Equalization of Local Governments’ Financial

Capacity

Emergency presentation prepared for the Prague Meeting of „Fiscal Decentralisation in South Caucasus Countries”, September 15-18, 2004

By Paweł Swianiewicz

Fiscal Federalism – Basic Assumptions

• Local governments provide mainly public goods, but their role in provision of redistributive functions is minimal

• Local taxes (with considerable local discretion to decide upon rates) are the main source of budget revenues. It means that those who pay are those who benefit from services

• Citizens are mobile• Catchment area of local services does not differ

significantly from the area of local government jurisdictions („free rider effect” is minimal)

Equalization – what for?

• Regardless what own revenues are allocated to local governments there are regional disparities in fiscal capacity

• Vertical equity – usually own resources allocated to local governments are not sufficient to provide compulsory services

• Horizontal equity – citizens in poor region should have access to the same services for the same price (tax paid)

• Reduction of „free rider” effect – support for local governments providing services for citizens from other jurisdictions

Equalization – what for? (2)• Securing minimal standard of services which

is defined nationally (important if local governments play a role in redistributive functions)

• Stimulation of the provision of merit goods, which are national priorities (for ex. education)

• Reduction of inefficient location decisions caused by the local tax competition

• Required by the European Charter of Local Self-Governments

Equalization – arguments against• Disturb the most effective (market) allocation

of capital (for example influence pattern of variation in costs of properties)

• Is in conflict with fiscal autonomy – makes match of local policies to local preferences more difficult

• Disincentive for stimulation of local economic development

• Transfers stimulate overall amount of public spending

• Equalization is rarely full, but it does exist in nearly all systems

How much equalization? Political philosophy answers.

• Egalitarian – full equalization regardless the cost

• Libertarian – no equalization, because it interferes with individual freedom principle

• Utilitarian – equalization to the extent which promotes higher economic effectiveness of the system

• Rawls – equalization which allows to maximize the welfare of the poorest local government

Types of equalization transfers

• General versus specific (conditional)

• Based on subjective decisions of central administration versus formula baseformula is often imperfect, but subjective decisions are: vulnerable to political manipulations, not transparent and unstable

• lump-sum versus matching

Lump-sum versus matching grants – microeconomic consequences

Grant in the system: Own revenues + grant Tax base

Tax rate

Tax Revenue x

Grant Tax revenue - reduced tax rate (2%)

Lump-sum

Matching Lump-sum

Matching

A 1200 5 60 0 24 0 0 24 24 B 600 5 30 30 12 20 12 32 24 C 200 5 10 50 4 50 20 54 24

Matching versus lump-sum grants – macroeconomic consequences

• Increase of the lump- sum grant – partial substitution of local tax revenues partial because of „budget maximizing bureaucracy” and „fiscal illusion effect”).

• Increase of the matching grant – stimulation of public expenditure

Matching versus lump-sum grants - conclusions

• Matching – better support horizontal equity

• Lump-sum – better support macroeconomic fiscal policies

• In practice: proportional – often in capital grants schemes (support local effort, macroeconomic consequence not dramatic)

• In practice: lump-sum more often in operating expenditure equalisation schemes

Types of equalization

• Vertical – upper tier provides grants for local self-government (for example UK, large part of the Polish system)

• Horizontal – „Robin Hood” tax paid by affluent to support poor (Sweden, Denmark, some elements in Poland)

What do we need to equalize?

• Revenue capacity• Spending needs (demand for

provided services)

Examples: snow removal; care of elderly people health care; road maintenance

• Unit costs of service deliveryExamples: education, road construction

Spending needs – a case of big cities• Number of service consumers significantly

larger than number of residents

• High unit costs of services due to:– Labour costs– Property costs

• High externalities (concentration of problems related to environment protection and transport)

• Concentration of social problems (spending on social services and security)

Factors used in allocation formula should:

• Be significantly correlated with spending needs or unit costs

• Have differentiated values across jurisdictions• Not be correlated with each other• Measurable and available• Not vulnerable for statistical manipulations by

interested parties• Neutral from the point of view of local fiscal

policies

Equalization in European Countries – typical characterstics

• Variation of the local tax base is usually big. Usually the smallest in the most territorially consolidated systems (in Poland 1:277 ratio between the most and the least affluent local government, in England 1:14)

• Equalization through general grants, while specific play different role

• Usually vertical allocation, but also countries with horizontal equalization systems

Equalization in European Countries – typical characteristics (2)

• In some countries full equalization (England), but more often partial (Norway – 85% difference to national average, Poland – „progressive” equalization to 92% of national average)

• Different number of equalisation factors considered:– „sophisticate” – large number of criteria (UK, Sweden, Denmark,

Norway);– Smaller number of criteria (Germany, Netherlands, Belgium)– „simplistic” – number of residents as the main criterion (Spain,

Italy, Greece)Usually more sophisticate systems in countries with more functions

provided by local governments

• Examples of UK, Netherlands and Spain – discussed in my LGI publication (in Russian)

• New Polish system (in operation from January 2004) – I may present if you are not exhausted yet.

Poland – equalization grant for municipalities

• Basic amount:– Received by local governments with local

fiscal capacity below 92% of national average– Progressive scale of equalization (75-90% of

the difference)

• Additional amount, for local governments:– with low population density– With local fiscal capacity below 150% of

national average

Poland – equalization grant for municipalities (2)

• Balancing amount:– Financed by „Robin Hood” progressive tax (up

to 30% of the „surplus” – horizontal equalization)

– Allocation formula takes into account spending needs related to social services (especially housing benefits)

• Spending needs component addressed also by „education general purpose grant”

Equalization mechanizm in Poland (2004)

0

50

100

150

200

250

300

350

400

Dzwola 34res./sq.km

Bielawy 112res./sq.km

Żurawica128

res./sq.km

Krokowa 48res./sq.km

Olkusz 347res./sq.km

Zielonka Mielno

"Robin Hood"

supplementary

basic

own fiscalcapacity