 The states
had broad scope to determine both the form and levels of a­ ssistance under

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 Evolving role of the Finance Commissions in India ­265

their programmes to assist poor households. The new welfare legislation

was signed into law in 1996 in an attempt to better understand the failure
of federal welfare programmes in the US and to use states as ‘laboratories’
to try to find out what sort of programmes would work. In a similar vein,
after exactly 20 years, the 14th FC provided a basis where both states and
local governments could serve as ‘laboratories’ for understanding what
programmes would work that can address issues of poor service delivery. In
fact, the 14th FC has met a long-standing demand from the states for greater
devolution and greater flexibility in the design of vertical programmes
(CSS), while leaving appropriate fiscal space for the centre.
The attempt to use states as ‘laboratories’ had both political and eco-
nomic reasons in India. In the last two decades there has been a general
trend towards coalition governments with a number of states and local
representatives now participating in politics at the centre. In addition, the
73rd and the 74th Constitutional Amendments in 1992 had incentivized
grass-roots level politicians to rise above the petty politics of local and
state level and occupy a space at the centre.

14th FC and Budget Outcomes

The 14th FC made several bold recommendations that gave greater

autonomy to the states and local governments in delivering services. Major
recommendations included: (i) an unprecedented increase in states’ share
of central taxes from 32 per cent of the central divisible pool (during the
13th FC) to 42 per cent; and (ii) a threefold increase in the total grants to
local bodies for improving basic services during the period 2015–20, total
grants to local bodies was fixed at INR 2874.4 billion (US$ 46 bn), includ-
ing INR 871.4 billion (US$ 14 bn) for urban local bodies and INR 2002.9
billion (US$ 32 bn) for rural local bodies. This 10-percentage-point jump
in tax devolution of the sharable central tax (divisible pool) over the 13th
FC is the largest increase in the history of Indian fiscal federalism. The
earlier Commissions had recommended changes in tax shares in the range
of about 1–2 per cent: 29.5 per cent in the 11th FC and 30.5 per cent in the
12th FC (Table 13.2). The increased tax devolution has been partly com-
pensated by a reduction in the CSS (Table 13.3). The increase for urban
local bodies over the 13th FC is fourfold, while for the rural local bodies
more than three times the 13th FC award (see details in Babu et al., 2018).
The 14th FC concluded that rather than continuing with a fragmented
approach of passing money to the states through multiple channels, it
would be more effective to devolve money by increasing states’ share
in central taxes in the spirit of cooperative federalism. The demand for
cooperative federalism has been echoed several times by various FCs, but

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 266 Intergovernmental transfers in federations

due to the dominance of the Planning Commission in economic policy and

proliferation of CSS with centripetal biases, the recourse to cooperative
federalism remained largely weak.
However, recently Rao (2017) has explained that increasing devolution
from 32 per cent to 42 per cent is not as generous as it looks. In order to
cover the requirements under both Plan and Non-Plan accounts, 5.5 per
cent of the divisible pool was required. In addition, the 14th FC eschewed
discretionary sectoral grants of 1.5 per cent of the divisible pool previ-
ously. Thus, the legitimate comparison should be between 39 per cent and
42 per cent. The increase from 32 per cent or 39 per cent (implicitly) to
42 per cent in the share of central taxes for the states was justified on two
grounds: (i) bringing a compositional shift from grants to tax devolution;
the shift would not result in any additional burden on the centre and it
would also meet a long pending demand of states for more unconditional
transfers; (ii) keeping the level of aggregate transfers to states to around 49
per cent of the gross revenues, in line with previous trends.
The 14th FC, however, did create an impression that the fiscal space
available to the states had significantly increased and the award was a
game changer. A closer examination of the 2015/16 budget does endorse
the compositional shift with a 1-percentage-point rise in tax devolution
offset by a less than commensurate decline in plan grants. According to the
central budget 2015/16, the aggregate central transfers to states as a share
of GDP increased from 5.4 per cent in 2014/15 to 6.0 per cent in 2015/16.
The tax devolution had increased from 2.7 per cent in 2014/15 to 3.7 per
cent of GDP in 2015/16. Part of the increase was offset by a decline in the
plan grants from 2.1 per cent of GDP in 2014/15 to 1.5 per cent of GDP
in 2015/16. The share of non-plan grants to states had increased from 0.6
per cent in 2014/15 to 0.8 per cent of GDP in 2015/16. Further, it needs
to be noted that the 10-percentage-point increase (or 3-percentage-point
increase as per Rao, 2017) in the share of central taxes to states subsumed
part of normal plan assistance, special plan assistance, special central
assistance and sector specific grants. It is important to appreciate that the
substantial tax devolution increase had factored in a number of variables
on the plan side which the government decided to either discontinue or
replace by untied transfers. The transition from tied to untied transfers
thus was a well thought out strategic shift in expenditure policy which the
14th FC facilitated.

An Aberration or Permanent Change

The question now arises is whether this experimentation is seen in India

more as a permanent change or as a circumstantial aberration. Since

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 Evolving role of the Finance Commissions in India ­267

100%

80%
Tax Devolution
60% Non-Plan Grants
Plan Grants
40%

20%

0%
13th FC 14th FC

Source: Central Government Budget Documents (various issues), Ministry of Finance, GoI.

Figure 13.2 Changes in transfer of resources from centre to states between

13th and 14th FCs

2019/20 is the terminal year of the 14th FC, a review of the entire period
(2015/16 to 2019/20) may help to provide some answers. A comparison with
the 13th FC indicates clear trends towards untied transfers (Figure 13.2).
While there was a 1-percentage-point increase on average in tax devolu-
tion to GDP under the 14th FC period, there was a 0.9-percentage-point
decline in plan grants to GDP, a 0.1-percentage-point increase in non-plan
grants to GDP during the same period. As a result, the total transfers as
a percentage of GDP increased by 0.1 percentage points compared to the
13th FC period. The major change is that the share of FC transfers has
substantially gone up during the 14th FC period (74 per cent) compared to
the 13th FC period (56 per cent).
Tied transfers (includes CSS and others) are now only a quarter of
the total transfers compared to 44 per cent during the 13th FC period
(Table 13.3). The changes so far indicated will in the medium term bring a
qualitative change in spending both at the centre and states. While the centre
would find its fiscal space less constraining since a large part of the trans-
fers to the states will be linked to the divisible pool which is formula driven,
it will render greater predictability and transparency in resource transfers.
Chelliah et al. (1992) had remarked that a time would come when transfers
would impart greater autonomy to states through the FC and the Planning
Commission would only lay down broad contours of development policy.
Two decades later, the 14th FC did find itself recommending and assessing
the entire revenue account of the centre for transfer of resources.
However, there is some dissatisfaction among the states over plan
transfers which have been discontinued, in particular, the formula driven

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 268 Intergovernmental transfers in federations

Table 13.3 Transfer of resources from centre to states (percentage GDP)

Thirteenth FC Fourteenth FCa

Tax Devolution 2.9 3.9
Plan Grantsb 2.7 1.6c
Non-plan Grants 0.5 0.6
Total Transfers 6.0 6.1
Memo:
Finance Commission Transfers 55.9 74.1
as % of Total Transfers
Tied Transfers (specific purpose) 44.1 25.9
as % age of Total Transfers

Notes:
a The Budget 2015/16 had delinked eight centrally sponsored schemes from central support.

The 14th FC had identified 30 centrally sponsored schemes to be delinked from central
support but all have not yet been delinked considering the national priorities and legal
obligations. Until 2014, specific purpose grants did not pass through the states’ budget,
instead the money was directly transferred from the central government budget to the
accounts of the societies or the implementing agencies.
b Refers to normal central assistance (NCA) and discretionary grants (CSS and others)

provided by the Planning Commission until it was discontinued in 2014. NCA remained
a predominant channel of central plan assistance to states, however, over time with
proliferation of CSS there has been a significant reduction in the formula-based NCA (from
34.6 per cent in 10th Plan to 9.6 per cent in 2014/15 as a share of total central assistance).
Part of NCA and other grants are now subsumed in tax devolution from the 14th FC
onwards.
c The sharing pattern of the CSS has undergone a change and is now 60:40 compared

to 80:20, with states’ contribution being increased to 40 per cent with the objective of
imparting greater responsibility and accountability to the states both in design and
implementation.

Source: Central Government Budget, Ministry of Finance (GoI), various volumes,

author’s estimation.

normal central assistance. In addition, states have started demanding

that the cesses and surcharges which are now a rising proportion of the
gross tax revenues of the centre should also be shared with them. The
relative stability in the share of tax devolution to gross tax revenues of
the centre is primarily because of the levy of cesses and surcharges which
are currently outside the divisible pool. The surcharges together with the
various cesses increased from 5.8 per cent of gross tax revenues in 1990/91
to 14.6 per cent in 2017/18 (Revised Estimate (RE)). This has resulted in
neutralizing the effect of the increase in tax devolution recommended by
various FCs for the centre. The centre in turn has been pre-empting a part
of the tax revenues due to increasing recourse to this stream of income.
It was believed that roll-out of GST would subsume some of these cesses

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 Evolving role of the Finance Commissions in India ­269

and surcharges, but the central government introduced some new cesses to
make up for the cesses subsumed under GST.
A comparison of the 2015/16 budget fiscal outcomes with the recent
2019/20 budget indicate fiscal consolidation at the centre has paused
(Figure 13.3a–b). The central government has recalibrated the FRBM
targets to reach a fiscal deficit of 3 per cent of GDP in 2021/22 instead of
2017/18 as envisaged at the time of the budget 2015/16. In addition, the
resolve of the centre to make the effective revenue deficit (which excludes
grants for capital creation) zero by 2017/18 has been stretched to 2021/22.
A pause in fiscal consolidation and relaxation in targets to adjust for the
transitional impact of GST in the interim make the task of the 15th FC dif-
ficult as it would need to emphasize adherence to FRBM targets and fiscal
consolidation in order to restore the confidence in the Indian economy.
The 15th FC will have to recast the fiscal consolidation path through tough
fiscal discipline rules (based on fiscal deficit and debt targets), particularly
for the central government. Furthermore, it should also review rational
ways of handling significant non-tax revenues from natural resources on
the surface (such as water), underground (such as coal) and in space (such
as spectrum).
Reddy and Reddy (2019) note that the TOR of 15th FC seem to not just
reverse some of the recommendations of the previous Commission but give
greater discretion than ever before to the Union (centre) government. The
outcomes of this are unclear. There are several reasons which the authors
have cited: (i) there has been some politicization of the TOR since the FC
has been asked to use 2011 population instead of 1971 population figures
in their estimation of the horizontal distribution; (ii) discontinuation of
the revenue deficit grant has constitutional ramifications; (iii) the central
government is granting access to borrowings to states with discretionary
conditionalities despite rules governing the fiscal deficits. The concern
is that the vertical and horizontal distribution that was so far confined
to revenues and expenditures is now being extended to public debt; (iv)
the one-nation-one-tax through GST is associated with erosion of fiscal
autonomy of states because the Sales Tax/VAT which is being transformed
into GST was the only broad-based tax with the states; (vi) a growing sense
among states that cooperative and competitive federalism is being replaced
with coercive federalism since many a time central government officials are
deployed for village outreach programmes to evaluate the working of the
schemes funded by the centre.
In this context, the 14th FC recommendations may appear to be
circumstantial or an accidental aberration. This, however, is not true.
In the history of Indian fiscal federalism, the 14th FC became the first
Commission which brought a structural change in the configuration of

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 Per cent Per cent
7.0 3.5 7.0 14th Finance Commission 3.5
14th Finance Effective Revenue
Effective Revenue Period (ex post)

YILMAZ_9781789900842_t.indd 270
Commission Award Deficit (% GDP)
6.0 Deficit/GDP (%) 3.0 6.0 3.0
(ex ante projections)
5.0 2.5 5.0 2.5
FRBM Target, FD/GDP = 3%
4.0 2.0 4.0 2.0

3.0 1.5 3.0 1.5

2.0 1.0 2.0 1.0

1.0 0.5 1.0 0.5

0.0 0.0 0.0 0.0

07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20
(RE) (BE) (Proj.) (Proj.) (RE) (BE)

a) 2015/16 FRBM Target b) 2019/20

270
Revenue Deficit/GDP Capital Expenditure/GDP Revenue Deficit/GDP Capital Expenditure/GDP
Fiscal Deficit/GDP Effective Revenue Deficit/GDP Fiscal Deficit/GDP Effective Revenue Deficit/GDP

Notes: The FRBM Act was amended twice, 2012 and 2015, to take into account the change in macroeconomic circumstances in the country.
The Act was amended for the third time in 2018 based on the recommendations of the FRBM Committee which submitted its report in January
2017. Following the implementation of the GST in 2017, the fiscal deficit to GDP target in 2017/18 was recalibrated to 3.5 per cent in order to
accommodate the transitional impact of GST on the economy. The Budget 2019/20 is a Vote on Account and not a full budget of the government
due to election. Revenue Deficit refers to current deficit and effective revenue deficit excludes grants for capital creation from the current deficit. BE
refers to Budget Estimate.

Source: Budget 2019/20, 2015/16 and some previous issues, Ministry of Finance, GoI.

Figure 13.3 Trends in key deficit indicators and FRBM targets as per central government budget, 2015/16 and 2019/20

16/12/2019 10:44
 Evolving role of the Finance Commissions in India ­271

intergovernmental transfers to states by considering the entire revenue

(current) account and subsuming plan transfers in tax devolution. This
new arrangement is permanent and is less likely to be reversed by future
Commissions.

13.5 CONCLUSION
In sum, this chapter traces the history of the FCs in India over the last 25
years in shaping the intergovernmental transfer system in India. The India
case presents an interesting transition from a market preserving federalism
towards laboratory federalism in the light of the recommendations made
by the 14th FC. The Indian federal structure is in search of a narrative,
in which the third tier can play an important role along with the states
(second tier) in strengthening objective and accountable subnational
governments (states and local governments together). In policy terms,
the biggest reform undertaken in the 2015/16 central government budget
was the acceptance of the bold recommendations of the 14th FC by the
government. The recommendations of the 14th FC reiterated building a
trust-based approach between the centre and the subnational governments
going forward. There was a conscious move to gradually shift public
expenditure policy decisively and firmly to the jurisdiction of the state
governments. This, along with the ongoing trend in decentralization of
fiscal policy, including the taxation policy through the implementation of
the GST, have altered the design of fiscal federalism in India.

NOTES

* The author is grateful for comments from Dr D.K. Srivastav (Advisory Council Member,
Fifteenth Finance Commission of India), Professor Roy Bahl (Regents Professor
Emeritus and Dean Emeritus, Georgia State University, USA) and Serdar Yilmaz (Lead
Public Sector Specialist, Governance Global Practice, The World Bank, Washington DC,
USA).
1. They are also called Panchayat Raj Institutions (PRIs); the third tier in India is divided
into urban and rural local bodies. The rural local bodies are multi-tiered comprising of
district, block and village, while urban local bodies are single tiered.
2. According to the Constitution, India is referred to as a union of states and union ter-
ritories. In the chapter, Union is interchangeably used and refers to federal or central
government.
3. A policy think tank of the Government of India (GoI), NITI Aayog (National Institution
for Transforming India Aayog), has replaced the Planning Commission in 2015 which
will provide strategic and technical advice to the centre and state governments.
4. While the FC role was confined to the examination of the non-plan revenue account of
the states’ budget, the Planning Commission assessed the overall requirements (in terms
of transfers to states) on the plan side until 2014 until it was discontinued.

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 272 Intergovernmental transfers in federations

5. Order made by the President, Government of India, 27 November 2017.

6. In India, economic reforms have led to the deepening of federalism in terms of expendi-
ture decentralization which demanded at the same time decentralization of revenue
raising powers at the subnational level. However, implementing VAT, to make India a
single integrated market, led to revenue losses for the states in the interim and reduced
their autonomy indicating greater centralization. The implementation of GST in 2017
marks a departure from more centralizing behaviour of the federal government in India
towards a trust-based approach with its subnational governments. The rates for GST are
decided by a GST council which comprises the Union finance minister and the finance
ministers of all the states. The objective of the GST council is to have one uniform tax
rate for goods and services across the country.
7. The existence of a fiscal capacity distance and an index of fiscal discipline in the same
formula contradict the objective of achieving horizontal equity. The reason being that
while fiscal capacity distance tries to enhance the fiscal capacity of states, the index of
fiscal discipline tries to limit their expenditure in rela­tion to their own revenue.
8. In a nutshell, the net impact on the states has been positive and some of the negative
effects of a change in formula have been offset by the large positive effect of the change
in divisible pool.
9. For details, refer to Wallace E. Oates, ‘An Essay on Fiscal Federalism’ in Readings in
Public Finance, edited by Bagchi (2005).

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Associated Publishing House, New Delhi, India.

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 14. Emerging trends in fiscal transfer
systems in selected federations:
implications for India*
Jorge Martinez-Vazquez

14.1 BACKGROUND AND MOTIVATION

Despite the significant policy reforms in recent years, the challenges facing
India’s decentralized system of finance run wide and deep.1 There is still
a significant vertical imbalance between the Union government and the
states. Currently, states have most of the responsibility for providing social
services while the Union government has the monopoly on most broad-
based taxes other than goods and services tax (GST). Second, transfers
continue to mix the objectives of tax devolution and equalization. Thus, it
is not clear for the Union government what is really being achieved, which
is accompanied by considerable unhappiness and frustration among other
stakeholders. Third, considerable economic and fiscal disparities across
the states remain; the disparity in spending per capita was almost tenfold
in 2015. The ineffectiveness of the transfer system is at least partially to
blame. And fourth, even though there has been significant simplification
of Central Sponsored Schemes (CSS), the effectiveness and efficiency of
those transfers still appear to be woefully lacking.
With that background, the 15th Finance Commission (FC) was con-
stituted in November 2017 and scheduled to deliver its recommendations
by October 2019. Its terms of references (TOR) are in many ways conven-
tional, but there is a significant departure (see details in Chapter 13). The
FC is mandated to use population data from 2011 in its recommendations,
instead of the population figures from the 1971 census used by all previous
FCs. This will imply significant shifts of resources from states in the south,
which experienced moderate population growth to northern poorer states
which have experienced faster rates of population growth over the past
four decades.
The chapter explores possible options for the reform of India’s trans-
fer system. To do that, the chapter takes a cross-country view of the

275

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 276 Intergovernmental transfers in federations

i­nternational experience with the design and implementation of transfer

systems, especially drawing from the experiences of large federations.

14.2 
EMERGING INTERNATIONAL TRENDS IN
TRANSFER DESIGN RELEVANT TO INDIA

Issue 1: As opposed to further expanding transfers, India’s considerable

vertical imbalance between the Union and state governments should be first
tackled by providing state governments with increased revenue autonomy.

India’s intergovernmental finance system shows a high level of vertical

imbalance. Using data for 2014–15, Rao (2017) shows that states collect in
taxes around 8 per cent in gross domestic product (GDP) but they spend
over 18 per cent of GDP.
Increased revenue autonomy can be achieved by devolving additional
new taxes to the states, or by inducing states to make better use of their
tax sources by enhancing administrative capacity and removing negative
incentives to tax effort. Low levels of tax revenue autonomy or transfer
dependency lowers accountability and reduces expenditure efficiency and
fiscal responsibility. These are all key issues for the long-term dynamic
performance of fiscal federalism in India.
The introduction of the new GST in 2017 represents a significant step
forward. The new GST rate of 12 per cent is equally split between the
Centre and the states and applied to a common base – final consump-
tion.2 However, from the viewpoints of visibility (accountability) and
revenue sufficiency, the introduction of the GST has contributed much
less. The new GST revenues for the states substitute for other taxes that
states were using, which being much more distortionary, one may claim,
were as visible to taxpayers if not more so. Being eminently a shared tax
with the Union government, it is arguable that many taxpayers will not
identify the GST as a state tax.
However, increasing states’ tax autonomy will not be easy. A distinctive
feature of India’s fiscal federalism is adherence to the principle of separa-
tion of tax bases. In addition, the residual powers to tax lie with the Union
government. Fundamentally, the states’ inability to tax non-agricultural
income has hindered access to broad-based and more buoyant taxes, other
than the GST. Also, some taxes in the state list, such as the property tax or
the professions tax, remain largely unexploited.
Internationally, a number of federal countries allow the concurrent use
of bases, at least for some levies, prominently, taxes on income. Concurrent
tax bases would appear to have more advantages than disadvantages.

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 Emerging trends in fiscal transfer systems in selected federations ­277

When properly coordinated, concurrent use of the same base helps

simplify administration and reduce compliance costs. Canada, the US and
many European countries have concurrent powers to levy income taxes at
the federal and subnational levels.3
The time may be ripe for allowing the states to tax personal income. An
optimal way to do this is through a state piggyback tax, using the same
base as the Union’s but with a state selected flat rate between minimum and
maximum federal legislated rates. Tax proceeds would accrue to the states
on a derivation basis. Another area where states’ revenue autonomy can be
enhanced, and with the double dividend of reducing negative externalities,
is with the wider extension of special excise taxes on alcoholic beverages,
tobacco products, transportation fuels and vehicle use.
The problem can be also addressed by improving the administration
of the property tax, a tax that has consistently underperformed in India.
Much remains to be done to modernize fiscal cadastres by implementing
fair and efficient valuation methods, and carrying out fair and transparent
administration procedures, including efficient appeals. There is also room
for the introduction and expansion of betterment levies and implementing
land value capture levies.

Issue 2: India could follow the international trend of fixing in the law the
sharing rate for the divisible pool in order to bring more stability and predict-
ability, and more importantly, to harden the states’ budget constraint.

After the rise in the sharing rate of the divisible pool to 42 per cent by the
14th FC there have been calls to fix the sharing rate in the law (or even the
Constitution) and scale down the work of the FCs only to the distribution
of funds among the states.4
There are certainly examples of countries in the international practice
that fix the size of the divisible pool in the law. For example, Australia
exclusively assigns to the pool of equalization transfers 100 per cent of
the collected value added tax (VAT) revenues. Other countries that use
a defined sharing rate of the revenue pool include Canada, Germany,
Switzerland, Russia and most of the Nordic European countries. There
are two main types of arguments in favour of this policy: the increased
stability and predictability of state revenues, and the elimination of an
implicit soft budget constraint for the states – they can fight for higher
revenue shares and do lower own tax effort. This would appear to have
been an overlooked important issue in the system. Probably the second
argument is the most meaningful in India’s context.5 There are, on the
other hand, arguments for the need of central flexibility in determining the
pool of funds, such as macroeconomic fiscal stabilization policies. Over

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 278 Intergovernmental transfers in federations

time, the type of argument has lost strength, as central governments have
been increasingly seen as the ablest to absorb cyclical risks.
A closer look at the incentives argument may be warranted. The states’
share in the divisible pool, fixed for 5 years by each FC, is a common lob-
bying target, with the states regularly asking for increases and historically
getting them. This is easier for the states, but not more efficient, than
increasing their own tax effort – and thus they become more accountable
to their constituencies. The components and trappings of a soft budget
constraint (increases in expenditures are met with subsequent additional
transfers) are all in place.
Different FCs have argued the need for discretion in setting the devolu-
tion share to reflect the expenditure needs of the Union and state govern-
ments. However, they have done a rudimentary, at best, job in measuring
expenditure needs. On the states’ side, incentives have been clearly set
to underestimate their tax revenue potential and overstate their needs.
The reality has been a bargaining game played for decades. The result
is a historical pattern of consistent increases in tax devolution shares6
overwhelming evidence that increased transfers have reduced states’ tax
revenue collection efforts.7 Finally, questions of incentives have weighed
heavily in the past reform of the tax devolution system in India with the
80th constitutional amendment. The 10th FC redefined the composition
of the divisible pool of funds in 1996, following the Chelliah Committee
recommendations in 1991, to remove the then-existing perverse incentives
for the Union to neglect the collection of sharable taxes.8

Issue 3: Tax devolution and redistribution are two very different objectives of
transfer pursued in many countries using separate instruments. India could
follow this international trend in the implementation of its tax sharing with
state governments.

The conventional financing systems of subnational governments around

the world include, beyond own tax revenues, revenue sharing on a deriva-
tion basis to pursue devolution objectives and help close vertical fiscal
imbalances, an equalization grant to reduce horizontal fiscal imbalances,
and conditional grants to reinforce national sectoral objectives and address
externalities.
India, as most Latin American countries including large federations like
Argentina and Brazil, uses a single instrument to pursue devolution and
redistribution objectives. The result is that in the end it is not clear what is
being achieved in any particular dimension or objective.
The objective of redistribution pursued via an equalization grant is
pretty obvious: to equalize access to basic services throughout the national

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 Emerging trends in fiscal transfer systems in selected federations ­279

territory regardless of where citizens live. The objective of devolution

may be less well understood. Most OECD (Organisation for Economic
Co-operation and Development) countries – including Australia, Canada
and Germany – and many developing countries, implement some form of
revenue sharing on a derivation basis to provide incentives to develop the
state economies and some sense of national cohesion.
Revenue sharing following devolution objectives clearly benefits the
most economically dynamic regions of the country. That is also true for
India. Often the southern, relatively richer, states in India express feelings
that their contributions are not being recognized and that, overall, they are
being penalized for trying harder to grow their economies. Revenue sharing
on a derivation basis would address those concerns. The larger inequality
or horizontal fiscal imbalances so created can be offset via a stronger
equalization grant, recognizing revenue sharing funds as part of the fiscal
capacity of the states. All this will imply splitting the divisible pool into
revenue sharing and equalization components. The FC would have to
decide on what level of equalization is feasible vis-à-vis straight devolu-
tion.9 The corporate income tax is generally a bad choice – income tends
to be exaggerated at the location of headquarters. The personal income tax
and the VAT are the largest most commonly shared taxes.

Issue 4: India’s equalization system could transition from its obsolete

multivariable weighted index methodology, and follow the international
trend using a formula based on the ‘fiscal gap’ methodology with the explicit
estimation of expenditure needs and fiscal capacity across the states.

Fiscal disparities among Indian states are extremely large by international

standards. The disparity between Goa and Uttar Pradesh in spending
per capita was almost tenfold in 2015. These fiscal disparities are partly
explained by smaller – but still large – economic disparities: in 2015, the
state of Haryana had per capita income five times that of Bihar (Rao
2017).10
Given the size of the fiscal disparities it may not be possible to suffi-
ciently close them. However, one may also ask whether those large dispari-
ties are partly associated with the defective weighted index methodology
used for many decades.
Can a reformed methodology be effective in further reducing existing
fiscal gaps? Increasing the equalization impact can be achieved by increas-
ing the pool of funds that goes into equalization, a political issue already
touched upon above, or by improving the distribution formula, a possibil-
ity further discussed in this section.

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 280 Intergovernmental transfers in federations

India’s Current Equalization Methodology Is Flawed

At the risk of simplifying, a synopsis of how the current tax devolution

formula is as follows.11 First, the multiple criteria formula involving several
criteria like population, land area, and so on – is applied to the divisible
(sharable) pool of funds – which last was 42 per cent, with which a transfer
amount is obtained for each state in the base year. Then, the FC projects
the normed amounts of ‘expenditure need’ and ‘fiscal capacity’ for each
state for the next 5 years, which involve a number of economic assump-
tions. The transfer amount obtained applying the multiple criteria formula
is then used to close the gap between the projected ‘expenditure need’ and
‘fiscal capacity’ for each state for each of the 5 years with the amount
remaining fixed in nominal terms over the entire period. The ‘normative’
principles used by the FC to project ‘expenditure need’ and ‘fiscal capacity’
are complex and vary significantly with each FC.12 Once the work of the
FC is done, there are no adjustments over the next 5 years. As a result,
often states are unhappy because projected revenue and expenditure flows
are grossly different from reality (Bhaskar 2018).
The current weighted index formula uses four variables, three of which
can be interpreted as measuring expenditure needs: population, land area
and forest area. The fourth, the distance of a state from the highest per
capita income state, can be interpreted as approximating fiscal capacity.
The different FCs have changed the devolution weighted index for-
mula.13 The most prominent trend has been a reduction of the weight given
to proxies for expenditure needs, especially population – and increases in
the weight given to the proxy for fiscal capacity. The formula adopted by
the 14th FC gave a 50 per cent weight to the deviation from the highest per
capita income, 27.5 per cent weight to population, 15 per cent weight to the
area, and 7.5 per cent weight to the forest area.
One fundamental problem with the weighted index approach is that
the criteria selected are more or less arbitrary and that their weights are
also in large measure arbitrary. From that perspective states have made
continuous efforts to change the criteria and their weights. For example,
as reported by the 14th FC, some states pushed for the inclusion of the
Human Development Index (HDI), others for the inclusion of poverty
measures or an index of social and economic backwardness, the lack of
infrastructure and communication facilities, or the cost of living. From
the perspective of equalization, many of these other suggested criteria
could be as well justified, if not more so than the criterion introduced
by the 14th FC related to ‘forest cover’.14 The implication is that a more
comprehensive methodology is needed to address the complex nature of
the states’ expenditure needs.

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 Emerging trends in fiscal transfer systems in selected federations ­281

Another obvious problem relates to the fact that the FC makes

­ rojections for 5 years and those estimates are never updated. Very few
p
countries adopt this approach, which would appear to be related to the old
practice of the 5-year plans; one exception is Vietnam. This practice has
been defended as imparting stability; transfers will keep coming no matter
what. A different approach would allow a new ‘permanent secretariat’ of
the FC to make updates every year. This would bring India’s practices
more in accord with international practices.
One long-recognized limitation of the distribution formula has been the
use of outdated population figures (from 1971). Fortunately, this issue has
been addressed in the TOR for the 15th FC, which mandate the use of the
2015 Census population. However, the long-lasting use of the 1971 Census
population has likely introduced distortions and inequities in the system
that will take time to correct. The reason for using the 1971 population
was to discourage states from following lax population control policies.
Since population increases have been much more moderate in the south,
states there are now complaining about being penalized. Nevertheless, it is
incontrovertible that no meaningful equalization policy can be established
based on population figures that are more than four decades old.
A more fundamental problem is that the current equalization methodol-
ogy does not account well for many differences in expenditure needs. For
example, Rao (2017) indicates that poorer states have a disproportionate
number of poor people requiring anti-poverty programmes, and a much
higher share of children under age 14, requiring higher outlays in educa-
tion and healthcare. Other demographic factors can add to expenditure
needs, such as a relatively higher presence of the elderly.15 There are other
types of state features that may impact expenditure needs. For example,
Rajaraman (2017) points to the environmental cost damages in the states
with mining activities.
In addition, the current methodology does a largely inadequate job in
measuring differences in fiscal capacity across the states. Obviously, low-
income states may have lower fiscal capacity. But fiscal capacity can be more
accurately measured by using methodologies that deal explicitly with the size
of tax bases or that can include proxies that can measure tax revenue poten-
tial. For example, the states’ share of the GST – as will be argued below – can
be used to directly measure the largest component of states’ fiscal capacity.

International Trends and State of the Art across Countries in the Design of
Equalization Grants

The state of the art in the design of equalization transfers in the inter-
national practice is the fiscal gap approach, defined as the difference

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 282 Intergovernmental transfers in federations

between separate estimates of expenditure needs and fiscal capacity of

the states. An increasing number of countries have adopted this meth-
odology. Among developed OECD countries we find Australia, Canada
for the Northern Territories, Italy, Japan, Korea, United Kingdom and
in many US states; among countries in transition, China, Latvia, Russia,
Ukraine and Vietnam; and among developing countries, Indonesia,
Peru and Uganda. Actual implementation differs in its complexity. In
Australia the fiscal gap formula is administered by an autonomous com-
mission, and revenue capacity and expenditure needs are meticulously
calculated every year for a long list of revenues and expenditure areas.
However, in Canada equalization for the provinces (as opposed to the
territories) is only on the basis of fiscal capacity per capita. Germany,
Poland and Spain use yet another variation of the methodology by
equalizing fiscal capacity per adjusted population reflecting differences
in expenditure needs.
Different methodologies are available to compute expenditure needs and
fiscal capacity across subnational government, as there are also different
ways to apply their difference – the fiscal gap – to implementing the actual
distribution of the available equalization funds among subnational govern-
ments.16 Estimates of tax capacity quantify the potential revenues that can
be obtained from the tax bases assigned to the subnational government,
when they exercise an average (or maximum) level of collection effort.
This avoids using actual revenues and therefore perverse incentives to
lower actual collections. The actual measurement of fiscal capacity also
includes actual revenue sharing and possibly other unconditional transfers.
For these latter sources actual quantities can be used since central govern-
ments, not subnational governments, control their amounts.
Significantly, the recent reforms of the GST would simplify the meas-
urements of states’ tax capacity (Rajaraman 2017). The GST tax base
is uniform across states and it is nationally administered by the GST
Network.17 Therefore, actual revenue collections should be very close to
potential tax revenues. Thus, the largest component of states’ tax capacity
is already measured. The task then would remain to estimate the potential
revenues for the rest of state taxes.18
Regarding expenditure needs, the task would be to quantify the funding
necessary to cover all state expenditure responsibilities at a common stand-
ard level of service provision.19 Typically, the estimation of expenditure
needs excludes those arising from capital expenditure needs. The latter are
more complex, lumpy and discontinuous, and generally they are better
addressed separately via capital grants.
Once expenditure needs and fiscal capacity have been estimated, the
pool of funds can be distributed among those jurisdictions – for which

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 Emerging trends in fiscal transfer systems in selected federations ­283

expenditure needs exceed fiscal capacity, proportionally to the fiscal gap or

in several alternative manners.
One final issue is the standard of equalization, fundamentally con-
strained by the pool of available resources. The standard used by the 14th
FC was to ensure that in the final year of the period, every state reached
at least 80 per cent of the all-state average projected per capita revenue
expenditure. If a fiscal gap approach were adopted, the equalization pool
of funds would need to be calibrated to allow that result.

Issue 5: If a fiscal gap methodology is not adopted, India could consider

refining the index formula approach to better capture needs and capacity. An
additional possibility would be just to explicitly estimate the fiscal capacity
(tax revenue potential) of the states and introduce the ‘ratio of fiscal capac-
ity to adjusted population’ methodology – to implement equalization grants.20

Refining the Current Weighted Index

Even though the current weighted index approach used in India could
be improved, it must be clear that these improvements would only help
ameliorate a substandard methodology, in which the choice of variables to
be included in the weighted index formula are still rather arbitrary, as are
the relative weights attached to each one of those variables.
First, for fiscal capacity there are alternatives to the criterion of ‘devia-
tions from the highest per capita income’. One used in countries like Brazil
and Argentina, which also use a weighted index formula, is the inverse of
the state per capita income. On the set of criteria approximating expendi-
ture need, the case for using forest ground cover as a proxy for expenditure
need is weak – and highly unusual in the international practice. This objec-
tive would be better pursued with a conditional performance-based grant.
The most critical aspect would be to approximate some expenditure needs
that now go unmeasured, such as those due to the different composition of
the population (more young people in need of education and more elderly
in need of assistance), the incidence of poverty, the presence of unsatisfied
basic needs (water, sanitation, and so on), and regional differences in the
costs of service provision due to mountainous terrain or remoteness.

Adopting a Fiscal Capacity per Adjusted Population Approach for

Equalization

Within the fiscal gap methodology, there are some countries which only
equalize differences in fiscal capacity per capita and ignore potential differ-
ences in expenditure needs, as for example is the case of Canada. On the

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 284 Intergovernmental transfers in federations

other hand, there are a number of countries that go a step beyond and use
a fiscal capacity per adjusted (for expenditure needs) population approach,
as in the cases of Germany, Poland and Spain. This methodology requires
the estimation of fiscal capacity for which the different approaches
discussed under the previous issue could be utilized and, second, the esti-
mation of expenditure needs, but in a simplified way. The basic intuition
is that the adjusted population in a state will exceed its actual population
when its expenditure needs are above the average expenditure needs of all
the states, while the adjusted population would be smaller when the state’s
expenditure needs are below the average. Those simplified expenditure
needs may be measured via a weighted index, as discussed above. The
adjusted population for each state can be obtained by multiplying the value
of the weighted index for the state by the total population of the states –
that is, the national population. The ratio of adjusted population to actual
population in the state denotes whether fiscal capacity per adjusted popu-
lation will go up or down and therefore whether the state will be eligible for
more or less equalization funds.21

Issue 6: India should follow the international trend towards further consolida-
tion of specific grants into block grants. However, there is no absolute domi-
nance of block grants; specific purpose grants (with ex ante conditionality
or ex post performance-oriented conditionality) may be what are needed
depending on the objectives of the Union government.

Over the past several decades there has been an international trend towards
the simplification of transfer systems in order to provide subnational
governments with more autonomy in the use of transferred funds. In
fact, this general trend can be decomposed into sub-trends both working
in the same direction of providing greater subnational authority: first an
increase in the share of unconditional grants over conditional grants, and
second, within conditional grants, an increase in general purpose block
grants with a decrease in specific purpose conditional grants. For several
decades before, the experience of many countries had been to see their
transfer systems grow into a jungle-like mix of specific purpose grants,
many of them too small, costly to administer and often times overlapping
in targeted roles with contradictory objectives.
Beyond seeking greater autonomy for subnational governments, other
reasons the general trend is avoiding include high administration and
monitoring costs and not taking over subnational competencies.
Departing from a similar scenario of a multiplicity of earmarked
specific grants, India has experienced in recent years a drastic simplifica-
tion of federal government specific grant schemes. As previously noted,

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 Emerging trends in fiscal transfer systems in selected federations ­285

the 14th FC increased the states’ share in the divisible pool of Union tax
revenues to the highest level on record of 42 per cent, with general purpose
unconditional transfers representing over two-thirds of the total transfers.
In addition, there has been a considerable reduction in the number of
specific purpose grants, including the CSS from 147 in 2012 to 66 in 2013
(Rao 2017). Further simplification took place in 2014, when a committee
of chief ministers of the states appointed by the Union government elimi-
nated the pass-through transfers and reduced the CSS to 28.
But, there is still room for further simplification. There are still 73 Union
transfers – 28 CSS plus 45 other Union schemes – competing for funds.
With total funding representing less than 2 per cent of GDP, it is hard to
see how so many transfers can have a significant impact on final public
service outcomes, and especially of services that are the exclusive respon-
sibility of the states. Many of the CSS are still seen as a backdoor for the
intervention and micromanagement of states’ exclusive responsibilities,
overburdening state administrations and diluting their priorities (Mathur
and Safdar 2018).22 A smaller number of Union CSS and other grants
should concentrate on service areas that present significant interstate
externalities and on service areas that can be considered highly meritorious
(Rao 2017).
The international experience offers a rich body of practice that can
inform further reforms of the conditional grant system in India.23
One of the essences of conditional transfers is that more often than not
they become a source of conflict between central and subnational govern-
ments because of the different priorities given to particular expenditures.
The resolution of that conflict often entails the use of conditional matching
grants – as is the case with most CSS in India – which allows central gov-
ernments to impose their priorities while subnational governments are free
to exercise their own budget decisions. Conditional grants – whether block
or specific – typically are best implemented (when feasible) on a ‘capitation
basis’ (i.e., per student and per inhabitant), with this basis appropriately
modified for costs or needs differences.24 Using fewer conditions and
making those transfers block grants generally has the added advantage of
allowing subnational authorities to exercise budgetary autonomy in terms
of setting some spending priorities and selecting the most efficient method
of service delivery. However, this is not to say that block grants are always
a superior instrument compared to specific purpose grants. In fact, there
are legitimate central government objectives that can be significantly better
pursued by means of specific purpose grants – for example, the vaccination
of children to eradicate encephalitis – than by block grants.
In recent years, many countries have transitioned from long lists of
earmarked grants to simplify much shorter portfolios of conditional block

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 286 Intergovernmental transfers in federations

grants.25 However, this transition has not been permanent, and in many
cases it experienced reversals. One of the reasons for the reversal to specific
purpose grants from block grants is associated with the political economy
of grant making, in what Borge (2009) calls the ‘blame game’ between the
central and subnational governments in Norway. The former were blamed
for providing insufficient funding, while the latter were blamed for the
wrong spending priorities and low tax effort. This led central authorities
to revert to using specific grants instead of block grants. It has been also
the case that the introduction of block grants has been accompanied by
an increase in regulations by the central governments.26 What we have
learned is that there are both advantages and disadvantages to using both
types of conditional grants, and there is no intrinsic superiority of one
type of grant over the other in all relevant dimensions. Administrative
capacity at the subnational level, degree of institutional fiscal autonomy
and the extent of horizontal accountability can differ considerably across
countries. Significant deficiencies in those areas may call for more reliance
on specific grants.
Even though specific grants tend to be costlier to administer, less
respectful of subnational autonomy, less predictable budget-wise, and
more subject to rent seeking and clientelism threats, they may work better
where the central government has incomplete information on costs and
expenditure need differences. They can also contribute to intergovern-
mental cooperation and be more conducive to developing more horizontal
accountability given the higher visibility of the expenditure-revenue link,
and be less prone to soft budget problems and lack of effective cost con-
tainment (Smart and Bird 2009; Lotz 2009; Kim 2009b).

Issue 7: India should follow the international practice of using distinctive

separate capital grants in support of states’ needs to build public capital
infrastructure. Because of their ‘lumpiness’ and non-recurrent nature, the
needs for capital infrastructure cannot be adequately taken into account in
the recurrent equalization transfer.

The most recent advances in public budget management call for the integra-
tion of all expenditure categories in the same budget – that is, not to have
a separate capital budget – so that all budget priorities can be compared,
and overall efficient decisions can be made on the allocation of scarce fiscal
resources. However, when it comes to supporting subnational governments
with their capital expenditure needs, it is generally necessary to count on
separate instruments. In particular, the international practice is not to mix
capital expenditure need support with the equalization transfers – which
only consider expenditure needs arising for recurrent obligations and fiscal

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 Emerging trends in fiscal transfer systems in selected federations ­287

capacity from recurrent funding. Capital infrastructure investment needs

are characterized by their lumpiness and discontinuous nature, features
that are very different from those of recurrent expenditure needs. In addi-
tion, from the financing potential side, in the case of capital infrastructure
it is generally necessary to consider the role that credit and borrowing
can play. However, access to credit cannot be easily incorporated in the
computation of the fiscal capacity measures typically incorporated in
equalization grant formulas.
In India, the 14th FC, following the demise of the Planning Commission
in 2014, made the decision to incorporate capital expenditure needs con-
siderations in the general devolution sharing formula. Before that, there
had been distinctive and separate capital grants – although with many
problematic features – implemented by the Planning Commission, which
de facto relegated the role of the FC to only considering the non-plan (or
recurrent) expenditure needs of the states (Rao 2017). Going forward,
there will be a need to review the options for using separate capital transfer
instruments. Should the FC introduce a separate devolution formula for
capital transfers that can take into account capital infrastructure needs
and borrowing ability of the states? Or, given the temporary nature of the
FC, should the responsibility fall on the Union government? Actually, both
options are possible and non-exclusive.
The international practice with capital transfers is highly varied
(Martinez-Vazquez 2000). In terms of objectives, capital transfers are
generally designed to assist subnational governments with financing con-
straints for lumpy capital, ameliorate significantly different infrastructure
endowments across those units, pursue and support central government
specific sectoral objectives, and possibly to address externalities across
subnational governments. Two major policy biases need to be openly
addressed in the design of capital grants: the belief that capital expen-
ditures are always more efficient than recurrent expenditures, and the
lack of maintenance of existing subnational government infrastructure.
In the latter regard, matching grant arrangements are generally used to
help subnational governments to take ownership of capital infrastructure
projects.27
In terms of design, capital grants vary by the degree of flexibility in the
use of the funds. They can either be specific project-based grants, closely
monitored by line ministries, and categorical or block grants, which can
be designed with strong equalization features and which give much more
discretion to subnational governments.
For their allocation, capital grants can be ad hoc, use pre-established
formulas, or require competition processes with defined application proce-
dures. No single approach is best in all cases.

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 288 Intergovernmental transfers in federations

Institutionally there has been a significant trend to remove the imple-

mentation of capital grants from ministries of planning to integrate them
with the rest of the budget process in ministries of finance. This has been
an imperative result from the need to coordinate all aspects of budgeting.
Despite that trend, countries often retain the vehicle of a PIP (Public
Investment Program) but integrated into a medium-term expenditure
framework (MTEF) or multi-year budget that covers the entire budget.
Finally, as in the case of most other transfers, incentives matter in the
design of capital grants. One of the overriding concerns is to achieve ‘addi-
tionality’ or ‘maintenance-of-effort’ by subnational governments, usually
through matching requirements. In addition, capital grants should not be
a substitute for using surplus funds and prudent borrowing policies under
the ‘golden rule’ (borrowed funds can only be used for capital investment).

Issue 8: India could follow the international trend towards further use of
performance-based grants and increased accountability of programmes/
schemes.

Performance-based grants have been suggested by some experts and

increasingly used in some countries as an alternative to specific earmarked
and block conditional grants. In India, the approach was recently sug-
gested by the Ministry of Finance during the consultations of the 14th FC
with stakeholders.
In general, ‘performance-based grant systems’ (PBGS) incentivize
improvements in service delivery by linking performance to access, level
and discretion in the use of funds.28 The basic idea is to move away from
ex ante controls intrinsic to most conditional grants (be specific or block
grants) to a system based on performance incentives coupled with ex post
monitoring and assessments.
PBGS have been used in OECD countries (Australia, Canada, Italy,
the UK and the US) and also in some developing countries (Uganda,
Philippines, Tanzania, Kenya, Bangladesh and Indonesia). The most
delicate design area in PBGS lies in the specification of the performance
measures. Socio-economic eligibility criteria is critical to ensure that richer
subnational governments – and therefore a priori already better perform-
ing – do not capture all the available transfer funds. Performance measures
should include only indicators that are under subnational government
control and should be employed only for activities that are completely
decentralized. This explains that the focus of most PBGS has been on
institutional process (such as budgeting or reporting) and on intermediate
output indicators, which can be accepted as being controlled by subna-
tional government actions.29

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 Emerging trends in fiscal transfer systems in selected federations ­289

Issue 9: India could follow international practice of increasing the effective-

ness of conditional transfers by carrying out an in-depth evaluation of the
most important CSS.

In some circumstances, conditional grants achieve all they were designed to

achieve. In other circumstances, they achieve very little (if anything). But,
how do we know? There is wide agreement among experts that all transfer
programmes should be subjected to rigorous evaluations.30 An increasing
number of countries have put that into practice. For example, in Australia,
the evaluations of transfer programmes, but also of all other federal
government spending programmes, have been carried out periodically
since the budget management reforms of the 1980s. In the United States,
routine evaluations of federal programmes are carried by the Government
Accountability Office (GAO). The most important transfer programme in
the European Union, the Structural Fund, has been evaluated routinely
since the mid-1990s. Some countries, like Sweden, go back many decades
with routine evaluations of transfers and other central government spend-
ing programmes.
In India, there has been little or no evaluation of CSS. Here it is
important to remark that evaluation is quite different from monitoring,
since the latter does indeed take place. In the case of monitoring the
concern is with compliance with overall conditionalities, schedules, uses
of inputs, and meeting financial requirements. In contrast, the nature
of evaluation is to focus on comparing the intended objectives and the
actual impact on the targeted clientele and whether the desired changes
can be observed.
Typically, performing a good evaluation is not an easy task since it is
complex to isolate the impact of the transfers from other confounding fac-
tors that may also have a bearing on the observed outputs and outcomes.
Essentially, the questions to ask are: what would have been the outcome or
outputs in the absence of the transfer? Are the observed outcomes cost-
effective given the size of the transfers?
Some recent assessments of a few CSS give a powerful hint of the benefits
that could be achieved from careful routine evaluation of existing transfer
programmes, the CSS in India. The National Health Mission (NHM) is
a specific transfer31 – the largest in India – to the states to provide wide
access to health services. Rao’s (2017) analysis of this programme finds it
wanting in several critical aspects, including lacking a clarity of purpose,
a defective distribution formula, and suffering from serious operational
issues. In the same vein, Berman et al. (2017) report that the NHM has
largely failed to achieve greater equity/convergence between states or an
increase in health spending.

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 290 Intergovernmental transfers in federations

The Universal Elementary Education Program or Sarva Shksha Abhiyan

(SSA) is a matching grant to the states with the goal of ensuring access to
elementary education in the whole country.32
The programme is actually implemented through 42 different interven-
tions (access, retention, gender, some tuition reimbursement to private
schools, infrastructure and so on). Rao (2017) identifies a long list of issues
with this transfer including poor identification of minimum standards, a
focus on physical inputs, or lack of equalization of expenditure per pupil
with untrained teachers, absenteeism and lack of learning materials in
poorer states.
Finally, the Mahatma Gandhi National Rural Employment Guarantee
(MGNREGA) is a conditional transfer for income support by providing
100 days of guaranteed employment each year for an adult member of every
household that enrols in the programme and operates in all Indian states
since 2008. The essence of the programme is to mitigate rural poverty. But as
Rao (2017) points out, the states with higher concentrations of poverty do
not receive higher transfers: transfer disbursements as recently as 2014–15
were highly negatively correlated with the states’ rural poverty ratio.
In India, currently, there is no institutionalized form of evaluation and
no formal evaluation policy for schemes and projects. And yet an August
2016 ministerial order mandated appraisal of all schemes (both new and
ongoing) and independent evaluation of all schemes for onboarding to the
next funding cycle. Going forward, the international practice offers several
lessons: the need for a general policy that regulates the evaluation activity
and sets standards, the preservation of transparency and independence in
the evaluation process, and the existence of a formal evaluation agenda.
The new Development Monitoring and Evaluation Office (DMEO) in
NITI Aayog could perhaps be expanded to become the main focal point
for the evaluation function of all transfers in India, including all CSS.

14.3 CONCLUSION

From a broad reflection on international experience and the specific Indian

political and institutional context, the following policy messages emerge
from the chapter: (i) address vertical imbalance through increased revenue
sources; (ii) define a medium-term period in the law for the divisible pool
for greater predictability in states’ finances and harden states’ budget
constraint; (iii) separate transfer instruments to distinguish between devo-
lution and redistribution objectives in the implementation of tax sharing
with state governments; (iv) transition from the obsolete multivariable
weighted index methodology to a distribution formula based on the ‘fiscal

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 Emerging trends in fiscal transfer systems in selected federations ­291

gap’ methodology. If the fiscal gap methodology is not adopted, the

country could refine the index formula approach to better capture fiscal
needs and capacity; (v) further consolidate conditional grants to reduce
fragmentation and move towards block grants; (vi) use distinct capital
grants or transfers to support states’ public capital infrastructure needs;
(vii) expand use of performance-based grants and increase accountability
of programmes/schemes; (viii) carry out an in-depth evaluation of the
most important CSS in order to increase the effectiveness of conditional
transfers.

NOTES

* I am grateful to Pedro Arizti, Aurelien Kruse and Farah Zahir for comments, and to
Krishanu Karmakar and Indira Rajaraman for useful insights.
1. See Rao (2017) and Forum of Free Enterprise (2018).
2. The 6 per cent Central GST is further devolved to states as part of their overall share of
42 per cent of central tax revenues in the divisible pool. In addition, there is a further
5-year guarantee of a top-up by the Union government to ensure state revenues increase
by 14 per cent.
3. A potential problem with concurrent tax bases is the presence of vertical externalities.
4. See, for example, Sivagnanam and Naganathan (2000). Of course, this is a totally differ-
ent issue from what the actual sharing rate should be.
5. Rajaraman (2017) concludes that there has been stability and predictability of Union
transfers over a long period of time. In the international practice, predictability is
increased by using a 1- or 2-year lag for defining the pool of funds.
6. This has been offset at times by decreases in other Union transfers, as with the 14th FC
(Rajaraman 2017). See details in Chapter 13.
7. Chelliah (1981), Rao (1981), and Sivagnanam and Naganathan (2000).
8. As noted in Chapter 13, currently, the divisible pool still excludes cess and surcharges
because those funds are already committed to specific expenditure needs of the Union
government. States have continued to complain about that since cess revenues have
practically doubled in the last 15 years, representing now close to 15 per cent of all Union
revenues.
9. See, for example, Rangarajan and Srivastava (2018) and Rao (2017).
10. As presented by Rao (2017), in 2014–15, an increase of 1 per cent in the state per capita
income represented an increase of 0.65 per cent in total expenditures per capita.
11. The Finance Commission makes other transfers including the ‘revenue deficit grants’,
grants to local bodies, grants for disaster management, sector-specific grants and state-
specific grants. Despite its rather misleading name – making it sound like a gap filling
grant between actual expenditure and revenues – the most relevant to equalization is the
revenue deficit grant, which is a top-up transfer redistribution for states that show sig-
nificant differences between estimated (normed) expenditure and revenue projections.
12. There is also an element of bargaining since the FC solicits from the states their
projected revenues and expenditure needs.
13. Other variables used by former Finance Commissions reflected population composi-
tion, infrastructure, tax effort and fiscal discipline (Rao 2017).
14. We also need to add that the 14th FC in so doing was reacting to its TOR which require
addressing environmental concerns in the devolution formula.
15. This may impact higher income states. For example, Kerala would appear to have higher
health expenditure needs due to its ageing population.

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 292 Intergovernmental transfers in federations

16. See Martinez-Vazquez and Boex (2006).

17. Only the responsibility for audit is split between centre and the states, and states may not
vigorously pursue audit because they have ensured their revenue will increase at least 14
per cent year on year for the next 5 years.
18. The list of other taxes includes state excise duties, stamp duty and registration fee,
motor vehicle tax, goods and passenger tax and other minor taxes. There are in addition
own non-tax revenues that should also be accounted for.
19. See Martinez-Vazquez and Boex (2006) for the different methodologies that can be used.
20. Although the methodology of ‘fiscal capacity to adjusted population’ would certainly
be new to India, a similar approach was used by the 14th FC to adjust states’ expendi-
ture projections for their fiscal capacity.
21. Note that in Germany, Poland and Spain, the states with ratios above the average are
forced to contribute, in a progressive manner, depending on how far they are above the
average, to the pool of equalization funds distributed to the poorer units.
22. Some of the reasons states have been against the extensive use of CSS should have an
easier fix. Many CSS are actually introduced quite far in the budget year creating distor-
tions and uncertainties in budget execution. Clearly, improvements in federal budgeting
actual procedures are needed.
23. Internationally, there is some terminology confusion regarding block grants because
different countries use the same terminology for quite different types of grants. See Bahl
(2009).
24. In particular, using existing capacity as the basis of the grants should be avoided so not
to penalize jurisdictions with less adequate physical facilities.
25. However, the strength of this trend may be easily exaggerated. A survey of Sweden,
United Kingdom, Italy and the United States finds that that there is almost no common
feature or pattern in the choice between general block grants and earmarked specific
grants (Kim 2009b). See also Blom-Hansen (2009), Hermansson (2009) and Blöchliger
and Vammalle (2009).
26. See, for example, Blom-Hansen (2009) for the case of Denmark and Brosio and Piperno
(2009) for Italy.
27. Matching arrangements may require adjustments for the fiscal capacity of subnational
governments.
28. See, for example, Steffensen (2010) for a description of PBGS.
29. There can be political economy factors associated with the application of PBGS (Shah
2009).
30. For further discussion on PBGS, see, for example, Blomquist (2003) and Ezemanari et
al. (1999).
31. Contributing 60 per cent in the case of general category states and 90 per cent in the case
of special category states.
32. The matching rate is 60 per cent for general category states and 90 per cent for the
special category states.

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Aiyar, Yamini and Avani Kapurb. 2018. ‘The centralization vs decentralization tug
of war and the emerging narrative of fiscal federalism for social policy in India’,
Regional and Federal Studies. https://doi.org/10.1080/13597566.2018.1511978.
Bahl, Roy. 2009. ‘Conditional vs. unconditional grants: The case of developing
countries’ in General Grants versus Earmarked Grants Theory and Practice: The
Copenhagen Workshop 2009. Junghun Kim, Jørgen Lotz and Niels Jørgen Mau
(editors). Albertslund: Korea Institute of Public Finance and Danish Ministry
of Interior and Health, pp. 126–48.

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Berman, Peter, Manjiri Bhawalkar and Rajesh Jha. 2017. ‘Government financing
of health care in India since 2005: What was achieved, what was not, and why?’ A
Report of the Resource Tracking and Management Project Harvard T.H. Chan
School of Public Health, Boston, MA.
Bhaskar, V. 2018. ‘Challenges before the Fifteenth Finance Commission’, Economic
and Political Weekly, 10 March.
Blöchliger, Hansjörg and Camila Vammalle. 2009. ‘Intergovernmental grants in
OECD countries: Trends and some policy issues’ in General Grants versus
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Kim, Jørgen Lotz and Niels Jørgen Mau (editors). Albertslund: Korea Institute
of Public Finance and Danish Ministry of Interior and Health, pp. 167–90.
Blom-Hansen, Jens. 2009. ‘The fiscal federalism theory of grants: Some reflections
from political science’ in General Grants versus Earmarked Grants Theory and
Practice: The Copenhagen Workshop 2009. Junghun Kim, Jørgen Lotz and
Niels Jørgen Mau (editors). Albertslund: Korea Institute of Public Finance and
Danish Ministry of Interior and Health, pp. 107–25.
Blomquist, John. 2003. ‘Impact evaluation of social programs: A policy perspec-
tive’. Revised draft. September.
Borge, Lars-Erik and Grete Lilleschulstad. 2009. ‘General grants and earmarked
grants in Norway’ in General Grants versus Earmarked Grants Theory and
Practice: The Copenhagen Workshop 2009. Junghun Kim, Jørgen Lotz and
Niels Jørgen Mau (editors). Albertslund: Korea Institute of Public Finance and
Danish Ministry of Interior and Health, pp. 191–217.
Brosio, Giorgio and Stefano Piperno. 2009. ‘Conditional intergovernmental trans-
fers in Italy after the constitutional reform of 2001’ in General Grants versus
Earmarked Grants Theory and Practice: The Copenhagen Workshop 2009. Junghun
Kim, Jørgen Lotz and Niels Jørgen Mau (editors). Albertslund: Korea Institute
of Public Finance and Danish Ministry of Interior and Health, pp. 218–38.
Chelliah, R.J. 1981. Trends and Issues in Indian Federal Finance. New Delhi: Allied
Publishers.
Ezemanari, Kene, A. Rudqvist, K. Subbarao. 1999. ‘Impact evaluation: A note on
concepts and methods’. Mimeo, Poverty Reduction and Economic Management
Network. World Bank (January).
Forum of Free Enterprise. 2018. ‘15th Finance Commission’, Newsletter (with
contributions by Indira Rajaraman; Abhay Pethe; and C. Rangarajan and D.K.
Srivastava), Delhi.
Fourteenth Finance Commission Report. Ministry of Finance. 2015. Report of the
Fourteenth Finance Commission. New Delhi: Government of India.
Garg, S., A. Goyal and R. Pal. 2014. ‘Why tax effort falls short of capacity in
Indian states: A stochastic frontier approach’. IGIDR Working Paper WP-2014-
032. IGIDR, Mumbai.
Hermansson, Andreas. 2009. ‘Specific and general grants in Sweden: What has hap-
pened after the grant reform in the 1990s?’ in General Grants versus Earmarked
Grants Theory and Practice: The Copenhagen Workshop 2009. Junghun Kim,
Jørgen Lotz and Niels Jørgen Mau (editors). Albertslund: Korea Institute of
Public Finance and Danish Ministry of Interior and Health, pp. 239–62.
Jha, R., M.S. Mohanty, S. Chatterjee and P. Chitkara. 1999. ‘Tax efficiency in
selected Indian states’, Empirical Economics, 24 (4), 641–54.
Kim, Junghun. 2009a. ‘Introduction’ in General Grants versus Earmarked Grants
Theory and Practice: The Copenhagen Workshop 2009. Junghun Kim, Jørgen

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Lotz and Niels Jørgen Mau (editors). Albertslund: Korea Institute of Public
Finance and Danish Ministry of Interior and Health, pp. 13–39.
Kim, Junghun. 2009b. ‘General grants vs. earmarked grants: Does practice meet
theory?’ in General Grants versus Earmarked Grants Theory and Practice: The
Copenhagen Workshop 2009. Junghun Kim, Jørgen Lotz and Niels Jørgen Mau
(editors). Albertslund: Korea Institute of Public Finance and Danish Ministry
of Interior and Health, pp. 149–66.
Lotz, Jorgen. 2009. ‘Member states’ practices for the funding of new competences
of local authorities’. Unpublished manuscript. European Committee on Local
and Regional Democracy, Council of Europe.
Martinez-Vazquez, Jorge. 2000, ‘An introduction to international practices and
best principles in the design of capital transfers’. Mimeo. Georgia State
University, Atlanta.
Martinez-Vazquez, Jorge and Jamie Boex. 2006. ‘Designing intergovernmental
equalization transfers with imperfect data: Concepts, practices, and lessons’ in The
Challenges in the Design of Fiscal Equalization and Intergovernmental Transfers.
Jorge Martinez-Vazquez and Robert Searle (editors). New York: Springer Verlag,
pp. 291–344.
Mathur, Om Prakash and Midhat Fatima Safdar. 2018. ‘Reforming vertical
programmes: The case of India’. Mimeo: Centre for Urban Studies, Institute of
Social Sciences New Delhi (June).
Mukherjee, S. 2017. ‘Changing tax capacity and tax effort of Indian states in the era
of high economic growth: 2001–2014’. NIPFP Working Paper No. 196. NIPFP,
New Delhi.
Rajaraman, Indira. 2017. ‘Continuity and change in Indian fiscal federalism’, India
Review, 16 (1), 66–84. DOI: 10.1080/14736489.2017.1279927.
Rao, H. 1981. Centre-State Financial Relations. New Delhi: Allied Publishers.
Rao, M. Govinda. 2017. ‘The effect of intergovernmental transfers on public
services in India’. NIPFP Working Paper No. 218. NIPFP, New Delhi.
Shah, Anwar. 2009. ‘Autonomy with accountability: The case for performance ori-
ented grants’ in General Grants versus Earmarked Grants Theory and Practice: The
Copenhagen Workshop 2009. Junghun Kim, Jørgen Lotz and Niels Jørgen Mau
(editors). Albertslund: Korea Institute of Public Finance and Danish Ministry of
Interior and Health, pp. 74–106.
Sivagnanam, K.J. and M. Naganathan. (2000). ‘Federal Transfers and Tax Efforts
of the States of India’, Indian Economic Journal, 47 (4), 101–10.
Smart, Michael and Richard Bird. 2009. ‘Earmarked grants and accountability in
government’ in General Grants versus Earmarked Grants Theory and Practice:
The Copenhagen Workshop 2009. Junghun Kim, Jørgen Lotz and Niels Jørgen
Mau (editors). Albertslund: Korea Institute of Public Finance and Danish
Ministry of Interior and Health, pp. 40–73.
Steffensen, Jesper. 2010. ‘Performance-based grant systems: concept and interna-
tional experience’. Mimeo. United Nations Capital Development Fund, New
York.

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 PART IV

Intergovernmental Transfers in Unitary

Federations

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 15. Intergovernmental fiscal transfers
in Kenya: the evolution of revenue
sharing under new devolution in a
quasi-federal system
Jamie Boex and Paul Smoke

15.1 INTRODUCTION

Kenya has a long and diverse history of local governance, both traditional
forms used by its varied ethnic groups and the British structures set up
during the colonial period.1 The formal local government system was
originally designed to serve the interests of British settlers, but the jurisdic-
tions were relatively autonomous and well resourced. The basic system was
maintained when Kenya gained independence in 1963. Deconcentrated
administration that reported to the national government was also set up
during the colonial period and played an important role in managing
national policies and resources.
From early independence negotiations, there were debates about how
to organize the public sector in the ethnically fragmented country. Some
groups – particularly ethnic minorities who feared domination and
marginalization – desired a federal (‘Majimbo’ in Swahili) state rooted
in (ethnically identified) regions. Others – led by the largest ethnic
group – promoted a centralized unitary system framed as better serving
nation building. A fleeting victory for Majimboism at independence led
to the creation of a federal system in the 1963 constitution, but it was
soon displaced by centralist forces who took power in the first national
election. Kenya became a unitary state under the 1969 constitutional
reform.
Post-independence local governments were gradually weakened under
the banner of promoting ‘national unity’, while the deconcentrated system
of provincial and district administration increasingly played a larger role in
managing public functions. Kenyan local governments, however, continued
to be governed by elected councils with devolved (if limited) responsibility

296

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 Intergovernmental fiscal transfers in Kenya ­297

for local revenues and services, with only very limited intergovernmental
fiscal transfers being provided for decades after independence. When the
economy began to experience challenges at a number of points in the 1980s
and 1990s and concerns about inequities intensified, broad dissatisfaction
with all levels of government gradually emerged. This resurfaced some
of the governance controversies and ethnic rivalries of the independence
period, and severe violence broke out during the 2007 elections. Attempts
to deal with the aftermath of this violence and its underlying causes
generated momentum to rethink national governance. After a few years
of debates and public consultations, a new constitution was adopted by
popular referendum in 2010. One of its major provisions was a funda-
mental restructuring of the intergovernmental system, with significant
devolution to a single tier of subnational government at the county level
that essentially replaced the previous variety of subnational entities.
This chapter describes and assesses the intergovernmental transfer
system adopted under the 2010 constitution. The next section provides
a brief history of subnational government and intergovernmental fiscal
relations prior to 2010 to help explain the motivations behind the new
system and the context in which it is being built. The third section outlines
the new county government system prescribed in the 2010 constitution
and offers a sense of its implementation to date, both accomplishments
and challenges. The fourth section explains the main unconditional
transfer – the equitable sharing of national revenues – and reviews its
history, what is known about its effects, its positive features and potentially
desirable reforms. This is followed by a review of the legal basis and role
of conditional transfers, their use to date and ideas about improving them.
We conclude by offering suggestions for priority reforms and a brief
assessment of political economy realities that may provide opportunities
for and impose constraints on further reform.

15.2 
A BRIEF HISTORY OF INTERGOVERNMENTAL
FISCAL RELATIONS IN KENYA

Kenya’s intergovernmental system prior to the new constitution was a

problematic mix of entities, levels and systems with poorly defined and/
or poorly respected roles and responsibilities.2 A provincial/district system
that reported to the Office of the President (de-concentration) existed in
parallel with the semi-independent system of elected local governments
(devolution) under the oversight of the Ministry of Local Government
(MOLG). In this dual system, the deconcentrated provincial/district
system was the main mechanism for public service delivery, while the role

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 298 Intergovernmental transfers in federations

of local governments was narrower in scope, focusing primarily on the

management of local affairs.
The set of subnational jurisdictions was relatively stable for years, with
112 single-tier elected local (municipal, town, urban and county) councils
and a deconcentrated administration that consisted of 8 provinces and
39 districts (geographically identical to the 39 county councils) in 1990.
Later in the 1990s, a large number of new districts and local governments
– many of them non-viable as service providers – were created (through
uncoordinated mechanisms that led to different numbers of districts and
county councils) to meet political objectives without systematic analysis
or the adoption of measures to ensure that they could deliver on their
responsibilities.
Immediately prior to the current system adopted in 2010, there were 175
single-tier elected local councils, including 67 county councils; 62 town
councils; 43 municipal councils; and 3 city councils. Despite their legal
empowerment and long history, many local governments inadequately
responded to the needs and priorities of a growing and more educated citi-
zenry. Central government officials typically attributed weak performance
to local government incapacity and corruption but seemed incapable or
disinclined to turn the situation around. Local government officials often
claimed they were impeded by undue central regulation and interference,
usurpation of their roles by provincial/district administration and limited
funding. Citizens, of course, bore the consequences of this intergovern-
mental stalemate, but challenging political realities hindered their ability to
generate meaningful change.
Despite recommendations by a national commission and an official
sessional paper calling for local governments to be strengthened soon
after independence, centralizing political dynamics in the 1970s and 1980s
contributed to hastening their decline. The power consolidation that began
after Kenya’s independence was intensified by a public sector restructuring
initiated in response to a 1982 coup attempt.3 Over time, deteriorating
local public services – although substantially a function of national policies
and outright neglect – bolstered the central government’s portrayal of local
governments as problematic entities requiring central control instead of
key developmental actors meriting financial and technical support. Many
citizens must have questioned the benefits of voting in local government
elections and paying local taxes given what they received in return.

The Post-Independence Intergovernmental System and Its Challenges

The relative fiscal importance of local governments before the 2010 devo-
lution reforms was modest, generally accounting for less than 6 per cent of

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 Intergovernmental fiscal transfers in Kenya ­299

total public expenditures and less than 5 per cent of total public revenues
(deconcentrated provincial and district administrations were incorporated
under the national budget). Local governments had (primarily permissive
rather than mandatory) legal authority for a number of public services,
including local roads, water schemes, sanitation services, and pre-primary
education, among others. They also provided other services important for
local economic development, such as markets, slaughter houses, livestock
auction yards and bus parks. The original colonial-era municipalities had
enhanced functions, including health services, which were elsewhere man-
aged by the deconcentrated administration. Exact functions in practice
depended on a mix of national decisions, local capacity and resources, and
rural versus urban location, among other factors, and delivery of some
devolved functions, such as roads and water, was later reorganized in ways
that bypassed or limited the local government role.
On the revenue side, Kenyan local governments relied heavily on
property rates, and from the late 1980s the local authority service charge
(LASC), a complex and unpopular own source revenue (the only new local
revenue source created after independence) that was later abolished. Local
governments also had access to various local fees, licences and a range
of other mostly modest revenues that varied in importance across highly
diverse jurisdictions.
Also consequential for local government fiscal performance was the
development planning and financial management system. Kenya had a
bifurcated system of subnational planning and budgeting that reflected
the dichotomy between the deconcentrated provincial-district system and
the semi-autonomous elected local authority system.4 Territorial spatial
land-use plans were produced on an ad hoc basis by the central govern-
ment. At all levels, there was only a weak linkage of development plans
to the annual budgeting process (the national budget for provinces and
districts, and the local budgets for local government councils) and local
accountability.

Evolving Realities and Local Government Reforms

Although there had been previous efforts to strengthen local governments,

changing global and domestic conditions in the 1990s opened opportuni-
ties for stronger reform. These efforts were largely pursued under the
broad-based Kenya Local Government Reform Program (KLGRP) sup-
ported by multiple donors over a long period.5 KLGRP’s most notable
achievements were with intergovernmental fiscal reforms, which started in
the late 1990s with steps to harmonize problematic central and local rev-
enues.6 In 2000, the productive but administratively difficult and p
­ olitically

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 300 Intergovernmental transfers in federations

unpopular LASC was replaced by the Local Authority Transfer Fund

(LATF), the first transfer created since Kenya largely abolished transfers
during post-colonial recentralization.7 Despite these fiscal reforms to
strengthen local governments, the problematic planning system outlined
above received scant attention.
The pre-2010-constitutional reforms were particularly deficient with
respect to citizen engagement in an environment where basic governance
was clearly at the core of government performance problems. Participatory
mechanisms were weak, and civil society’s ability to drive more meaningful
participation from below was hampered by central regulation and political
apathy. Some promising improvements were adopted, but their use was
uneven and results poorly documented.8
Further complicating the public service delivery challenges created
by the provincial-district and local government systems, the Kenyan
Parliament created a Constituency Development Fund (CDF) in 2003 to
fight poverty by providing allocations to parliamentarians to serve their
electoral districts.9 The CDF further confused the accountability channels
open to Kenyan citizens. In national budgets around the time the new
constitution was passed, an increasing proportion of resources for other
programmes was also being allocated on a constituency basis.10

Summary of the Post-Independence Evolution of Local Administration and

Local Government

Since independence, there have been many efforts targeted at improving

local government fiscal and service-delivery performance in Kenya. Some
were genuine, while others were likely cosmetic or largely undertaken to
secure donor funding. Underlying institutional complexities and political
dynamics, however, did not favour successful and sustainable local gov-
ernment empowerment. A core challenge was the deliberate weakening
of the local government system and the assumption of responsibility
for delivering major public services by an increasingly unresponsive
and politicized central government. The post-2007 election violence
generated new and urgent interest in redressing historical inequities and
more genuine local governance, but through a systemic restructuring
of the public sector rather than in ways that tried to fix existing local
institutions. Accordingly, the 2010 constitution included provisions for a
devolution that differs considerably from the previous local government
system.

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 Intergovernmental fiscal transfers in Kenya ­301

15.3 
DEVOLUTION AND THE 2010 CONSTITUTION:
INSTITUTIONAL STRUCTURES,
FUNCTIONS, OWN SOURCE REVENUES AND
INTERGOVERNMENTAL TRANSFERS

Compared to the previous centralized system, Kenya’s 2010 constitution

introduced far-reaching changes to the way that government operates and
relates to its citizens, with the goal to make the public sector more fair,
efficient, transparent and accountable.11 The previous system was a hybrid
between a presidential and a parliamentary system (with cabinet positions
filled by Members of Parliament), while the new system is presidential,
creating some space between the legislature and the executive (the national
departments of which were seen as having dominated parliamentary deci-
sions). The intergovernmental system was also dramatically restructured.
Whereas under the previous system the central government provided many
public services, the 2010 constitution established 47 county governments to
play a lead role in service delivery.
These new county governments replaced the disjointed system of
deconcentrated and devolved jurisdictions that had dominated for dec-
ades, including both the provincial and district administration and the
independent urban and other local government authorities that had
existed since the colonial period. Although this dramatic consolidation of
subnational government and administration dealt with many of the plan-
ning, budgeting, financing and service-delivery fragmentation challenges
outlined above, a number of concerns about this organization structure
were also highlighted during debates on the new constitution.
Kenya’s path towards a devolved public sector with a single subnational
tier was informed by a combination of governance objectives (e.g. local
self-governance and popular participation in the exercise of the powers of
the state) as well as developmental objectives (e.g. service delivery and social
and economic development). Underlying these objectives, however, was a
deep-seated mistrust of an unresponsive central government (and its decon-
centrated agents) detached from local needs/priorities and a broadly shared
perception that historical inequities in government attention to some regions
urgently needed to be redressed. The depth of these sentiments created an
opportunity to push for a more independent and well-resourced system of
local government than the one that had existed since independence. These
forces and inclinations in some ways resurrected the concerns of the federal-
ist factions that were prominent during the independence negotiations.
The structure of the new county governments mirrors that of the
national level, with full separation of the executive and legislature in
a presidential system. County governors are directly elected by simple

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 302 Intergovernmental transfers in federations

county majority and are expected to nominate a cabinet from outside the
county assembly. The county assemblies are comprised predominantly of
representatives from single member constituencies, with some additional
members representing women and marginalized groups selected from
party lists. There are strong provisions in the constitution to ensure an
important role for civic engagement.
The devolved governance framework was effectively operationalized
by the election of county governors and county assemblies in March
2013. Since then, county governments have been working to take on the
important political, administration and fiscal powers assigned to them in
the constitution and have started providing essential public services. As the
government level closest to the people, the introduction of county govern-
ments has fundamentally reshaped the public sector and the relationship
between people and the public sector in Kenya.

Assignment of Functional Responsibilities

Similar to many other federal and quasi-federal constitutions, Kenya’s

constitution (in the Fourth Schedule) provides for the distribution of
functions and powers between national and the county governments. The
following functions and powers are assigned to the county governments:

a. Agriculture;
b. County health services (including county health facilities, as well as
functions such as cemeteries and solid waste management);
c. Control of air pollution, noise pollution, other public nuisances and
outdoor advertising;
d. Cultural activities, public entertainment and public amenities;
e. County transport, including county roads;
f. Animal control and welfare;
g. Trade development and regulation;
h. County planning and development;
i. Pre-primary education, village polytechnics, homecraft centres and
childcare facilities;
j. Implementation of specific national government policies on natural
resources and environmental conservation;
k. County public works and services (including water and sanitation
services);
l. Fire-fighting services and disaster management;
m. Control of drugs and pornography;
n. Ensuring and coordinating the participation of communities in
governance at the local level.

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 Intergovernmental fiscal transfers in Kenya ­303

Although the Public Financial Management Act (PFM Act 2012)

requires counties to follow prudent financial management practices and
requires them to spend at least 30 per cent of their budget on development
expenditures, county governments are otherwise free to plan and budget
their resources across different functional responsibilities in accordance
with county priorities.
The constitution (in Article 186(2)) recognizes the existence of concur-
rent functions and specifies that national legislation prevails in areas of
concurrent jurisdiction when there is a conflict between national and
county legislation (Article 191). However, unlike in some countries, the
constitution does not enumerate the specific powers and functions that are
concurrent or how the funding or delivery of concurrent functions ought
to differ from exclusive county functions.
Upon the first round of county elections in March 2013, county
governors moved quickly to establish control over administration in
their respective counties, including all aspects of service delivery within
their mandated functions (facilities, staff and funding).12 Although some
national ministries have successfully retained resources for activities that
de jure fall under county responsibility, governors – individually, and
collectively through the Council of Governors – have advocated consist-
ently to assume their legal powers. The challenges involved in forming
a consolidated county government have been considerable since new
counties absorbed functions, assets, resources and staff from multiple
former jurisdictions within their boundaries. These represented a mix of
deconcentrated and devolved entities, which, as explained above, used
different systems, further complicating the transition process.
For the most recent completed financial year (FY 2017/18), total county
government expenditures amounted to KShs. 303.8 billion, comprising
KShs. 236.9 billion for recurrent expenditure and KShs. 66.9 billion for
development expenditure (OCOB 2018a: xv).13 County expenditures, how-
ever, reflect only approximately 12 per cent of total government spending
(OCOB 2018b: x).

Own Source Revenues

By design, Kenya’s devolution involves a large disparity between the

aggregate county expenditure responsibilities and own source revenue
assignment. While substantial public sector functions are assigned to
counties, they are, under Article 209(3) of the constitution, only assigned
revenue authority over property rates, entertainment taxes, and any
other tax authorized by an Act of Parliament.14 These are essentially the
sources assigned to the local level under the previous local government

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 304 Intergovernmental transfers in federations

system, ­suggesting that increasing the independent revenue powers of

the new county governments was not an initial priority. Greater revenue
autonomy would have empowered county governments further (and argu-
ably stimulated county revenue mobilization efforts). Addressing historical
geographic and ethnic inequities, however, was a driving force behind the
new constitution, and there may have been concerns that greater revenue
decentralization could have made equalization more difficult to achieve.
During the most recent financial year (FY 2017/18), the aggregate rev-
enue raised by county governments amounted to KShs. 32.5 billion. Given
the size of other county funding sources (including intergovernmental
fiscal transfers), own source revenues only account for slightly more than 8
per cent of total county revenues (OCOB 2018a: xv).

Structure of Intergovernmental Fiscal Transfer System

The third pillar of any fiscal decentralization reform or any system of

intergovernmental finance is the provision of intergovernmental fiscal
transfers, the main focus of this volume. As in other countries, transfers
are needed to fill the gap between the extensive expenditure responsibilities
of county governments in Kenya and the limited own revenue sources
assigned to them.
Guided by the constitution (Article 202), the backbone of Kenya’s inter-
governmental fiscal transfer system is formed by a large, unconditional
grant scheme – known as equitable sharing. The constitution (Article 218)
further lays out the process through which the ‘Division on Revenue’ (both
between government levels and among county governments) is determined
annually. As discussed in greater detail below, the equitable sharing of
national revenue accounts for close to 92 per cent of transfers to counties,
while conditional grants account for slightly more than 8 per cent.15
Although the constitution places a lower bound on the size of the
vertical sharing of sharable national revenues (at 15 per cent of national
revenues), it does not require this channel to dominate total transfers.16 In
operationalizing the constitution, however, a vigorous debate on how to
share resources eventually resulted in a decision that the cost of devolved
public services – such as health services, agriculture extension services,
and so on – should be funded as part of the equitable revenue sharing
mechanism rather than through conditional (sectoral) grants (CRA 2012).

Intergovernmental Fiscal Arrangements

The Kenya Commission on Revenue Allocation (CRA) is constitutionally

mandated to make recommendations concerning the equitable sharing of

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 Intergovernmental fiscal transfers in Kenya ­305

revenue raised by the national government between national and county

governments and among counties. Parliament, however, has the final word
in determining the vertical sharing and horizontal allocation formula. In
turn, detailed intergovernmental transfer allocations (for equitable sharing,
as well as for conditional grants) are determined by the CRA and National
Treasury as part of the annual Division of Revenue Act (DORA), which
precedes the preparation of the national budget.17 In this sense, there are
close parallels between the Kenyan transfer system and the South African
intergovernmental fiscal transfer system (discussed further in Chapter 16
of this volume).
The constitution also established the Office of the Controller of Budget
(OCOB) in order to oversee and report on implementation of budgets
of both the national and county governments. Among its other respon-
sibilities, the OCOB approves the transfer of funds from the national
Consolidated Fund to the various County Revenue Funds (CRFs) in line
with the DORA, ensuring the regular and timely disbursement of funds
by the National Treasury. The OCOB further prepares quarterly budget
implementation review reports at the national as well as county levels,
thereby providing improved transparency and accountability of public
sector finances vis-à-vis the prior centralized system.

Summary of Current Situation

Five years into the devolution process under the new quasi-federal
constitution, Kenya’s path towards devolution has largely been an initial
‘political’ success: county governments were established, they prepare
annual plans and budgets, control their own public servants and operate
service-delivery facilities. The central dominance over political power
has been reduced, and a more politically competitive political system
was introduced. Power and resources are generally perceived to be more
equitably distributed across Kenya under the new system, both geographi-
cally as well as across the country’s main ethnic groups. Public support
for the new devolved system appears to be strong, as county governors
and assemblies – being closer to the people – are widely perceived to
have legitimate power and authority (e.g. IPSOS 2016). The extent to
which devolution has led to more accountable governance and improved
service delivery, however, is far less self-evident and much less well broadly
documented.18 As such, perhaps the most important challenge facing the
intergovernmental fiscal transfer system in Kenya is the need to ensure
that fiscal devolution achieves improved service-delivery outcomes and
responsiveness to citizens.

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 306 Intergovernmental transfers in federations

15.4 
EQUITABLE SHARING OF NATIONAL
REVENUES19

As noted above, the equitable share of national revenue provided to county

governments is their most important source of revenue. The constitution
is clear about the general basis of this transfer, but with the exception of
the minimum threshold of 15 per cent, considerable scope is given to the
central government – through the CRA, Parliament and National Treasury
– for determining the vertical and horizontal allocation of national funds.

Constitutional and Legal Context of Equitable Sharing of Revenues

Article 202 of the Kenyan constitution states that revenue raised nationally
should be shared equitably among the national and county governments.
Article 203 indicates that the equitable (vertical and horizontal) distribu-
tion of these revenues shall take account of the following factors:

a. The national interest;

b. Any provision that must be made in respect of the public debt and
other national obligations;
c. The needs of the national government determined by objective
criteria;
d. The need to ensure that county governments are able to perform func-
tions allocated to them;
e. The fiscal capacity and efficiency of county governments;
f. Developmental and other needs of counties;
g. Economic disparities within and among counties and the need to
remedy them;
h. The need for affirmative action in respect of disadvantaged areas and
groups;
i. The need for economic optimization of each county and to provide
incentives for each county to optimize its capacity to raise revenue;
j. The desirability of stable and predictable allocations of revenue; and
k. The need for flexibility to respond to emergencies/temporary needs
using objective criteria.

The Vertical Allocation of the Equitable Share

In line with the constitutional guidance that the distribution of resources

should take into account ‘the need to ensure that county governments are
able to perform the functions allocated to them’, the CRA has traditionally
drawn a strong link between the expenditure needs of county governments

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 Intergovernmental fiscal transfers in Kenya ­307

Table 15.1 
Financing of county government functions (in KShs. million)

Actual Actual Recommend

Devolved Functions 2016/17 2017/18 2018/19
Health Services 76,677 89,131 95,846
Planning and Development 57,661 54,694 58,815
Agriculture, Livestock and Fisheries 21,881 26,452 28,445
Culture, Public Entertainment and 3,351 3,272 3,519
Public Amenities
Youth Affairs and Sports 4,848 6,481 8,969
Trade, Cooperative Development and 4,855 6,096 6,555
Regulation
Roads and Transport 44,256 49,596 59,677
Lands, Housing and Public Works 6,316 6,754 7,263
Water, Natural Resources and 7,937 8,119 8,731
Environmental Cons.
Pre-Primary Education 2,605 4,241 4,560
Subtotal devolved functions 230,387 254,836 282,380
New County Structures 49,913 47,164 54,783
Total equitable share 280,300 302,000 337,163

Source: CRA (2017: Table 7).

(based on their constitutional mandates) and the vertical distribution of

nationally collected resources.
The Commission’s recommended vertical allocation of nationally raised
revenue to the county level for FY 2012/13 (the first full year of devolu-
tion) included (a) the estimated cost of county administration; (b)
National Treasury’s estimate of the cost of current devolved functions;
and (c) a contingency allocation of 10 per cent (CRA 2012: 18). The
recommended vertical allocation of resources regarding the counties’
collective equitable share in subsequent years has continued to be based
on the estimated cost of county-level administration and service provision
(Table 15.1).

The Horizontal Allocation of the Equitable Share

In line with its constitutional and legal mandate, the CRA has prepared
over the last six financial years two bases that have guided the sharing of
revenues among the 47 county governments from 2013 forward. A sum-
mary of these two horizontal allocation formulas is provided in Table 15.2.
Although there are slight differences between the formulas that were
applied, the variations in the horizontal distribution were quite minor.

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 308 Intergovernmental transfers in federations

Table 15.2 
The horizontal allocation of the counties’ equitable share: first
and second basis

Parameter First Basis % Weights Second Basis % Weights

FY 2013/14–2015/16 FY 2016/17–2018/19
Population 45 45
Equal Share 25 26
Poverty 20 18
Land Area 8 8
Fiscal Effort 2 2
Development Factor* 1

Note: * The county development factor is based on access to economic infrastructure,

including road access, and the per cent of households with access to electricity and
improved water sources.

Source: CRA (2017: Table 10).

The rationale behind the mix of factors included in the allocation formulas
or horizontal ‘bases’ for equitable sharing was transparently documented
by the CRA (CRA 2012; 2014). In contrast to the vertical allocation of the
counties’ equitable share, the horizontal allocation is only (very) loosely
driven by the functions and expenditure responsibilities assigned to the
county level. Although the formula provides a small window (2 per cent)
to stimulate revenue performance, it does not include any measures of
county budget performance or service-delivery performance. In fact, the
horizontal allocation formula almost completely loses the link between the
allocation of funds and the functional responsibilities of counties.
Although there was considerable discussion of the importance of this
link and debate about if and how to incorporate it, the data required to
operationalize a more ‘functional’ allocation formula did not exist. In
addition, there were further challenges created by the fact that the new
counties were an amalgamation of a set of subnational jurisdictions
that were managed under the different planning and budgeting systems
outlined earlier.
The relative simplicity of the first and second bases was not necessarily
merely a technical matter. As Kenya began to implement the 2010 constitu-
tion, there were serious concerns raised by some who sought to ensure a
more federal-like public sector structure (hailing back to the period of
Majimboism in the 1963 constitution) that a more detailed, functionally
linked allocation formula could serve as a pretext for the national govern-
ment to continue the top-down micromanagement and control entrenched
in the system since independence. Instead of a technically precise formula,

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 Intergovernmental fiscal transfers in Kenya ­309

their priority was to protect counties from central capture, as well as

to ensure that historical injustices were redressed by shifting public
finances away from regions (and ethnic groups) that had been advantaged
since British times, in favour of areas/groups that had been historically
disadvantaged.
The current (so-called ‘second basis’) allocation formula does not result
in the same – or equal – per capita allocations to all counties. This is con-
sistent with the constitutional (policy) objective of achieving an equitable
(rather than equal) per capita allocation across counties. Some counties are
expected to have greater needs (per resident) and therefore should receive
a greater per capita allocation, while other counties are expected to have
lower needs (or greater revenue capacity) and therefore should receive a
smaller per capita allocation.
During the first five years of devolution in Kenya, an important consid-
eration driving the horizontal allocation was the historical disadvantage of
some areas as noted above. Accordingly, the horizontal allocation formula
distributes considerably greater resources to these undeveloped and less
(densely) populated counties due to the effects of the ‘equal share’, land
area, and poverty factors. Whereas the 2017/18 distribution of the equi-
table share resulted in an average per capita allocation of KShs. 10,199,
county allocations range from KShs. 34,973 per capita (Lamu County) to
KShs. 5,033 per capita (Nairobi City County).

Assessment of the Equitable Share

An assessment of the role of Kenya’s equitable share ought to note a

number of positive features as well as some areas of concern. On the posi-
tive side, equitable sharing has provided county governments with a mean-
ingful level of unconditional financial resources that has allowed county
governments to establish themselves as a significant sphere of governance
and service delivery in the public sector. By and large, the institutional
mechanisms surrounding equitable sharing have ensured that these funds
are distributed in an objective, formula-based, predictable, equitable (as
defined by the government) and transparent manner.
The constitution has placed the stewardship of the equitable sharing
under the CRA, which analyses county-level expenditure needs and spend-
ing patterns and annually recommends vertical sharing arrangements – as
well as develops periodic recommendations on the revision of the hori-
zontal allocation formula – in order to ensure the efficient and equitable
distribution of national revenues.
The main areas of concern and possible reform with respect to the
equitable sharing mechanism include:

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 310 Intergovernmental transfers in federations

a. 
Given its importance in county finances, the vertical allocation of the
equitable share does not appear adequate to fund county functional
mandates. While the equitable share (as highlighted in Table 15.1)
might be more or less sufficient to finance the recurrent costs of
service delivery, these resources are inadequate to simultaneously
fund recurrent costs and to fill the infrastructure gap in previously
disadvantaged (and even other) county governments.
b. 
The horizontal allocation formula only provides a weak link between
the distribution of revenues among counties (finances) and the pattern
of expenditure needs (based on county functions).
While the horizontal allocation formula aims to be redistributive to
c. 
historically disadvantaged counties, it may underfund the produc-
tive areas of the country and send resources to counties that do not
have the capacity to effectively absorb them. It is unclear whether
the current allocation formula strikes an adequate balance between
redistribution and growth.
While the CRA provides recommendations on the vertical and hori-
d. 
zontal allocation of resources (thus providing a space for evidence-
based advice), the ultimate decision on equitable sharing – by
Parliament – seems to be made on basic political considerations.

A final concern with equitable sharing concerns the balance between

unconditional and conditional grants. Given the relative weaknesses of
many county institutions and intergovernmental relations, the current
approach may be considered excessively unconditional. The provision of a
large unconditional grant achieved its initial political objectives, but with-
out strong vertical, horizontal and downward accountability mechanisms,
the largely unconditional grant scheme may be ineffective at promoting
improved county service delivery.

15.5 CONDITIONAL TRANSFERS

Although conditional transfers were provided for in the constitution,

the initial focus in implementing the new system was almost exclusively
on the unconditional equitable sharing of revenue. This was in large
part due to the political dynamics that motivated Kenya’s transition
to a more decentralized state as outlined above – reducing central
state power and addressing historical inequities. As counties’ sustain-
able ­political ­relevance seems increasingly assured and some concerns
have been raised with their failure to allocate enough resources to cer-
tain key services, more attention has recently been given to conditional

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 Intergovernmental fiscal transfers in Kenya ­311

transfers, with both some positive steps and some areas of concern
evident.

Constitutional, Legal and Policy Context of Conditional Grants

Article 202(20) allows county governments to be given additional alloca-

tions (beyond the 15 per cent minimum) from the national government’s
share of revenue, either conditionally or unconditionally. The broad
responsibility of the CRA to make recommendations to Parliament on
matters concerning the financing of county governments includes condi-
tional grants.
As such, in its first recommendations to Parliament in 2012, the CRA
dealt not only with the distribution of equitable share, but also with the
role of conditional grants (CRA 2012). Despite effectively deciding to fund
all county mandates from the unconditional equitable share, in formulating
the design of the Kenyan transfer system, the CRA (2012: 39–40) acknowl-
edged five broad economic arguments for conditional grants, including:

a. To ensure common minimum standards across subnational govern-

ments and enable poorer areas to provide an acceptable level of
service for the attainment of national equity objectives.
b. To compensate for interjurisdictional spillovers, where one county
provides a service that people from other counties can benefit from. If
those who benefit do not contribute to the cost of providing it, coun-
ties may under-provide and focus benefits only on their constituents.
c. To create macroeconomic stability in depressed regions.
d. To influence local priorities in areas of high national interest but low
local priority and provide flexibility of national government in carry-
ing out targeted functions.
e. To address special issues, such as, gender, age and disability.

In 2016, the National Treasury issued guidelines for managing intergov-

ernmental fiscal transfers. These guidelines define conditional transfers
as those with the primary objective of providing incentives for county
governments to carry out specific programmes or activities or to support
a particular sector central to specific national policy objectives. They also
broadly specify a range of conditions which may be imposed, including
one or a combination of the following:

a. Input-based conditions, which must specify the type of expenditure

that can be financed. These may be capital expenditures, operating
expenditures or both.

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 312 Intergovernmental transfers in federations

b. Output-based conditions, which require the attainment of certain

results in service delivery.
c. Grant matching requirements, which may incorporate a provision
that requires county governments to finance a specified percentage of
expenditures using their own resources.

The Evolution of Conditional Grants in Practice

A range of different conditional grants is currently being provided by

the national government to county governments. The conditional grants
contained in the County Allocation of Revenue Act, 2017 are summarized
in Table 15.3.
In the absence of a well-defined policy framework and detailed criteria
(beyond the relevant 2016 guidelines) it appears that conditional transfers
in Kenya have emerged in a more or less ad hoc manner from sectoral and/
or political requests, rather than based on any strategy or technical acumen.
In fact, many of the current conditional grants are simply a c­ arry-forward

Table 15.3 Conditional grant allocations, FY 2017/18

KSh. Billion % of Total

National Government Conditional Grants
Leasing of Medical Equipment 4.5 10.3
Level 5 Hospitals 4.2 9.6
Road Maintenance Fuel Levy Fund 11.1 25.3
Compensation for User Fee Foregone 0.9 2.1
Development of Youth Polytechnics 2.0 4.6
Construction of County HQs 0.6 1.4
Development Partner Grants
World Bank Supplemental Financing of County 0.9 2.1
Health Facilities,
World Bank Kenya Devolution Support Programme 2.2 5.0
World Bank Transforming Health System for 2.8 6.4
Universal Care
World Bank National Agricultural and Rural 1.1 2.5
Inclusive Growth
DANIDA Universal Healthcare Grants 0.8 1.8
European Union (EU) Grants 1.0 2.3
KSDP ‘Level 2’ Grants 4.0 9.1
Other Loans and Grants 7.8 17.8
Total Conditional Grant Allocations 43.9 100.0

Source: OCOB (2018a).

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 Intergovernmental fiscal transfers in Kenya ­313

of sectoral programmes initiated prior to the new constitution, or specific

earmarked programmes funded by donors.
Although the 2016 guidelines provide some context for the adoption of
new conditional grants, they were not an attempt to reform the existing
system, or to impose binding policy constraints on new sectoral/­conditional
grants. As such, the adoption of conditional grants may remain idiosyn-
cratic and risks becoming supply driven and highly fragmented. The CRA
recognizes that a more systematic approach would optimize the benefits
from such grants (CRA 2017: 10).

Assessment of Conditional Grants

There has been little attempt to document the effects of conditional grants
in Kenya, including any impact that they have had on service delivery and
infrastructure development. In order to properly assess the effectiveness
of the system, it is important to answer a more fundamental question:
what are conditional grants supposed to fund vis-à-vis activities from
the equitable share and own source revenues? This question cannot be
meaningfully answered without clearer guidance on the functions (and/or
level of services) counties are expected to fund from their equitable share.
After all, most constitutional mandates of county governments are actu-
ally concurrent responsibilities, so counties would be expected to spend a
considerable share of their unconditional resources on concurrent service
functions, even if the central government does not provide conditional
grants.
That being said, it should be noted that many – if not all – current con-
ditional grants are targeted at county-level functions for which the national
government has a legitimate interest in ensuring adequate service provi-
sion. The current list, however, seems somewhat arbitrary, raising concerns
as to whether the conditional grant system achieves (or even has) intended
policy objectives. At present, it seems that conditional transfers may be
used excessively in some sectors and not enough in others: for instance, the
health sector relies extensively on conditional grants to encourage better
health services, while other key sectors, such as agriculture or water and
sanitation, do not use them.
Another expressed concern is the legitimacy of using conditional grants
at all. County governors have argued that functions that fall within their
mandate should be funded through unconditional equitable sharing, rather
than through conditional grants. Given that many of the powers and func-
tions assigned to county government are concurrent in nature, however,
the national government does have a valid policy interest in targeted
funding towards specific sectors and functions. Indeed, a cursory review

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 314 Intergovernmental transfers in federations

of the conditions imposed by the different conditional grant schemes

generally appear to be appropriate in balancing the policy objectives of the
national government, on one hand, and the ability of county governments
to effectively perform their constitutionally mandated functions, on the
other hand.
At same time, county governments have reason to be concerned about
the increasing number of conditional grants being introduced within the
various sectors. The excessive fragmentation of such grants within the
same sector (e.g. health) results not only in decreased spending discretion
on the part of county officials, but also increases their administration and
compliance costs. In order to prevent unnecessary fragmentation, it would
be prudent for the CRA, in collaboration with sectoral stakeholders in
each key sector – including health, agriculture, water, urban development
and (pre-primary and vocational) education – to develop conditional grant
position papers that help to ensure coordination, integration and rationali-
zation of the conditional grant schemes within each sector.

15.6 PROSPECTS FOR THE FUTURE

Five years into the devolution process under the 2010 constitution, there
is a sense that Kenya’s path towards devolution has in some ways been a
‘political’ success. The basic elements of the county government systems
have been defined and are being implemented. The focal element of
this chapter, the intergovernmental fiscal transfer system, is firmly in
place, providing a reasonably sound framework for intergovernmental
funding and ensuring a degree of vertical balance in the division of
power and resources between the national government and county
governments.
The extent to which devolution has led to improved service-delivery
and governance outcomes, however, is far less self-evident. An important
challenge in converting fiscal devolution into improved outcomes is to
ensure the development and use of an appropriate intergovernmental fiscal
framework. The CRA – together with other stakeholders – is seeking to
address this challenge in a number of ways:

a. Better linking finances to functions and improving the horizontal

distribution of equitable sharing resources;
b. Continuing to address the vertical fiscal imbalance;
c. Strengthening the conditional grant system;
d. Ensuring adequate financing of urban development; and
e. Revisiting the role of own source revenues and borrowing.

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 Intergovernmental fiscal transfers in Kenya ­315

In addition, there is a need to strengthen the broader intergovernmental

institutional framework and provide for mechanisms for regional or inter-
jurisdictional cooperation. Each of these key issues is briefly discussed in
turn.

Better Linking Finances to Functions and Improving the Horizontal

Distribution of Equitable Sharing

At the time writing this chapter, the Commission of Revenue Allocation

is preparing for a ‘Third Basis’ for equitable sharing, which is supposed
to cover the five-year period from FY 2019/20–FY 2023/24 (CRA 2018).
The Commission has identified the lack of a conceptual foundation of the
horizontal allocation under the first and second bases as one of the most
significant weakness of the horizontal distribution of financial resources.
To address this problem, the CRA is developing proposals to create a
stronger link between the horizontal distribution of the equitable share
and the main policy objectives for which these resources are provided
to the county level, including county service delivery; the promotion of
balanced development; the encouragement of county revenue collection;
and the promotion of fiscal prudence at the county level. This may lead
Kenya’s equitable sharing formula to evolve in a similar direction to South
Africa’s provincial equitable shares formula, which divides the funding
pool (for indicative purposes) into a number of functional components.
Stopping short of shifting the grant system to a stronger reliance on
conditional grants, a more ‘functional’ approach to equitable revenue
sharing would provide an opportunity for the national government to
have a discussion with county governments on one of the main financing
challenges at the county level: counties do not appear to plan or prioritize
their spending in a results-based manner. For instance, county leaders may
prefer to allocate greater resources for highly visible infrastructure projects,
such as roads, rather than fund the recurrent cost associated with pro-poor
county services, such as health services or agricultural extension services.
Similarly, in the health sector, there is a concern that while the equitable
share and conditional grants may reach the counties, funding often does
not reach the facility level where services are delivered. Unless county ser-
vices start improving gradually over the coming years, the popular support
for devolution noted above is likely to falter.

Addressing the Vertical Fiscal Imbalance

Ensuring that the Third Basis adheres to the mantra that ‘finance should
follow function’ also highlights an emerging vertical fiscal imbalance – if

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 316 Intergovernmental transfers in federations

the equitable share resources were divided among the various functional
mandates assigned to the county level as part of the allocation formula, it
would become increasingly clear that the current vertical share allocated
to the county level is not adequate to fund the services the counties are
expected to provide.
Although determining the vertical fiscal balance is ultimately a national
political decision, the CRA is positioning itself to make an evidence-
based argument that there is need to increase the share of nationally
raised revenues that is transferred to the county level, particularly if
this increase can be linked more effectively to expected improvements in
county services.

Strengthening the Conditional Grant System

As already noted above, if the CRA opts to move the Third Basis of
equitable sharing in the direction of a function-based allocation formula, it
would be appropriate for relevant stakeholders – the CRA and the relevant
sectoral ministries – to determine an affordable, realistic level of public
services that each county should be able to attain with the equitable share
resources provided to it. Beyond helping guide the vertical allocation of
resources between the national and county levels, this analysis would also
provide an important point of departure for determining which services
could be productively funded from conditional grants.
Although Kenya started with a largely unconditional transfer system,
it may be appropriate to use conditional transfers more significantly and
strategically, including more use of performance-based transfers, which
development partners are already experimenting with. A number of coun-
tries, such as Indonesia, South Africa and Uganda, moved towards greater
conditionality over time. This approach, however, can have both positive
and negative effects, so it is important to conduct the analyses necessary to
use conditional transfers constructively if they are to be a more important
fiscal instrument in Kenya.

Establishing Urban Bodies and Ensuring Adequate Urban Finances

One of the ‘victims’ of the 2010 constitution was at the local government
level, as urban local governments – which had existed since before inde-
pendence and some of which played a valuable role in local governance
and service delivery – were abolished in favour of the new county govern-
ments. Prior to 2017, few counties had moved to establish urban boards
provided for in the legal framework, and local political economy pressures
kept many governors from encouraging urban development (Boex et al.

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 Intergovernmental fiscal transfers in Kenya ­317

2017). This is a potentially significant consideration because urbanization

is high in Kenya and is seen as the foundation for economic growth. Under
the pre-2010 system, independent urban governments kept the revenues
they generated. Now that these revenues go to the county governments,
there are concerns that, at least in some counties, revenues collected in the
urban areas that could be providing valuable urban services and promoting
urban development will instead be used to buy rural votes. More evidence
is needed on this front.
With this concern in mind, the Kenya Urban Support Program (KUSP)
is supporting implementation of the National Urban Development Policy
(NUDP). The main component of KUSP is a performance-based urban
development grant (in the amount of US$300 million) to municipal areas
– through their respective county governments – in counties that have
legally established municipal bodies and appointed municipal boards in
line with the Urban Areas and Cities Act. If the value of such an initiative
can be proven, there may be renewed interest in reinvigorating urban
government.

Revisiting the Role of Own Source Revenues and Borrowing

In addition to the strengthening of the intergovernmental transfer system,

the role of own source revenues and borrowing should not be ignored. As
noted earlier, the county government own source revenues are largely the
revenues that were assigned to the pre-2010 local governments. That was
not an impressive set of sources to begin with, and there was clearly sub-
stantial under-collection in many areas. Despite claims and evidence that
there is considerable untapped own source revenue potential in many local
jurisdictions (as under the former system), use of own source revenue has
for the most part not been a focal policy of county governments to date.
Given that own source revenue can be critical not only for financing local
service delivery, but also for enhancing the efficiency and accountability
with which county resources are spent, this is clearly a priority area for
considering future reforms and incentives.
Thus far, there has not been much attention to county government bor-
rowing, a potentially critical component of subnational finance in a rapidly
urbanizing country with substantial infrastructure gaps. County govern-
ments are obligated to spend a share of equitable sharing resources on
development, but that is not likely to be sufficient to meet the needs. Local
governments under the previous system used to borrow for infrastructure
development, largely through the now defunct Local Government Loans
Authority. Under the present system, there has been no significant
movement on the borrowing front. Country governments are allowed

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 318 Intergovernmental transfers in federations

to borrow under the 2010 constitution, but they need central govern-
ment permission and guarantees, a provision that can create problematic
behaviour. Working on how to offer county governments options to secure
and responsibly manage development finance in the future is an essential
consideration in developing the evolving intergovernmental fiscal system.

Strengthening the Intergovernmental Institutional Framework and

Mechanisms for Regional or Interjurisdictional Cooperation

It is important to re-emphasize that the intergovernmental fiscal system

is only part of the formula that makes up a successful devolved system.
As Kenya moves down the path of greater devolution in the context of
the quasi-federal 2010 constitution, the effectiveness of intergovernmental
relations is also a key concern. Attention will have to be paid to ensuring
that an institutional framework is in place to ensure adequate intergovern-
mental coordination, at national level (among national-level stakeholders),
vertically (between national and sectoral stakeholders), as well as at county
level (between different counties and groups of counties that may benefit
from interjurisdictional or regional cooperation that used to be managed
by the former deconcentrated provincial administration). Such changes
take time to design and implement, and measures will be required to ensure
that policies are informed from experience and that successful reforms can
be mainstreamed, sustained and improved as needed.

15.7 CONCLUDING THOUGHTS

Kenya has experienced disagreements about how to structure its intergov-

ernmental system since independence negotiations. The persistent lack of
consensus on this front and the ethnic and political power issues in which it
is grounded (and which unleashed the post-2007 election violence) shaped
the path to the 2010 constitution as well as recent actions and ongoing
debates over public sector reform. However, uncertainty remains about
how the nascent devolution will unfold.
One point, however, is certain – the reformists, who clearly wanted to
leave behind the disappointing performance of the unduly centralized pre-
2010 government system, have prevailed. The devolution enshrined in the
2010 constitution bypasses the provincial administration (long associated
with an elite, rent-seeking, top-down system) and the marginalization of
the previous local governments (popularly perceived as unaccountable
and ineffective). Few countries have swept away a fragmented set of public
sector institutions in the way that Kenya has, and the devolution of powers

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 Intergovernmental fiscal transfers in Kenya ­319

and functions to the new county entities has been substantial and dra-
matic. Mistakes have been made by most accounts, but Kenya’s devolution
has been bold and transformative.
The intergovernmental transfer system, which is substantial and pri-
marily unconditional, has been a cornerstone of the devolution. This
chapter has outlined key positive features and major challenges of the
transfer system, as well as some of the ongoing debates and possible
options for improving the system and other interrelated elements of fiscal
decentralization. More work needs to be done on the technical side and is
already in process. At the same time, the political economy dynamics that
have shaped Kenya’s history as an independent country are not going to
go away. They will continue to evolve and influence the debates over the
nature, mix and allocation of equitable revenue sharing.

NOTES

1. See Hicks (1961), Mueller (1984), Smoke (1993, 1994, 2003, 2008), Steffensen et al.
(2004), Branch and Cheeseman (2006), Government of Kenya Task Force on Devolved
Government (2011), Smoke and Whimp (2011) and World Bank (2012) for details on
the evolution of Kenya’s public sector and local government system.
2. This section is largely drawn from background readings provided in the previous note.
3. The most important intergovernmental policy on this front was District Focus for Rural
Development (DFRD), which significantly strengthened the deconcentrated provincial
and district administration under the Office of the President and further undermined
the relationship between local governments and their constituents.
4. See Cohen and Peterson (1999), Republic of Kenya (2005) and Romeo and Smoke (2016).
5. See Smoke (2003) and Steffensen et al. (2004) for a summary of evolving conditions and
Kenyan reforms in the late 1990s and early 2000s and the KLGRP.
6. Devas and Kelly (2001) provide details on business licensing harmonization reform.
7. Local Authority Transfer Fund Law, Government of Kenya, Law No. 8 of 1998.
8. For discussions of civil society in Kenya, see Orvis (2003), Nyamu-Musembi and
Musyoki (2004), World Bank (2012) and Munene and Thakhathi (2017).
9. Constituency Development Fund Act, Government of Kenya Law No. 10 of 2003.
10. For example, a percentage of funding for rural roads earmarked through the Road
Maintenance Levy Fund was allocated by constituency. Funding under an economic
stimulus package responding to the 2008 global economic crisis was also allocated by
constituency.
11. See Kramon and Posner (2011), Barkan (2016), Cornell and D’Arcy (2016).
12. See, for example, Cheeseman (2016).
13. The exchange rate currently fluctuates around KShs. 100 per US dollar.
14. Schedule 4 of the constitution also assigns county governments the responsibility for
trade development and regulation, which has been interpreted as providing a constitu-
tional basis for Single Business Permit collection to transition from local authorities to
county governments (World Bank 2012: 76).
15. Kenya’s constitution also introduced an Equalization Fund to provide basic services to
marginalized areas. This Fund receives 0.5 per cent of all national revenue. However,
rather than being transferred to marginalized county governments, the constitution
determines that spending from this Fund is directed by the national government (with
the option to disburse resources in the form of conditional grants).

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 320 Intergovernmental transfers in federations

16. The lower bound was a compromise between those who did not want to specify any
minimum and those who wanted to have a much higher minimum. The positive effect of
this lower bound is to ensure that national government would be unable to hollow out
the constitutional mandate of county governments by underfunding them to the point
that they would no longer be a meaningful political and institutional actor.
17. In dividing responsibilities between the CRA, National Treasury and the Senate, the
process seeks to ensure that the national government honours its constitutional obliga-
tions with regard to the vertical sharing of revenues.
18. See, for example, Khaunya et al. (2015), Cornell and D’Arcy (2016), D’Arcy and Cornell
(2016), Cannon and Ali (2018).
19. This analysis of Kenyan transfers in this chapter draws on Boex and Smoke (2018a and
2018b).

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African Studies Review, 59 (3): 155–67.
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Urban Finances and Urban Development in Kenya, Washington/Nairobi: The
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Revenues among County Governments in Kenya’, discussion paper prepared for
the Commission on Revenue Allocation, August 2018.
Boex, J. and P. Smoke (2018b), ‘Conditional versus Unconditional Grants: Theory,
International Experiences and Lessons for Kenya’, discussion paper prepared for
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Branch, D. and N. Cheeseman (2006), ‘The Politics of Control in Kenya:
Understanding the Bureaucratic-executive State, 1952–78’, Review of African
Political Economy, 33 (1): 11–31.
Cannon, B. and J. Ali (2018), ‘Devolution in Kenya Four Years On: A Review
of Implementation and Effects in Mandera County’, African Conflict and
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Cheeseman, N. (2016), ‘Decentralization in Kenya: The Governance of Governors’,
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Cohen, J. and S. Peterson (1999), Administrative Decentralization in Developing
Countries, Boulder, CO: Lynne Reinner.
Commission on Revenue Allocation (CRA) (2012), ‘Recommendations on Sharing
of Revenue Raised Nationally between the National and County Governments
for the Fiscal Year 2012/2013 and among County Governments for the Fiscal
Years 2012/13 – 2014/15’. 8 August 2012.
Commission on Revenue Allocation (CRA) (2017), ‘Recommendation on the Basis
for Equitable Sharing of Revenue between National and County Governments
for the Financial Year 2018/2019’. 18 December 2017.
Commission on Revenue Allocation (CRA) (2018), ‘The Third Basis for Sharing
Revenue among County Governments’, Consultation Draft.
Cornell, A. and M. D’Arcy (2016), Devolution, Democracy and Development in
Kenya, Visby: Swedish International Center for Local Democracy.
D’Arcy, M. and A. Cornell (2016), ‘Devolution and Corruption in Kenya:
Everyone’s Turn to Eat?’, African Affairs, 115 (459): 246–73.

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Devas, N. and R. Kelly (2001), ‘Regulation or Revenues: Analysis of Local

Business Licenses, with a Case Study of the Single Business Permit in Kenya’,
Public Administration and Development, 21 (5): 381–91.
Government of Kenya (2005), Guidelines for the Preparation, Implementation and
Monitoring of Local Authority Service Delivery Action Plans, Nairobi: MOLG.
Government of Kenya (2011), Final Report of the Task Force on Devolved
Government, Nairobi: Office of the Deputy Prime Minister and Ministry of
Local Government.
Hicks, U. (1961), Development from Below: Local Government and Finance in
Developing Countries of the Commonwealth, Oxford: Oxford University Press.
IPSOS (2016), ‘SPEC Barometer: 1st Quarter Survey’. Mimeo. 6 September 2016.
Khaunya, M., B. Wawire and V. Chepng’eno (2015), ‘Devolved Governance in
Kenya: Is it a False Start in Democratic Decentralization for Development?’,
International Journal of Economics, Finance and Management, 4 (1): 27–37.
Kramon, E. and D. Posner (2011), ‘Kenya’s New Constitution’, Journal of
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Mueller, S. (1984), ‘Government and Opposition in Kenya, 1966–9’, The Journal of
Modern African Studies, 22 (3): 399–427.
Munene, J. and D. Thakhathi (2017), ‘An Analysis of Capacities of Civil Society
Organizations Involved in the Promotion of Community Participation in
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Nyamu-Musembi, C. and S. Musyoki (2004), ‘Kenya Civil Society: Perspectives
on Rights-Based Approaches to Development and Participation’. IDS Working
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Budget Implementation Review Report for FY 2017/18’. September 2018.
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Budget Implementation Review Report for FY 2017/18’. September 2018.
Orvis, S. (2003), ‘Kenyan Civil Society: Bridging the Rural-Urban Divide’, Journal
of Modern African Studies, 41 (2): 247–68.
Romeo, L. and P. Smoke (2016), ‘The Political Economy of Local Infrastructure
Planning in Developing Countries’, in Jonas Frank and Jorge Martinez-Vazquez
(eds), Decentralization and Infrastructure in the Global Economy: From Gaps to
Solutions, Oxford: Routledge, Chapter 13.
Smoke, P. (1993), ‘Local Government Fiscal Reform in Developing Countries:
Lessons from Kenya’, World Development, 21 (6): 901–23.
Smoke, P. (1994), Local Government Finance in Developing Countries: The Case of
Kenya, Oxford and Nairobi: Oxford University Press.
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D. Olowu (eds), Local Governance in Africa: The Challenge of Decentralization,
Boulder, CO: Lynne Reinner, pp. 212–35.
Smoke, P. (2008), ‘The Evolution of Subnational Development Planning under
Decentralization Reforms in Kenya and Uganda’, in V. Beard, F. Miraftab and
C. Silver (eds), Planning and Decentralization: Contested Spaces for Public Action
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Smoke, P. and K. Whimp (2011), ‘The Evolution of Fiscal Decentralization
under Kenya’s New Constitution: Opportunities and Challenges’, National Tax
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Steffensen, J., H. Naitore and P. Tidemand (2004), A Comparative Analysis of

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Decentralization in Kenya, Tanzania and Uganda, Report by Nordic Consulting

Group for the World Bank. Oslo: Nordic Consulting Group.
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Kenya, Nairobi: Australian AID/World Bank.

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 16. Reforming vertical programmes:
the case of South African local
government
David Savage

1. INTRODUCTION

Many intergovernmental fiscal systems, particularly in developing coun-

tries, experience the mutually reinforcing pressures to horizontally frag-
ment funding schemes and vertically centralize expenditure authority.
These pressures are often underpinned by demands to rapidly address
urgent development priorities, particularly to provide basic services, often
in an environment of weak public sector capacity.
This chapter reviews the trajectory of intergovernmental fiscal reforms
in South Africa from 1994 to the present, with a particular focus on local
government. It characterizes the main periods of reform in South Africa,
identifies cross-cutting debates and issues, and draws out key lessons from
the South African experience for other countries.
The South African experience provides a useful comparator for other
countries, due both to relatively limited time since its introduction and
subsequent periods of reform, as well as the relative coherence of efforts
to reform the overall system of public financial management. Importantly,
the South African system represents a relatively more mature and coherent
fiscal framework for the local government tier.
The South African case is, however, like most other countries, deeply
influenced by the context in which reforms have been introduced and the
effectiveness with which they have been designed and implemented. In
both its brevity and nature, this review does not seek to provide a compre-
hensive description or analysis of the South African experience, but rather
to highlight key priorities, concerns and issues that informed and continue
to shape the ongoing evolution of the intergovernmental fiscal system in
South Africa.
Comparative analysis of this nature is a useful exercise to the extent that
it reveals similarities and contrasts between contexts, facilitating domestic

323

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 324 Intergovernmental transfers in federations

policy dialogue. It allows policymakers to build on the wisdom and errors

of other approaches, rather than providing standardized solutions. The key
questions this chapter seeks to contribute to include: (a) how have other
countries shifted from specific-purpose grants to unconditional transfers?;
(b) how have transfer systems been designed to align subnational spending
with national policy priorities while accommodating locally defined prefer-
ences?; and (c) what arrangements are in place to address fiduciary, value
for money and accountability concerns?

2. BACKGROUND

a) Country Context

No two countries are alike, and South Africa differs from others in many
respects. South Africa has a population of 55.7 million people (2016), with
Gauteng (the largest province) having a population of 13.4 million in 2016.
The South African population is young and urbanizing, with an economy
that is not growing fast enough to keep pace with the demands of demo-
graphic and economic change. South Africa is, however, a significantly
urbanized country with a relatively slow urbanization rate in comparison
to many other developing countries.

b) Intergovernmental Functional Assignments

South Africa is a unitary state with federal characteristics. The Constitution

establishes three interdependent and interrelated ‘spheres’ of government
at national, provincial and local levels, which are intended to work together
in a cooperative manner. This arrangement provides for functional assign-
ments between spheres, but also a significant degree of concurrency in
functions. In general, the nine provincial governments are assigned health,
education and social welfare functions, while local governments are
assigned basic local service delivery functions such as water services, elec-
tricity distribution, roads and transport and refuse removal. Importantly,
local government is also assigned spatial planning functions.
In general, therefore, provincial governments perform labour intensive
functions that are largely funded through transfers from nationally
collected taxes, while local governments focus on capital-intensive func-
tions that can – at least in part – be funded through user charges or
property taxation. The relatively greater discretion this provides to local
government has led the South African intergovernmental framework to
be characterized as an ‘hour-glass federalism’, with national and local

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 Reforming vertical programmes: South African local government ­325

governments having considerably greater powers and autonomy than

provincial governments,
However, the South African Constitution also provides for significant
concurrency in functions. These are particularly important in relation to:

●● The management of the urban built environment, where provinces

and municipalities are both involved in public housing and transport
services;
●● The provision of bulk services, where national government entities
and municipalities are both involved in aspects of energy generation
and water resource management (such as dams); and
●● The performance of some social services, where provinces and
municipalities both deliver primary healthcare and early childhood
development services.

In some instances, a reassessment of concurrency has led to a reassignment

of functions. This has been the case in social protection services, where
grants are now administered through a single national agency, and in
spatial planning, which has been assigned via a judicial process to the local
sphere. However, despite a constitutional commitment to the principle
of subsidiarity, and extensive regulation of the process of functional
and fiscal transfers, these shifts have tended to be the exception rather
than the norm. Concurrency thus remains a key point of friction in the
system of intergovernmental relations. This is typically managed through
an elaborate and extensive system of coordination at both political and
administrative levels.

c) The Intergovernmental Fiscal Framework

The South African intergovernmental fiscal framework attempts to resolve

these frictions through a regulated system of revenue assignments and
transfers. The Constitution assigns revenue powers to local governments
for property taxes and user charges, as well as providing for long-term bor-
rowing by municipalities to fund infrastructure investment. Similar powers
are not granted to provinces, which are largely dependent on transfers
from national government. The Constitution guarantees both subnational
spheres an ‘equitable share of nationally raised revenues’ to address the
mismatch between revenue and expenditure assignments. Significantly,
however, the Constitution:

●● Prevents functional reassignments from occurring without concomi-

tant resources;

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 326 Intergovernmental transfers in federations

●● Does not require national government to compensate for a lack of

own revenue effort by subnational governments; and
●● Allows for the direct transfer of national resources to local govern-
ments, rather than via provinces.

For local governments, who have significant own revenue authority,

the fiscal framework is then regulated by both overarching legislations
governing the assignment local revenue sources (the Municipal Fiscal
Powers and Functions Act, the Municipal Property Rates Act, and the
Municipal Systems Act) and borrowing powers (the Municipal Financial
Management Act). Special attention is given to the regulation of the
borrowing powers of municipalities, given their largely capital-intensive
functions. Municipalities are only permitted to borrow for beyond a finan-
cial year in order to fund infrastructure investment (capital expenditure)
programmes, and their borrowing operations may not be guaranteed by
other spheres of government. The exercise of these powers is subject to
procedural regulation that requires extensive public disclosure.

Transfers to subnational government

Transfers to both spheres of subnational government are also regulated
through the annual national budget process. This is managed on a three-
year rolling cycle (the Medium-Term Expenditure Framework, or MTEF),
that enables parliamentary appropriations through both an annual national
Appropriations Act, and an annual Division of Revenue Act (DoRA).
Given the constitutional status of both provinces and local government,
the DoRA establishes the vertical division of revenue between spheres
of government and regulates the individual programmes that transfer
nationally raised revenues to subnational spheres as well as between
provincial and local governments. The schedules to the DoRA also provide
for three-year, rolling allocations from individual transfer programmes
to individual receiving governments. Funding for individual conditional
transfer programmes is appropriated to the transferring national depart-
ments in the national Appropriations Act.

The equitable share of nationally raised revenue The primary transfer

to subnational government is the unconditional, constitutional entitle-
ment known as the ‘equitable share’. This is distributed to provinces and
municipalities through the Provincial Equitable Share (PES) and the Local
Government Equitable Share (LGES), both of which are formula-based
allocations that are distributed without conditions.
The PES accounts for 81.5 per cent of transfers to provinces and alloca-
tion is through a weighted formula based on six variables (with indicators

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 Reforming vertical programmes: South African local government ­327

and weights provided in brackets): basic share (share of population, 16

per cent), education (school-aged population and enrolment, 48 per cent),
health (population without medical aid, health risk, and hospital and clinic
use, 27 per cent) poverty (share of poverty, 3 per cent), economic activity
(share of regional gross domestic product, 1 per cent) and institutional
(equal allocations to each province, 5 per cent).
The LGES is allocated through a formula to enable all municipalities to
provide basic services to poor households and assist those municipalities
with limited own resources to afford basic administrative and governance
capacity and perform core municipal functions. It is designed around a
threshold measuring the affordability of basic services to households that
provides R293 per month for a package of free basic services to those
households with an income of less than two old age public pensions per
month. This variable is complemented by institutional and community
services components to the formula that are targeted to poorer municipali-
ties for the costs of administration and community services respectively.
The formulae for both of these transfers have been fairly stable and
are published annually as part of the national budget documentation (see
Figure 16.1 for provincial and local government transfers for 2019/20).
They are updated annually with cost data to account for price increases
and estimates of household growth A new LGES formula was introduced
in 2013/14 following extensive consultation and is being phased in over five
years. This has a more redistributive structure than the previous formula,
while the phasing in provisions provide for a stable transition.
South Africa’s tax base is highly concentrated in urban areas. The
system of intergovernmental transfers is thus extensively distributive
towards more rural provinces and municipalities. For example, allocations
per household to rural municipalities are more than twice as much as those
to metropolitan municipalities.

Conditional grants The DoRA requires that any transfer of resources

between spheres of government happens in terms of the Act. It allows
conditional transfers for both operating and capital expenditures. It also
regulates non-cash (or in-kind) transfers in the case of assets that are
created on behalf of another sphere of government, or functions that are
performed on their behalf. The Act distinguishes between grants that are
specific-purpose transfers and those which provide supplementary alloca-
tions to the budgets of receiving authorities. It also requires that all grant
programmes publish a clear framework of rules for their allocation and
use, including their measurable objectives, conditions, disbursement sched-
ules, reporting requirements, records of past performance and criteria for
allocation.

YILMAZ_9781789900842_t.indd 327 16/12/2019 10:44

YILMAZ_9781789900842_t.indd 328
16 12

3.7 10
12 1.9 4.4
2.7 1.6
1.9 1.8 1.9 8
1.9 3.7
8 1.6
6
2.7
10.6 10.2 11.0
9.5 9.3 9.2

Rands thousands
4 8.8 2.4
7.0 7.7 4

Rands thousands
2.4 6.8
5.7
0 2 4.3
3.3

328
2.5

Gauteng
Limpopo
Metro Secondary Large Small Rural

Free State
North West
(8) cities towns towns municipalities

Mpumalanga

Eastern Cape
(19) (26) (99) (61)

Western Cape

KwaZulu-Natal
Northern Cape
Average equitable share per capita Average equitable share per household
Average conditional grant per capita Average conditional grant per household

Source: National Treasury (2019).

Figure 16.1 Provincial and local government transfers (2019/20)

16/12/2019 10:44
 Reforming vertical programmes: South African local government ­329

Although not mandatory, the majority of these programmes allocate

their resources through formulae, which vary depending on the grant
purpose.

The division of revenue process The process leading to the annual division
of revenue between spheres of government is procedurally elaborate. It is
initiated with recommendations from Parliament, those of the constitu-
tionally independent Financial and Fiscal Commission, and a ‘mandate
paper’ from the executive on developmental and fiscal priorities. An
extensive set of technical meetings between the National Treasury, national
sector departments, functional groupings of departments and intergovern-
mental technical committees results in technical budget proposals being
forwarded to a legislated political process of consultation. This includes
the Budget Council, consisting of the Minister of Finance and his or her
provincial counterparts, and the Budget Forum, consisting of the Budget
Council and representatives of local government. The recommendations
of these fora are forwarded to the Ministers Committee on the Budget
and then to an extended cabinet meeting, including Premiers of all nine
provinces.
This process produces a Medium-Term Budget Policy Statement in
October of each year that is subject to parliamentary hearings and recom-
mendations, adjustment and subsequently the tabling of the Medium-
Term Expenditure Framework (or main budget, including the Division
of Revenue Bill) in February of each year. It is important to note that the
division of revenue appropriations do not include own revenue raised by
subnational governments, which are significant for the local government
sphere. If these are included, local government accounts for about a
quarter of the total revenues raised by the three spheres of government.

Data underpinning allocations In terms of the Statistics Act, only offi-

cially published data may be used for the calculation of any allocations
made through the DoRA. This data is updated in decadal census, inter-
spersed with various other statistical surveys that vary in their utility for
allocative purposes. Concerns remain on the accuracy of census data, and
on the utility of inter-census data for allocative purposes at the subnational
(and particularly local) level. Various techniques have also been assessed in
efforts to improve the accuracy and relevance of measurement, for exam-
ple reviewing the relative accuracy of reported household income versus
imputed household expenditures as the basis for poverty measurement.
Notwithstanding these concerns – and the ongoing extensive debates in
the statistical community – the quality and coverage of data has generally
improved.

YILMAZ_9781789900842_t.indd 329 16/12/2019 10:44

 330 Intergovernmental transfers in federations

In introducing this information into the intergovernmental resource

allocation process, Government has sought to balance the competing needs
for objectivity and impartiality with that of fiscal stability. Put simply,
those subnational entities that stand to benefit from changes in underlying
data have an interest in the rapid adoption of changes (without necessarily
always having the expenditure programmes in place), while those that lose
out will often have existing expenditure commitments to wind down. The
approach adopted has been to introduce a stabilization factor into the for-
mulae that is activated during a period of change. This typically provides a
‘glide path’ to entities with declining allocations that will guarantee them a
percentage of their former allocation on a sliding scale

Monitoring transfers and the intergovernmental fiscal framework An exten-

sive system of in-year and annual monitoring has been developed to assist
with the oversight of the intergovernmental fiscal framework and indi-
vidual transfer programmes. All provinces and municipalities are required
to report monthly and quarterly on their revenues and expenditures, and
quarterly on non-financial performance. These reports are submitted to
both the relevant sector department and the National Treasury, which in
turn submits quarterly reports to Parliament. Annual reports and financial
statements are also prepared and audited by the Auditor General. Unspent
or misspent conditional grant funds do not automatically roll over to the
next financial year and can be recovered against future equitable share
transfers.

3. 
CONSTRUCTING THE LOCAL GOVERNMENT
FISCAL FRAMEWORK

Although little detailed data existed at the time, it was generally under-
stood that, at the dawn of democracy in 1994, South Africa faced massive,
racially based backlogs in access to basic services (see Figure 16.2 for
the historical evolution of the percentage of households with access to
basic services). This crisis was deepened by both a deep recession that
weakened public finances, as well as the racially based distribution of
available resources. Public policy priorities in this period were focussed
predominantly on efforts to universalize access to basic services across the
country, while simultaneously restructuring service delivery arrangements
– ­particularly at subnational level. Thus, basic services investment pro-
grammes were driven centrally by national sector departments (for water,
electricity, and so on), while deep institutional reforms were introduced in
local government in particular. This legislatively driven local government

YILMAZ_9781789900842_t.indd 330 16/12/2019 10:44

 Reforming vertical programmes: South African local government ­331

100

90

80

70

60

50

40 Water (piped) Electricity

Sanitation Refuse
30
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: Statistics South Africa (2017) and own calculations.

Figure 16.2 Percentage of households with access to basic levels of service

(1993–2016)

reform programme resulted in the establishment of large, wall-to-wall

municipalities (the Municipal Demarcation Act), the establishment of
standardized structures for municipal political oversight and functional
assignments (the Municipal Structures Act), the modernization of munici-
pal planning and administrative systems (the Municipal Systems Act) and
the fundamental reform of municipal budgeting financial management
practices (the Municipal Financial Management Act).
By 2003, a significant restructuring of both subnational government
and associated resource flows had occurred, and a (controversial) mac-
roeconomic adjustment programme had restored public fiscal health to
the point that subnational resource allocations were poised for significant
growth. Strengthened subnational capacity, as well as some experience
of the effectiveness of central and subnational service delivery systems,
resulted in a second round of reform efforts. At the local government level,
these focussed on deepening the devolution of functions to municipalities,
particularly for water services. Funding for local infrastructure delivery,
previously administered through asset transfers and/or a plethora of small
sectoral infrastructure grants was consolidated into a single, formula-
based Municipal Infrastructure Grant (MIG). Conversely, at the provincial
level it was agreed that social safety functions, such as the payment of
social grants, required consolidation and centralized management, which
was introduced in agreement with provincial governments through the
formation of the South African Social Security Agency.

YILMAZ_9781789900842_t.indd 331 16/12/2019 10:44

 332 Intergovernmental transfers in federations

By 2008, the stage was set for a significant growth in resources to

subnational governments. Importantly, much of this growth happened as
government was seeking to ramp up public investment in infrastructure
and prepare for the 2010 FIFA World Cup. The latter, for local govern-
ment in the host cities in particular, provided a significant inflexion point.
Unlike the resources that had been provided through the MIG in the past,
specific-purpose, project-based grants were introduced specifically to fund
World Cup stadia and associated Bus Rapid Transit Systems.
However, while attention was focussed on the significant delivery
challenges associated with hosting the World Cup, there was growing
concern that other investment programmes – such as the MIG – were
delivering declining returns. In particular, there was concern that there
had been significant central administrative clawback of the autonomy of
local governments in investment selection and execution that was granted
through the MIG, which had originated from a concern over delivery
capacity by the weakest municipalities. Additionally, there was growing
concern that larger urban municipalities were failing to invest adequately
in infrastructure renewal and extension, despite having largely succeeded in
meeting historical backlogs to basic services.
These concerns laid the foundation for increasing fiscal differentiation
among local governments. This sought to provide a more prescrip-
tive, sector-based framework for infrastructure investment in more rural
municipalities that were perceived to have weaker capacity. In large, more
urban municipalities (and particularly metropolitan municipalities) it
sought to provide significantly greater certainty over allocations and
reduced central administrative interference in investment selection and
execution, in order to promote more integrated, locally led development.
Importantly, these arguments for differentiation focussed largely on the
needs of larger and more urban municipalities and were accompanied by
associated efforts to effect functional and operational reforms. In more
rural municipalities a far less programmatic approach was evident, with the
change in approach being driven through the proliferation of sector-based,
specific-purpose grant programmes and a resurgence of in-kind (asset)
transfers to municipalities.
Most recently, from 2012 the National Treasury has led a broad process
to review the fiscal framework for municipal infrastructure investment,
focussing both on the role of grants and on opportunities to expand
the scope for sustainable and responsible borrowing by creditworthy
municipalities. A key finding of this review, beyond the ongoing need
for differentiation, has been the need to focus investment on supporting
infrastructure renewal and expansion as a central municipal contribution
to faster and more inclusive economic growth. For large and more urban

YILMAZ_9781789900842_t.indd 332 16/12/2019 10:44

 Reforming vertical programmes: South African local government ­333

municipalities, the emphasis has been on providing greater incentives

for improved performance in both the self-financing of infrastructure
(and thus a reduction in the proportion of investments financed through
grants), and in the developmental outcomes of these expenditures. While
the current national programme of fiscal consolidation has begun to
reduce the real value of transfers to urban municipalities, the alignment
and introduction of performance-based measures in grant programmes
for urban municipalities has supported a programme of intra-urban
­spatial targeting of public infrastructure investments designed to alter
the urban spatial form of South African cities, which is considered
to have a significant negative impact on long-term economic growth
prospects.

4. PHASES OF REFORM

The intergovernmental transfer system in South Africa has been subject

to ongoing reform and fine-tuning since the introduction of the new
Constitution in 1996 (see Figure 16.3 for the historical evolution). With
hindsight it is now possible to identify various phases of reform, as well as
to reflect on the various countervailing pressures that have constrained or
altered the impacts of reform initiatives over time.

a) Characterization of Phases of Reform

Establishment (consolidation and stabilization)

The first phase of intergovernmental fiscal reform in South Africa
was associated with the establishment of governance and fiscal systems
required by the new constitutional dispensation. The legacy of the
apartheid period had provided a deeply fragmented and highly centralized
system of governance that was mirrored in associated fiscal arrangements.
Subnational authorities were deeply fragmented on racial lines, and
national government transfers were both inequitably distributed between
racially defined subnational authorities and structured into a complex
series of specific-purpose operating and capital grants.
The 1996 Constitution introduced a comparatively clearer set of func-
tional and fiscal assignments between spheres of government, along with a
constitutional requirement for an unconditional ‘equitable share of nation-
ally raised revenue’ for both provinces and municipalities. The respective
equitable shares were initially funded from the consolidation of the major-
ity of existing specific-purpose operating transfers and inter-agency agree-
ments, and then progressively expanded, and were distributed by formulae.

YILMAZ_9781789900842_t.indd 333 16/12/2019 10:44

 45,000 Water Supply and Sanitation Capital Programme

2013 MTEF: Indirectgrants grow 2010 FIFA World Cup Stadiums Development Grant

YILMAZ_9781789900842_t.indd 334
and proliferation continues Integrated Sustainable Rural Development
40,000
Urban Transport Fund
Sport and Recreation Facilities
35,000 2011: USDG (for metros)
breaks off from MIG Local Economic Development Fund
Community Based Public Works Programme
30,000
Water Services Project
2007 to 2010: World Cup
grant anomaly but growth Consolidated Municipal Infrastructure Programme (CMIP)
25,000 elsewhere too
Rural Roads Asset Management Grant
Integrated Cities Development Grant
20,000
USDG Rural Households Infrastructure Grant (Direct transfer)
Rural Households Infrastructure Grant (Indirect transfer)
15,000 2004: Consolidation of

334
Neighbourhood Development Partnership Grant (NDPG)
local government grants
Integrated National Electrification Programme (INEP) –
municipalities
10,000
Municipal Water Infrastructure Grant (MWIG)
Integrated National Electrification Programme (INEP) –
5000

CMIP Regional Bulk Infrastructure Grant (RBIG)

0 Public Transport Infrastructure and Systems Grant (PTIG)
1 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Urban Settlements Development Grant (USDG)
/0 / / / / / / / / / / / / / / / /
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Municipal Infrastructure Grant (MIG)

Source: National Treasury (2014).

Figure 16.3 The historical evolution of infrastructure grants

16/12/2019 10:44
 Reforming vertical programmes: South African local government ­335

Various minor amendments were made to the formulae in this period, of

which three were most significant for the local government sphere. Firstly,
transition arrangements were introduced to progressively consolidate
remaining operating transfers into the mechanism, specifically in the case
of certain settlements in former homeland areas (known as R293 towns)
that were almost entirely funded by special purpose transfers and stood to
lose from the new formula. Secondly, a specific variable was introduced
to fund the cost of allowances for municipal councillors. Finally, in 1999
government sought to clarify that the equitable share should primarily be
used for the provision of free basic services to poor households.
The process for the consolidation of infrastructure grants to local gov-
ernment took a similar but somewhat longer route. In the initial period, a
range of sector-based specific-purpose transfers emerged to fund national
programmes that sought to address national backlogs in access to basic
services. These transfers were made both in cash and as asset transfers,
managed by respective central government departments. By 1998 it had
become clear that the proliferation of small transfer programmes was
largely ineffective. The system was criticized for having high transaction
costs (individual administrative and reporting requirements), being unre-
sponsive to local development priorities and development plans, making
inappropriate and expensive technology choices, and failing to address
the long-term operating costs of infrastructure investments. The National
Treasury proposed a consolidated MIG to address these issues, to be
managed cooperatively among departments, distributed by formula and
funded through the consolidation of existing programmes.
The MIG proposals were met with considerable resistance by national
departments, who stood to lose direct control of funding and infrastruc-
ture programmes. This resistance was ultimately overcome through a
two-track approach of:

a) Prolonged negotiations on the management approach to the new

programme, including an agreement to establish a jointly controlled
special purpose vehicle to manage the MIG.
b) The exclusion of the bulk of transfers for housing and public trans-
port, which were transferred through provincial governments due to
concurrency in the functional assignment.
c) A progressive tightening of the regulatory requirements in the DoRA
that governed existing programmes, specifically through requir-
ing the publication of rolling three-year allocations to individual
municipalities of all transfers and the written consent of receiving
municipalities for all asset transfers prior to the commencement of
construction.

YILMAZ_9781789900842_t.indd 335 16/12/2019 10:44

 336 Intergovernmental transfers in federations

The MIG was formally introduced in 2003, and quickly expanded

through additional allocations to become the largest single infrastructure
funding source for most municipalities.

Differentiation
The foundation for a greater recognition of the significant contextual vari-
ations between urban and rural local governments was introduced with the
reform of municipal financial management legislation that was introduced
in 2003. It had long been understood that there were marked variations in
the demographic trajectories, economies, service delivery requirements and
development pressures, institutional and fiscal capabilities and fiscal risks
associated with larger urban municipalities and their rural counterparts.
However, the initial reforms to the regulatory and fiscal framework largely
treated all municipalities alike (although the two-tier structure of district
and local municipalities was dispensed with in the largest metropolitan
areas).
The Municipal Financial Management Act (2003) built extensively
on new Public Management-style reforms to modernize public financial
management, but also introduced key elements of the capital financing
framework for municipalities. Importantly, this included an emphasis on
market-based borrowing for infrastructure investment by creditworthy
municipalities, without any central government guarantees. In order to
provide a framework to deal effectively with municipal fiscal distress that
might lead to debt default, a specific regime for interventions was also
introduced. The National Treasury also took direct responsibility for the
oversight of the largest municipalities that presented the greatest national
fiscal risks and opportunities, while delegating the remainder for oversight
by Provincial Treasuries.
As early as 2007, it became clear that the Department of Provincial
and Local Government would not administer the MIG in conformity
with the finally agreed proposals. In particular, it failed to establish a
special purpose vehicle for programme administration (relying instead on
a joint committee to oversee allocations) and introduced complex project
registration mechanisms before municipalities could proceed with project
implementation. While the latter was notionally intended to facilitate the
tracking of investments it had the effect of requiring central government
approval of individual investments. This led to growing concern from
larger, more urban municipalities that the MIG was constraining their
ability to respond to urbanization in a timely and integrated manner.
In response, the National Treasury commissioned research on the
efficacy of municipal infrastructure investment programmes which found
that:

YILMAZ_9781789900842_t.indd 336 16/12/2019 10:44

 Reforming vertical programmes: South African local government ­337

a) Considerable progress had been made in eliminating backlogs in

access to basic services, but that there remained severe underinvest-
ment in asset maintenance and renewal, as well as expansion of
infrastructure to accommodate economic growth and urbanization.
b) A one-size-fits-all approach to municipal financing was failing to
adequately differentiate between the funding requirements of urban
and rural settlement types and the fiscal and institutional capacity of
their associated municipalities.
c) Larger urban municipalities, in particular, were constrained in
responding to urban growth pressures through ongoing concurrency
in housing and public transport functions which complicated the inte-
grated management of the urban built environment. This functional
and fiscal fragmentation was evident in both poor planning align-
ment and investment outcomes, with patterns of urban development
continuing to reinforce the low-density, fragmented, exclusionary and
fiscally costly spatial form inherited from apartheid.
d) The financing of infrastructure was becoming progressively more
dependent on grants from central government, proportionately
squeezing out local sources of capital finance from local revenues and
municipal borrowing and threatening the long-term fiscal sustain-
ability of urban local governments.

South Africa won the bid to host the 2010 FIFA World Cup and
initiated a large-scale programme to build or refurbish football stadia and
associated public transport infrastructure in host cities across the country.
This programme was funded through two specific-purpose grants, for
stadia and public transport networks respectively. It was the latter, which
favoured the construction of Bus Rapid Transit Systems, that was to have a
more lasting effect on the fiscal system. Thus, countervailing pressures had
emerged to consolidate and decentralize funding to municipalities, while
simultaneously to expand specific-purpose transfers to support national
priority investments.
The initial fiscal response to this was to remove metropolitan municipali-
ties from the MIG programme to release them from the need for detailed
compliance with grant registration requirements. This initially took the
form of a new grant called the MIG-2. This was later converted into the
Urban Settlements Development Grant (USDG), with its administration
moved to the Department of Human Settlements, and the consolidation
of a portion of existing housing subsidies for metros into the grant.
The USDG was a significant advance over previous funding arrange-
ments, not only in the greater discretion granted to metros in investment
selection, but also in a much closer link to the investment planning process

YILMAZ_9781789900842_t.indd 337 16/12/2019 10:44

 338 Intergovernmental transfers in federations

that was introduced, through a requirement that they develop results-

oriented, integrated Built Environment Performance Plans (BEPPs) that
outlined their expenditure programmes across all sectors and sources of
finance, and eventually also included investments by other spheres of
government and public entities within their jurisdictions.

Towards performance
By 2012, the tensions in the fiscal system, particularly for large urban
municipalities, remained unresolved. One the one hand, the USDG had
consolidated and decentralized a significant portion of grant finance
for infrastructure investment, while funding for housing top structures
(housing subsidies) and public transport investment remained centralized,
project driven and fragmented. Moreover, there was growing evidence
that the growth of the municipal borrowing market was stagnating with
municipalities becoming increasingly reliant on grants as their primary
source of capital finance.
A review of infrastructure grant arrangements confirmed the original
basic principles of the intergovernmental fiscal framework, emphasizing
the need to respect constitutional mandates, provide stable and predict-
able financing, encourage transparency, simplicity and accountability,
integrated funding sources, differentiation between jurisdictions, and
be focussed on supporting inclusive growth and poverty reduction. The
National Treasury committed to a grant reform programme that would:

a) Improve grant structures, particularly through consolidation of grants

and differentiation between municipalities;
b) Emphasize the importance of asset management and maintenance;
c) Improve the overall management and efficiency of the grant system
and individual grant programmes, through clarifying roles for national
departments, and rationalizing reporting requirements to enable
measurement of actual performance.

While this process is ongoing and incremental, the current emphasis of

reform implementation has been on:

a) The development of an effective non-financial outcomes measure-

ment system for the built environment, which can form the basis
of both an outcomes-led planning system and the provision of
performance-based grants in the future. This has required extensive
technical investment and consultation;
b) The gradual reduction of project-based approvals associated with
certain grants, in favour of programmatic oversight (for instance, in

YILMAZ_9781789900842_t.indd 338 16/12/2019 10:44

 Reforming vertical programmes: South African local government ­339

the implementation of overall public transport strategies rather than a

specific bus route); and
c) The introduction of performance-based grants, or grant components,
based on specific eligibility requirements and objective performance
variables. This has taken the form of a small dedicated perfor-
mance grant (the Integrated City Development Grant) and a per-
formance component introduced into the Public Transport Network
Grant.

5. 
RESULTS OF REFORMS TO THE LOCAL
GOVERNMENT FISCAL FRAMEWORK

This characterization of the periods of reform to the intergovernmental

fiscal system in South Africa highlights the close connection between the
design of the transfer system and the nature of the development challenges
facing subnational authorities. At the introduction of the system, the
development focus was on universalizing access to basic services, while
simultaneously strengthening the governance systems that would sustain
the services delivered on the back of new infrastructure assets. The fiscal
system was thus designed to drive largely sectoral, project-based asset crea-
tion, often through asset transfers. This approach drove a rapid expansion
in access to basic services, but rapidly generated its own challenges. Unit
costs of connecting households to infrastructure networks rose as central
agencies pursued even larger regional investment programmes, with little
concern for long-term operating cost implications. Asset maintenance
suffered as municipalities often found the assets too technically complex to
operate and maintain, or were unwilling to take transfer of the assets due
to the absence of sustainable revenues. Prospects of repeated central invest-
ments to rehabilitate or replace failing infrastructure created perverse incen-
tives for municipalities to abandon preventive maintenance programmes,
or budget adequately for infrastructure depreciation. This led to growing
concerns with the sustainability of centrally driven investment programmes.
Following the establishment and stabilization of the local govern-
ment system, significant impetus developed to align the functional and
fiscal responsibility for infrastructure investment at the local govern-
ment level. As the national fiscal position stabilized providing scope for
additional grants to local government, and local government capacity
was improved, the transfer system was consolidated and decentralized,
particularly through the introduction of the MIG. However, this occurred
in an undifferentiated manner, accounting neither for variations in context
of capability across municipalities. Moreover, it provided no clear signals

YILMAZ_9781789900842_t.indd 339 16/12/2019 10:44

 340 Intergovernmental transfers in federations

to municipalities on national development priorities to follow after the

universalization of basic services access, nor adequate guidance on respon-
sibilities for asset maintenance and renewal.
However, despite efforts to differentiate the approach to intergovern-
mental transfers, many of these issues remained unresolved. This led to
a proliferation of new grant instruments, both to reintroduce centrally
driven, project-based investments in weak capacity municipalities, and
to drive national spending priorities in larger urban centres (particularly
related to the World Cup). Yet neither of these approaches managed to
address the core issues of weak capacity or national developmental priori-
ties effectively. In the case of institutionally weaker municipalities, simply
reintroducing project-based approaches did little to strengthen capacity,
nor stem growing evidence of ineffective resource use or corruption. In
larger urban centres, project-based grants promoted fiscally unsustainable
investment choices, generating large-scale fiscal commitments that may yet
threaten the sustainability of larger urban municipalities.
The consensus on the need for differentiation did, however, open the
door to the ongoing programme of reforms to the intergovernmental fiscal
system. It has led to the progressive introduction of performance-based
funding instruments (albeit still small scale and fragmented), which has
reasserted the importance of co-locating functional and fiscal responsi-
bility, and strengthening planning and project preparation practices in
municipalities. The current programme of national fiscal consolidation,
and associated reductions to grants to municipalities, is likely to accelerate
this process and encourage municipalities to leverage private finance more
aggressively to fund their investment needs.
Reforms to the intergovernmental fiscal system in South Africa have
gone through periods of rapid and radical change, hiatus and incremental
progress. A few key features of the reform process stand out:

a) Grants have seldom been reformed for their own sake. Periods of rapid
change have been as part of a broader reform to the intergovernmen-
tal system, whether through the restructuring of the local government
system, or the introduction of a broader differentiated approach to
metropolitan municipalities, focussed on improved integrated plan-
ning and delivery.
b) Reforms have not been linear. While the National Treasury has
maintained a consistent approach to the management of the inter-
governmental fiscal system and the role of grants within it, there have
always been countervailing pressures and perspectives and pressures
that have disrupted or contested the reform trajectory. Some of these
pressures have been rooted in legitimate concerns about the capacity

YILMAZ_9781789900842_t.indd 340 16/12/2019 10:44

 Reforming vertical programmes: South African local government ­341

of subnational governments. However, others reflected often powerful

vested interests in sector departments seeking to maximize their own
control, or established rent-seeking coalitions that are resisting disrup-
tion to their activities.
c) The quality of grant design and management is often weak, under-
mining reform efforts. The experience of the MIG, MIG-2 and
USDG all reveal problems in the quality of grant design and the effec-
tiveness of implementation. Inadequate quality at entry, the absence
of credible and regular review and adjustment to design, and a lack
of investment in grant administration capacity have all weakened and
delayed reform efforts, creating justifications for central administra-
tive clawback.
d) The quality of spending must remain the ultimate goal. Although
competing perspectives on the design of the fiscal system are inevita-
ble, reform programmes must respond to changing contexts in order
to improve the quality of life of citizens as their ultimate ­beneficiaries.
Spending performance, in both financial and non-financial terms – is
ultimately essential to the design of robust fiscal transfer systems and
individual transfer programmes.

6. CROSS-CUTTING ISSUES

There are a number of cross-cutting issues that are evident from this brief
review of the intergovernmental fiscal system and its reform in South
Africa:

a) Addressing coordination failures: much of the debate over the struc-

ture of the fiscal transfer system has sought to trade off the pursuit
of national development priorities with functional assignments in
the Constitution. Historically, sector departments have expressed
a preference for centrally managed, project-based transfers, rather
than integrated local-level determination of priorities through the
planning system. More recently, efforts to ‘align’ national and local
priorities and plans have placed increasing emphasis on improved
intergovernmental coordination and alignment through the planning
system. While significant progress has been made in this regard,
‘joined up planning’ comes with significant transaction costs itself
and does not necessarily align incentives or actual investment
practices. It may in reality merely seek to play down the costs of not
abiding by – or adjusting – the system of functional assignments in
the first place.

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 342 Intergovernmental transfers in federations

b) Capacity and accountability: concerns over expenditure performance,

particularly in terms of value for money and fiduciary issues have
been a key driver of efforts to recentralize the transfer system, and to
differentiate it. This has revealed a presumption that central authori-
ties have both greater planning and execution capacity, and sufficient
capability for oversight than is necessarily the case. What has been
missing in this system is the perspectives and role of non-state parties
in being able to address both capacity and accountability concerns.
Private financiers will have a direct interest in the maintenance of
assets and associated revenue streams, and thus also in the quality of
project design. Citizens themselves will have direct interests that go
beyond confirming investment needs (through participatory planning
processes) but also in the co-production of services and the oversight
of performance (through various social accountability tools, such
as social audits). For non-state actors, a key starting point for their
involvement is much greater information of, and sense of ownership
of, intergovernmental resource flows.
c) The role of incentives: recent efforts to expand performance incen-
tives offer a promising new direction for a differentiated fiscal
transfer system. However, performance-based systems require careful
construction of objective and measurable indicators and targets
which can take significant effort to develop, negotiate and manage.
Moreover, simple cash-based rewards are not the only form of incen-
tive to which organizations respond. Greater discretion over resource
use, for example, may provide a greater incentive at the margin than
simply more money with strings attached.
d) Project finance and fiscal transfers: the push towards consolidated,
formula-based transfers must pay careful attention to the needs of
larger investment projects and programmes. In the first instance these
may demand very lumpy expenditures that are not well suited to an
annual grant allocation. However, large infrastructure projects also
pose significant risks that require careful mitigation in the project
preparation process, and may offer significant opportunities to lever-
age private finance, for which grant allocations are typically poorly
designed.

7. IMPLICATIONS FOR OTHER COUNTRIES

The trajectory of the intergovernmental fiscal system in South Africa

remains unique to its own changing context. There are, however, three
broad lessons from this experience that could be considered to be universal:

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 Reforming vertical programmes: South African local government ­343

a) Monitoring and oversight: all transfer systems require monitoring

and oversight, which in turn requires regular, useful and verifiable
information flows. These are typically easier to establish in relation
to purely financial matters, rather than actual outputs and impacts.
Considerable, complementary investment in management informa-
tion systems, which provides a critical feedback loop to planning and
budgeting systems, is thus a long-term priority for any system of inter-
governmental transfers and should be central to any reform efforts.
The government has struggled to improve verifiable flows of both
financial and non-financial information. While the South African case
demonstrates the financial information can easily be improved, this is
of limited value if not accompanied by relevant service output data
associated with financing arrangements.
b) Incentives and triggers for reform: any reform to the system of inter-
governmental transfers will generate winners and losers, both in terms
of administrative authority and in terms of opportunities provided
for rent-seeking. In many cases this will lead to ongoing resistance to
efforts at reform, which can be expressed through blocking of propos-
als, poor design or application of new approaches, or outright efforts
to block project level implementation. Addressing these obstacles
requires reformers to pay far closer attention to the political-economy
of reform, and particularly to the design and execution of the reform
process itself.
  Systemic reforms to the transfer system are often easier in times of
more systemic reforms (for example, to the local government system
as a whole), and in times of fiscal crisis when few other options are
available, not least as the authority required to execute reforms is often
more clearly established. Yet even in these cases the momentum of
reform needs to be established and maintained into implementation.
Regulatory tools (as were used in the DoRA) and more positive efforts
to strengthen collaboration most often need to work in tandem to
achieve this.
c) Strengthening accountability: intergovernmental transfers, by their
nature, create accountability challenges for both transferring and
receiving authorities. Famously, those who ‘pay the piper, call the
tune’ and an excessive reliance on central transfers will ultimately
weaken the downward accountability of the receiving authority to its
citizens. Addressing this fundamental challenge is often posited as a
choice between local state discretion and central state control, with the
latter perspective most often argued for in terms of an absence of local
state capacity.

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 344 Intergovernmental transfers in federations

However, both these perspectives ignore the central role of non-state

actors in strengthening downward accountability for results. Ultimately,
citizens are the intended beneficiaries of these resources and can play an
important local role in advising on resource allocations, co-producing
services, monitoring outputs and assessing value for money. Limited,
obscure, complicated and outdated information all undermine the capacity
of citizens to engage with resource allocation and programme execution
processes. Much greater innovation in, and basic standards for, citizen
engagement are a critical gap that South Africa has yet to address in the
design of its intergovernmental fiscal systems.

REFERENCES

National Treasury (2014), Review of Local Government Infrastructure Grants:

Recommendations for Reform. Draft Report to Budget Forum, September 2014.
Accessed online on 1 February 2019 at www.ffc.co.za/. . ./804-review-of-local​
-government-infrastructure-grants-recommendat.
National Treasury (2019), Budget Review 2019, 20 February 2019. Government
Printers, Pretoria.
Statistics South Africa (2017), General Household Survey 2017. Statistical Release
P0318. Accessed online on 1 February 2019 at www.statssa.gov.za/?page_id=1854​
&PPN=P0318.

YILMAZ_9781789900842_t.indd 344 16/12/2019 10:44

 Index
access to basic services 330, 331, 339 principles and guidelines for reform
accountability 239–43
Australia 197­–200, 201 Special Laws transfers 226, 238, 239,
India 288 240
principle 118 structural and institutional features
South Africa 342 224–6
strengthening 343–4 asymmetrical power-sharing 64–5
ad hoc transfers 9, 16 asymmetrical vertical compensations
additionality 288 66, 71–2
adjustment payment 113–14 Atlantic Accords 120–21
affordability 9, 29 Australia 8, 10, 14, 15, 18, 29, 35, 249,
Alberta 110, 121, 124 277, 282, 289
pipelines 122–3 Commonwealth Grants
announcement effects 100 Commission (CGC) 176, 178,
apartheid 333 180, 181, 182, 187–8, 189, 190
architecture of intergovernmental independence 200
transfers 2, 7–20 methodology and data revisions
equalization 16–18, 19 197
guidelines for structuring objective of equalization 173–4
horizontal and vertical sharing Constitution 163
18–19 Council of Australian Governments
horizontal sharing 8, 9, 13–16 (COAG) 181–2
normative guidelines and 8 Council on Federal Financial
vertical sharing 8–13 Relations 182
area 260–62, 280 horizontal fiscal equalization 3, 31,
Argentina 4, 13, 14, 16, 17, 224–47 70, 173–81, 185–202
CFI co-participation scheme 226, accountability and benchmarking
227, 232–3, 238, 239, 240 197–200
Fiscal Pact of 2017 237, 243 accuracy of calculated disability
Fiscal Responsibility Law 237–8 factors 178
intergovernmental transfer system breadth and categorization of
addressing horizontal imbalances assessments 177
238 contemporaneity of assessment
addressing vertical imbalances 178
235–8 coping with changes to
current 235–8 distributions 180
history and evolution 227–32 detail in the assessments 177–8,
National Pension System (NPS) 179
227, 228, 242 disincentives to undertake public
political economy of fiscal finance reforms 191–5
federalism 232–5 economic impacts 191–7

345

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 346 Intergovernmental transfers in federations

effectiveness in achieving Australian Bureau of Statistics (ABS)

equalization 189–91 180
frequency of updating autonomy principle 118, 135
calculations 178–80 average-rate effect 192
how it works 186–9
implementation 176–81 Bahl, R. 26, 27
objective of 173–6 balance of payments
state budget management 195–7 crisis in India 251
Intergovernmental Agreement on estimates for states in the US 96–7
Federal Financial Relations basic services, access to 330, 331, 339
(IGAFFR) (2009) 182–3 benchmarking 197–200
Intergovernmental Agreement on Bird, R. 22, 26, 27, 31, 32
the Reform of Commonwealth- block grants
State Financial Relations India 264–5, 266, 267
(1999) 174 consolidation of specific grants
intergovernmental fiscal relations 3, into 284–6
163–84 US 88, 89, 98, 100
Commonwealth payments for Boadway, R. 44
local government 170–71 Boex, J. 42
institutional arrangements Bolsa Família programme (BFP) 204,
181–2 216–18, 221
interface between tied and untied borrowing, subnational, see
grants 181 subnational debt/borrowing
state payments to local bottom-up benchmarking 199
government 171 Brazil 4, 15, 17, 204–23
structure of government 163–4 Bolsa Família programme (BFP)
tied funding 13, 165–9, 171–2, 204, 216–18, 221
175, 181, 190 evolution and special features of the
untied grants, see untied grants/ federal system 205–8
transfers Fiscal Responsibility Law (LRF)
vertical fiscal imbalance 164–5, 206
166, 171–2, 183, 186–7 Fiscal Stabilization Fund (FSF) 213
National Disability Insurance Fund of Participation for
Scheme (NDIS) 166–7 Municipalities (FPM) 213–15
National Health Reform payments Fund of State Participation (FPE)
166, 167 213, 214
National Housing and intergovernmental fiscal relations
Homelessness payments 166, 208–16
167 multiplication of municipalities 216
National Partnership Payments National Fund for the Development
(NPPs) 166, 167–8, 190 of Education (FUNDEF/
National Specific Purpose Payments FUNDEB) 214, 215
166–7, 190 National Health System (SUS) 214,
Productivity Commission 195 215–16
benchmarking 199 political system 206–8
report on Horizontal Fiscal Social Emergency Fund (FSE) 213
Equalization 169, 174, 176, states’ performance grants and
185, 200–201 subnational innovation 204–5,
Quality Schools Program 166, 218–20, 221
168 Brennan, G. 24

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 Index ­347

British Columbia (BC) 110, 122, 123 central interventions 23

Buchanan, J.M. 24, 43, 44 CFI co-participation system 226, 227,
budget cycles 196 232–3, 239
buoyancy 28–9 transfers and poverty 238, 240
burden sharing 258 Chakraborty, P. 260
Chelliah, R.J. 252, 267
Cadastro Único 217 Chernick, H. 32, 92, 94, 99
Canada 3, 10, 17, 27, 109–33, 176, China 8, 10, 12, 13, 26
249, 282 cities
assignment of spending/regulatory urban areas in Switzerland 147, 149,
responsibilities and taxation 155
powers 110–11 US 92, 99
Commission on Fiscal Imbalance see also urban development
(CFI) (Séguin Commission) City of Buenos Aires (CABA) 236
117, 119 common pool problem 23
demography, economy and complexity 242–3
institutions 109–10, 132–3 concordats 134–5
Established Programs Financing concurrent tax bases 276–7
(EPF) 114 conditional transfers/grants
federal-provincial transfers 111–15 Australia 13, 165–9, 171–2, 175,
financial flows 115–16 181, 190
fiscal arrangements after the Séguin interface with untied grants 181
report 118–19 Brazil 214, 215–16, 216–18, 221
fiscal imbalance debate 117–18 Canada 111
natural resources 118–19, 119–25 India 267, 268, 284–6
carbon taxation 123–5 Kenya 310–14, 316
hydroelectric rent 119–22 South Africa 327–9
pipelines 122–3 US 87–9, 100
Canada Assistance Plan (CAP) 114 consolidation, fiscal 269, 333–6
Canada Health and Social Transfer cooperative behaviour 243
(CHST) 114, 115, 116, 119 cooperative federalism 265–6
Canada Health Transfer (CHT) 13, 15, coordination failures 341
111, 114–15, 116, 119, 126, 127 co-participation law 227, 232–3; see
Canada Revenue Agency (CRA) 111 also CFI co-participation system
Canada Social Transfer (CST) 13, 15, Cordoba 236
111, 114–15, 116, 119, 126, 127 corporate tax 68, 74–6
capacity 342 cost reimbursement, see matching
cantons’ financial capacity 145, 146, grants
151 costs, see expenditures/expenditure
fiscal, see fiscal capacity needs
South Africa 342 countercyclical fiscal assistance 93–5,
capital investment grants 101
Argentina 231–2 Courchene, T.J. 121
Brazil 212 coverage ratios 69
India 286–8
US 87, 99–100, 101–2 Dafflon, B. 51
carbon taxation 123–5 data
Carlino, G. 95, 98 revisions 197
categorical grants 87–9, 100 underpinning allocations in South
Ceará state, Brazil 204–5, 218–20, 221 Africa 329–30

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 348 Intergovernmental transfers in federations

debt of service delivery 195

India 251, 258–60 solidarity vs in Germany 74–6
dynamics at central government elasticity effect 192
level 259 ‘Energy East’ pipeline 123
relief for states 258 energy resources 194–5
subnational, see subnational debt/ hydroelectric rents 119–22
borrowing oil revenue 210
decentralization 225 environmental policy
Argentina 224, 225, 227–9 Canada 123–5
Brazil 205 Switzerland 140, 141
defence spending 96, 104 equal per capita (EPC) distribution
demography 168, 181, 188, 189–90
Canada 109–10, 132–3 equalization 2, 16–18, 19, 30–32,
demographic factors as sharing 41–62
criteria 261, 262, 281 Brazil 213–15, 221
see also population Canada 111–14, 115, 116, 118–19,
derivation approach 9, 13–14, 19 125–6
design of intergovernmental transfers, and natural resources 118–19,
see intergovernmental transfer 119–25
design economic characteristics and
development planning 299 determinants of 53–7
devolution first- and second-generation 47–51
Kenya 301–5, 318–19 fiscal disparities vs differences 45–7
tax sharing on a devolution basis fiscal gap methodology 281–3
278–9 Germany 30, 70
differences, fiscal 45–7 effects of VAT 66, 69–70
differentiation 332, 336–8 equalization yardstick 71
discretionary budget approach 9, explicit horizontal equalization
11–13, 19 66, 70–71, 72–4, 76
disparities, fiscal 45–7, 58 grants and intermunicipal
determinants of 53–7 equalization 80–82
measurement of 51, 52, 53 horizontal, see horizontal
drought relief 171 equalization
India 260–62
earmarked transfers, see conditional fiscal capacity per adjusted
transfers/grants population approach 283–4
economic context 57 options for reform 279–84
economic growth 252, 253 refining the current weighted
economic shocks 32–3, 44 index 283
education transfers 83 key issues 51–2
Australia 166, 168, 169 choice of equalization formula
assessments 178, 179 51, 52
Brazil 214, 215 funds allocated to equalization
state performance grants 219–20, 51, 52
221 measuring disparities 51, 52
India 290 philosophies 70
Switzerland 139, 141–2, 157–8 rationale for 41–3
US 89, 92, 95, 99, 101 solidarity and 42, 43–5
efficiency Switzerland, see Switzerland
fiscal 260 two-tiered 175–6

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 Index ­349

US 18, 70, 90–95, 101 first-generation theory of fiscal

vertical, see vertical equalization federalism (FGT) 21, 22, 25, 31,
equitable share/sharing 35
Kenya 11, 12, 15, 304, 306–10 fiscal balance, principles of 118
addressing the vertical fiscal fiscal capacity 14, 81, 282–3
imbalance 315–16 measuring 30–31
concerns regarding 309–10 principle 118
functional approach 314, 315 Switzerland 142
horizontal allocation 307–9, 314, Fiscal Capacity Cap (FCC) 113
315 fiscal capacity for equalization (FCE)
vertical allocation 306–7, 314, 113
315–16 fiscal capacity per adjusted population
South Africa 16–17, 35, 326–7, 328, approach 283–4
333–5 fiscal consolidation 269, 333–6
equity 260 fiscal correction 257
Ethiopia 15 fiscal differences 45–7
European Union Structural Fund 289 fiscal discipline 261, 262
evaluation of central transfers 289–90 fiscal disparities, see disparities, fiscal
evolving federations 3–4; see also fiscal efficiency 260
Argentina; Brazil; India fiscal equalization, see equalization
excluded payments, judgements fiscal federalism 21–2
regarding 197 evolution of theory 22–4
expenditures/expenditure needs 14–15, fiscal gap methodology 281–3
27–8, 282–3 fiscal recklessness 23–4
Argentina 229–32 fiscal responsibility legislations (FRLs)
assignment 22–3 206, 257–8
assignment of responsibilities in fiscal rule strengthening 243
Canada 110–11 fiscal wars 211
Brazil 211–12 Fisher, R. 99–100
cost sharing in Germany 82–4 five-yearly review of HFE positions
effects of grants on state and local 178–80
expenditures in the US 97–100 Flatters, F. 44
equalization 44, 45, 47–57, 58 flypaper effect 98–9
Switzerland 142, 143, 144, 145–7, forest area 261, 262, 280
148–9, 152, 156–7, 162 formula-based transfers/grants 9,
Kenyan counties 303 14–15, 19, 34–5, 88
reforms in Australia 195 frequency of updating 178–80
Switzerland 137–42 functions
explicit horizontal equalization assignments
(Finanzausgleich) 66, 70–71, 72–4, Argentina 229–31
76 Canada 110–11
South Africa 324–5
Feehan, J. 122 Kenya
FIFA World Cup 332, 337 assignment of functional
financial capacity, cantons’ 145, 146, responsibilities 302–3
161 better linking finances to 314,
financial needs 81 315
Finanzausgleich (explicit horizontal
equalization) 66, 70–71, 72–4, 76 Galper, H. 98, 100
first-generation equalization 47–50 Garran, R. 187

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 350 Intergovernmental transfers in federations

GDP health transfers

Argentina Australia 166, 167, 169
contribution to and percentage Brazil 214, 215–16
share of federal tax transfers state performance grants 220,
236–8 221
intergovernmental transfers and Canada 13, 15, 111, 114–15, 116,
tax burden as percentage of 119, 126, 127
226 India 289
US grant share of 86–7 Switzerland 139, 141
general revenue sharing (GRS) 102–3 US, see Medicaid
geo-topographic needs 147, 148, 149, Hessen 81–2
152–3, 155, 156 highway grants 95, 99, 100
geography 55–6 horizontal cooperation 135
grant distribution patterns in the horizontal equalization 48, 49
US 95–6 Argentina 235, 238, 240–41
Germany 2, 8, 10, 14, 15, 18, 30, 64–85 Australia, see Australia
horizontal fiscal balance 17, 66, 70–76 Brazil 213–15, 221
allocation and distribution effects Germany 17, 66, 70–76
72–4 India 260–62
asymmetrical vertical options for reform 279–84
compensations 66, 71–2 horizontal fiscal imbalance 41–2
solidarity vs efficiency 74–6 addressing 25, 29–32
institutional set-up 64–6 horizontal sharing 8, 9, 13–16
local finances 77–84 ad hoc transfers 9, 16
cost sharing and incentives 82–4 allocation of the equitable share in
grants and intermunicipal Kenya 307–9, 310, 314, 315
equalization 80–82 cost reimbursement and matching
municipal own revenue 77–80 grants 9, 15
reform 2020 76–7 derivation 9, 13–14, 19
revenue allocation 66–8 formula grants 9, 14–15, 19
vertical fiscal balance 66, 68–70 guidelines for structuring 18–19
Goetz, C.J. 44 housing transfers 83, 166, 167
goods and services tax (GST) hydroelectric rents 119–22
Australia 164, 172–3, 175, 176, 190,
191 ICMS (VAT in Brazil) 208–9, 210, 211,
distribution of GST pool 187–9 218, 219
impact of state tax reforms 192–4 incentives 19, 243
size of the total pool 197 closing the vertical gap 26–7
state budget cycles and payments disincentives to undertake public
196 finance reforms in Australia
state per capita GST relativities 191–5
185, 186 Germany 82–4
volatility 197, 198 India 278
India 249, 256, 268–9, 272, 276, 282 South Africa 342, 343
governors 233, 244 income support 290
Gramlich, E. 98, 100 income tax 68, 74–6, 277
grants independent institutions 34–5
grants-in-aid in India 262–3 India 10, 12, 14, 15, 16, 33, 34
US, see United States (US) abolition of octroi 28
Great Recession 94–5 Constitution 248–9

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 Index ­351

Finance Commissions 4, 248–74 specific purpose grants 284–6

10th 252 states’ increased revenue
core mandate and recent autonomy 276–7
developments 250–51 transition to fiscal gap
economic reforms and evolving methodology 279–83
role 251–3 Planning Commission 249, 250, 263,
full convergence phase 254, 266, 267, 287
256–60 Universal Elementary Education
grants-in-aid 262–3 Program (SSA) 290
horizontal devolution criteria individuals 43, 44, 87
260–62 Indonesia 10, 14, 175–6
impact of the 14th Commission information flows 343
263–71 infrastructure
laboratory federalism 34, 264–5 India 257–8, 286–8
measuring vertical imbalances index of infrastructure 261, 262
254–6 South Africa 331, 332–3, 334,
phases of approach 254 335–9, 342
political agents 35, 37 initiative principle 135–6
terms of reference for the 15th Inman, R. 32, 95, 98
250–51, 269, 275 institutions 34–5
genesis of key institutional Argentinian framework 224–6
arrangements 248–50 Australia 181–2
GST Council 263, 272 Canada 109–10, 132–3
Mahatma Gandhi National Rural Germany 64–6
Employment Guarantee India, see India
(MGNREGA) 290 Kenya 301–2, 304–5
National Development Council 249, strengthening 315, 318
263, 264 market-based and rule-based
National Health Mission (NHM) institutional mechanisms 24
289 Switzerland 134–6
National Institution for insurance taxes 193, 194
Transforming India (NITI) intergovernmental transfer design 3,
Aayog 264 21–40
Development Monitoring and evolution of fiscal federalism theory
Evaluation Office (DMEO) 21–2, 22–4
290 international trends relevant to
options for reform 4, 275–94 India 276–90
capital grants 286–8 purposes of transfers 24–33
evaluation of central transfers addressing horizontal inequalities
289–90 25, 29–32
fiscal capacity per adjusted closing the vertical gap 25–9
population approach national goals, objectives and
283–4 priorities 25, 32–3
fixing the sharing rate in the law spatial spillovers 25, 32
277–8 interjurisdictional cooperation
performance-based grants 288 mechanisms 315, 318
refining the current weighted iron ore royalties 192, 193, 194–5
index 283
separation of tax devolution and Japan 10
redistribution 278–9 Jenkins, G. 121

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 352 Intergovernmental transfers in federations

Kenya 5, 10, 12, 17, 33–4, 296–322 Public Financial Management Act
Commission on Revenue Allocation (2012) (PFM Act) 303
(CRA) 304–5, 309, 310, 316 strengthening the institutional
conditional grants 311, 313, 314, framework and cooperation
316 mechanisms 318
horizontal allocation of equitable urban development 314, 316–17
share 307, 308, 315 Kenya Local Government Reform
conditional transfers 310–14, 316 Program (KLGRP) 299
constitutional, legal and policy Kenya Urban Support Program
context 311–14 (KUSP) 317
effects 313–14 Knight, B. 99
evolution in practice 312–13
strengthening 314, 316 laboratory federalism 34, 264–5
Constituency Development Fund labour, cost of 53
(CDF) 300 Ladd, H.F. 45
Constitution of 2010 297, 301–5, land tax reform 193–4
306, 311 local preferences 45–7
County Allocation of Revenue Act low- and middle-income countries 2,
(2017) 312 7–20
devolution 301–5, 318–19 lump-sum grants 88
assignment of functional
responsibilities 302–3 macroeconomic stabilization, see
intergovernmental fiscal stabilization
arrangements 304–5 maintenance-of-effort (MOE)
own source revenues 303–4, requirements 88, 95
317–18 malapportionment 207, 222
structure of the Manitoba 124, 125
intergovernmental transfer marginal retention rates 74–6
system 304 market-based institutional
Division of Revenue Act (DORA) mechanisms 24
305 market preserving federalism 251–3
equitable sharing, see equitable Martinez-Vazquez, J. 42
share/sharing matching grants 9, 15
future prospects 314–18 Brazil 214, 215–16
history of intergovernmental fiscal Germany 83–4
relations 297–300 India 285
local government reforms US 88, 90–91, 93
299–300 matching requirements 288
post-independence system 298–9 materiality test 174
independence 296 mature federations 2–3; see also
local authority service charge Australia; Canada; Germany;
(LASC) 299–300 Switzerland; United States
Local Authority Transfer Fund (US)
(LATF) 300 Medicaid 89, 90–91, 96, 97, 100–101,
National Urban Development 103, 104–5
Policy (NUDP) 317 countercyclical fiscal relief 94–5
Office of the Controller of Budget growth in spending on 98, 103
(OCOB) 305 Mexico 10, 15, 26, 216
own source revenues and borrowing migration 43–4
303–4, 314, 317–18 mineral resources 192, 193, 194–5

YILMAZ_9781789900842_t.indd 352 16/12/2019 10:44

 Index ­353

mining 177 state grants 204–5, 218–20, 221

boom 175, 185, 189 India 288
mixed models 12–13 South Africa 338–9, 340, 342
monitoring 330, 343 peripheral provinces 233–4, 244–5
moral hazard 76, 206 personal income tax 68, 74–6, 277
Philippines, The 10
national goals, objectives and priorities pipelines 122–3
25, 32–3 policy neutrality 191, 200
natural resources 56–7 policy reform disincentives 191–5
Australia 194–5 policymaking
Canada 118–19, 119–25 Argentina 233–4, 244
needs, see expenditures/expenditure Brazil 206–7
needs political agency 35, 37
Nepal 115 political parties 206–7
net fiscal benefits 30 political representation 206–8,
New Brunswick 124 233–4
New South Wales (NSW) 189 population 53, 54–5
Newfoundland 113, 120–21 sharing criterion in India 260–62,
non-automatic transfers 226, 239, 280, 281
241 poverty
non-matching grants 214, 215 reduction
normative guidelines 8 Brazil 218
‘Northern Gateway’ pipeline 122 India 290
Northern Territory 190, 191 transfers in Argentina and level of
Norway 286 238, 240–41
notional prices 122 president, role of 233
Nova Scotia 120–21 Prince Edward Island (PEI) 110
principal component analysis (PCA)
O’Brien report 118 147, 152, 153, 154, 156
octroi, abolition of 28 project-based grants 88
oil pipelines 122–3 South Africa 332, 337, 340, 342
oil prices 122 property taxes
oil revenue 210 Germany 74–6, 78, 79, 80
one objective/one instrument approach India 277
242–3 Province of Buenos Aires (PBA)
Ontario 110, 114, 124, 125 236–8
oversight 343 public services
own source revenues, see subnational needs for 53–7
revenue-raising unit cost of 53–7
purposes of intergovernmental
Pakistan 10 transfers 24–33
Pan-Canadian Framework on Clean addressing horizontal fiscal
Growth and Climate Change inequalities 25, 29–32
123–4 closing the vertical gap 25–9
Penner, R. 96 national goals, objectives and
pension system 227, 228, 242 priorities 25, 32–3
performance-based grants/transfers spatial spillovers 25, 32
31, 84
Brazil 204–5 quarantined payments 190
Bolsa Família 204, 216–18, 221 Québec 110, 115, 117, 121, 126

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 354 Intergovernmental transfers in federations

Rangarajan, C. 254 second-generation equalization 16, 48,

Rao, M.G. 266, 276, 281, 289, 290 50–51
Ravishankar, V.J. 257 second generation theory of fiscal
real prices 122 federalism (SGT) 21–2, 23–4,
recessions 93–5, 97, 99–100, 101 25–6, 31, 34, 35
Reddy, G.R. 269 Séguin report 117–18
Reddy, Y.V. 269 service delivery, efficiency of 195
redistribution 278–9 shared tax approach, see tax sharing
redistributive bias 242 shocks 32–3, 44
redistributive justice 42 small transfers 111
referendum principle 135–6 Smart, M. 31, 32
regional cooperation mechanisms 315, social security/social transfers
318 Canada 13, 15, 111, 114–15, 116,
regional development funds 214, 215 119, 126, 127
regional economic characteristics 53–7 Switzerland 136, 137, 139, 141
regulatory responsibilities 110–11 socio-demographic needs 147, 148,
rent-seeking 24 149, 153–4, 155, 156
representative tax system (RTS) 45, 50 soft budget constraint 23, 35
Canada 111–14, 118, 121–2 solidarity
Switzerland 145 vs efficiency in Germany 74–6
Reschovsky, A. 92, 94 and equalization 42, 43–5
resistance to reform 343 South Africa 5, 15, 16–17, 35, 315,
resources equalization, see revenue 323–44
equalization Built Environment Performance
revenue adequacy 28–9 Plans (BEPPs) 338
revenue assignment 22–3 Bus Rapid Transit Systems 332, 337
revenue autonomy, see subnational consolidation and stabilization 333–6
revenue-raising Constitution 325–6, 333
revenue equalization 47–57, 58 cross-cutting issues 341–2
Switzerland 142, 143–5, 146, 151, differentiation 332, 336–8
154–7, 161, 162 Division of Revenue Act (DoRA)
revenue sharing, see tax sharing 326, 327, 329
revenue sources division of revenue process 329
Australia 177 implications for other countries
Brazil 208–10 342–4
Switzerland 136–7, 138 intergovernmental fiscal framework
Rio de Janeiro state 204–5, 220, 221 325–30
risk sharing 32–3 transfers to subnational
roads government 326–30
Australia 170, 171 intergovernmental functional
highway grants in the US 95, 99, assignments 324–5
100 Local Government Equitable Share
Rodden, J. 25 (LGES) 35, 326, 327, 328
rule-based institutional mechanisms 24 local government fiscal framework
330–33
sales tax 229 phases of reform 333–9
Santa Cruz 238 results of reforms 339–41
Santa Fe 236 Medium-Term Expenditure
Saskatchewan 124, 125 Framework (MTEF) 11–12,
Scott, A.D. 43–4 326

YILMAZ_9781789900842_t.indd 354 16/12/2019 10:44

 Index ­355

Municipal Financial Management expenditure needs equalization

Act (2003) 336 31, 142, 143, 144, 145–7,
Municipal Infrastructure Grant 148–9, 152, 156–7, 162
(MIG) 331, 332, 335–6, 339 historical context 142–3
MIG-2 337 reform of the system 142–3,
performance-based transfers 338–9, 156–7
340, 342 revenue equalization 142, 143–5,
Provincial Equitable Share (PES) 146, 151, 154–7, 161, 162
35, 326–7, 328 transition fund 143, 144, 147–50
Urban Settlements Development geo-topographic needs 147, 148,
Grant (USDG) 337–8 149, 152–3, 155, 156
South African Social Security Agency institutional background 134–6
331 National Council 134
spatial spillovers 25, 32 overview of the public sector 136–42
specific purpose payments/grants performance analysis 151–4
(SPPs) 2019 reform 151–2
Australia 165–9, 171, 175, 181, 190 socio-demographic needs 147, 148,
Germany 82 149, 153–4, 155, 156
reform in India 284–6
South Africa 332, 335, 337, 340 tax effort 261, 262
Srivastava, D.K. 254 tax points 114–15
stabilization 32–3 tax potential 80–81
South Africa 333–6 tax sharing 9, 10–11, 12–13, 19
stamp duty 193–4 Argentina 226, 227, 232–3, 238, 239,
step functions 32 240
subnational budget management Brazil 208–11
195–7, 198, 200 Canada 111–14
subnational debt/borrowing 22–3 Germany 66–70, 78, 79
Brazil 205–6 Kenya, see equitable share/sharing
Kenya 314, 317–18 India 250, 256–60, 268
South Africa 326 fixing the sharing rate in law
subnational revenue-raising 25–8 277–8
Brazil 208–11 on a devolution basis 278–9
Germany 77–80 rise in the sharing rate 265–6, 277
increasing revenue autonomy in South Africa 326–7, 328, 333–5
India 276–7 taxation
Kenya 303–4, 314, 317–18 powers in Canada 110–11
subsidiarity principle 135 state tax reform disincentives in
supplementary federal grants 71–4, 76, Australia 192–4
77 tied grants/transfers, see conditional
Switzerland 3, 10, 13, 14, 15, 18, transfers/grants
134–62 Tombe, T. 114
Conferences of Cantonal Ministers top-down benchmarking 199
135 trade taxes
Council of States 134 Argentina 227
equalization 17, 137, 142–50, 154–7 Germany 78, 79, 80
cantonal benefits or contributions ‘Trans Mountain’ pipeline (TMP) 122,
154–6 123
evolution of equalization funds transition fund 143, 144, 147–50
162 transparency 201, 242–3

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 356 Intergovernmental transfers in federations

transport transfers untied grants/transfers 88, 310

CIDE funding in Brazil 214, 215 Australia 13, 17–18, 165, 166,
Germany 83–4 172–81
South Africa 332, 337 accountability and benchmarking
two-tiered equalization 175–6 197–200
interface with tied grants 181
unconditional grants, see untied to local government 170–71
grants/transfers size of the pool 172–3
unit costs 53–7 India 264–5, 266, 267
unitary federations 4–5; see also updating
Kenya; South Africa calculations in Australia 178–80
United States (US) 2–3, 8, 12, 15, 32, estimates in weighted index formula
34, 86–108, 249 281
Affordable Care Act (2010) 91, 96, urban areas 147, 149, 155; see also
100 cities
Aid to Families with Dependent urban development 83
Children (AFDC) 98 financing in Kenya 314, 316–17
American Recovery and
Reinvestment Act (2009) VAT
(ARRA) 94 Brazil (ICMS) 208–9, 210, 211, 218,
Children’s Health Insurance 219
Program (CHIP) 91, 100 Germany 66, 72–4, 77
effects of grants on state and local equalizing effects 66, 69–70
expenditures 97–100 gauging the VAT share 68–9
equalization 18, 70, 90–95, 101 India 249, 256, 269, 272
federal level 90–92 Verbundmasse (equalization fund) 80,
grants as countercyclical fiscal 81
instruments 93–5, 101 vertical equalization 49
state level 92 Argentina 235–8
features of the grant system 86–90 Germany 66, 68–70
aggregate amounts 86–7 vertical fiscal imbalance (VFI) 9, 41
grant characteristics 87–9 Argentina 234–5
grants and tax expenditures addressing 235–8
89–90 guidelines for reform 242
Federal Medical Assistance Australia 164–5, 171–2, 183, 186–7
Percentage (FMAP) 90–91, 94 overcoming 165, 166
Government Accountability Office closing the gap 25–9
(GAO) 289 India 254–60
laboratory federalism 264–5 balancing fiscal policy 256–60
Medicaid, see Medicaid increasing states’ revenue
Medicaid Relief Act 95 autonomy 276–7
politics of grants 95–7 measuring 254–6
geographical distribution patterns Kenya 314, 315–16
95–6 vertical sharing 8–13
perspectives on intergovernmental allocation of equitable share in
fiscal flows 96–7 Kenya 306–7, 310, 314, 315–16
Tax Cut and Jobs Act (2017) discretionary budget approach
(TCJA) 90 11–12
Temporary Assistance for Needy guidelines for structuring 18–19
Families (TANF) 98 mixed models 12–13

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 Index ­357

shared taxes 10–11 weighted index methodology 260–62,

size of the vertical share 9–10 279
Victoria 189 flawed 280–81
volatility 197, 198 refining 283
voluntary grants 214, 215 Weingast, B.R. 21, 22, 26, 31–2
Von Hagen, J. 33, 44 Western Australia (WA) 173, 174, 175,
voter-representation ratios 207, 222 185, 186, 189, 190, 192

wage taxes 74–6 Yilmaz, S. 47, 49–50

Wallace, S. 27
Wassmer, R. 99–100 Zuker, R. 121

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