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© TAX ANALYSTS. Reprinted with permission.
Note: This report is available in its entirety in the Portable Document Format (PDF).
I. Introduction and Context
Why Local Tax Design Matters
The World Development Report Entering the 21 Century reaches the conclusion that two forces shape the world in which development policy will be defined and implemented: globalization (the continuing integration of countries) and localization ("self-determination and the devolution of power," WDR, 1999-2000).1 What is labeled as localization elsewhere is often cited as decentralization—the division of public-sector functions among multiple types of government, central and subnational.2 That decentralization can, and is, occurring in unitary and federal states alike.
Sorting out fiscal power has been occurring even in "inherently centralized" countries such as: the kingdoms of Jordan and Morocco (Ebel, Fox, and Melhem, 1995; Vaillancourt, 1997; Yilmaz, Fox, and Ebel, 2003); Central and Eastern European states that are in the transition from a command to a market economy (Dunn and Wetzel, 2000; Bird, Ebel, and Wallich, 1995; Wong and Martinez-Vazquez, 2002); military regimes (Shah, 1996; Pakistan NRB, 2001); countries that view decentralization as a strategy for improving local service delivery in reaction to financial crises (Thailand: Weist, 2000); nation-states that are trying to avoid the centrifugal forces of separatism (Bosnia and Herzegovina, Indonesia, Sudan, and several other countries: Bird, 2003); and regions in which "bottomup" participatory budgeting is taking hold (Latin America: Burki, Perry, and Dillinger, 1999; and Campbell, 2003).
The achievement of the millennium development goals (MDGs)—the gains that can be made to improve the lives of the poor by 2015—depends in large part on the integrity, efficiency, and sustainability of decentralized governance. Nearly every one of the MDGs entails some element of intergovernmental service delivery.3 The challenge is that all that decentralization can be done well or badly. Done well, it can lead to the benefits promised by a well-functioning state and local system: better services (for example, girls' education, clean water, local transportation, and picking up the garbage); national cohesion; and the creation of a potentially powerful tool for poverty alleviation. But if decentralization is done badly, it can lead to a macroeconomic mess, corruption, and the collapse of the safety net—the same things that many big central governments have delivered.
The elements of a well-designed decentralized system have been adequately discussed elsewhere (http://www.decentralization.org). It is a design (and, some argue, a sequence) of getting right the fundamental questions:
- Who does what (expenditure assignment)?
- Who levies which revenues (revenue assignment)?
- How can the fiscal imbalances—vertical and horizontal—be resolved when, as usually happens, one finds that the case for decentralizing spending is greater than that for decentralizing revenues (a role for intergovernmental transfers)?
- How should timing of revenues be addressed (debt and the hard budget constraint)?
- What is the institutional framework required to deal with political problems and implementation challenges of decentralizing states (the mix of capacity and knowledge for facilitation)?
The decision to decentralize is political. But once the decision is made, whether gradually (as in Hungary) or with an initial big-bang reform (as in Indonesia and Pakistan), a necessary condition is to get the intergovernmental fiscal design "right." That in turn leads to the decentralization theorem: the set of governments closest to the citizens can adjust budgets to local preferences in a manner that best leads to the delivery of a bundle of public services responsive to community preferences. Subnational governments (SNGs) become agents that provide services to identifiable recipients until the tax price for those services reflects the benefits received.
The focus is on improving public-sector efficiency. An efficient solution maximizes social welfare subject to a given flow of land, labor, and capital resources. The rule for achieving an efficient allocation of resources is to supply a service until at the margin—for the last "unit" of the service supplied—the welfare benefit to society just matches its cost. In the private sector, as a rule, the market-price system accomplishes that goal. When the private market fails in this objective (pure public goods, externalities, and monopoly), there is a case for public intervention—the public's commandeering of resources to supply the activity. Once the public sector intervenes, the efficiency logic is in favor of some form of fiscal decentralization. The argument is that, because of spatial considerations, SNGs become the conduit for setting up a system of budgets that best approximates the efficient solution of equating benefits and costs. In the economist's jargon, this is the "benefit model" of local finance.
To satisfy those conditions, subnational (local) governments must be allowed to exercise ownsource taxation at the margin and be in a financial position to do so. That is the essence of decentralization. That is why subnational local tax policy design matters.
Structure of the Article
This article addresses five questions of subnational tax policy design in an intergovernmental framework:
- What is the fiscal architecture that will frame, and constrain, the subnational tax policy options?
- What is an own-source subnational revenue?
- What is the conceptual framework for assignment of revenues between and among governments, and what are the implications for a "practical" tax policy?
- What are the options for administering subnational revenues?
- Once the principles and the framework for subnational tax policy are established, what other policies should be considered for subnational tax policy design?
The final section provides conclusions.
The focus of this article is developing and transition countries. The economic range is wide, making generalizations about policy design difficult. The World Bank's clients include upper-middle-income countries (for example, South Africa, Mexico, Slovenia, and Brazil); lower-middle-income countries (for example, Egypt, Indonesia, the Philippines, Colombia, Turkey, Poland, and Jordan); and lowincome countries (for example, the Caucuses, most of sub-sub-Saharan Africa, Anglophone and Francophone, Cambodia, Laos, Vietnam, Yemen, Bangladesh, and Pakistan).4 Beginning in 2002, an increasing focus has been placed on a subset of poor countries labeled low-income countries under stress (LICUS). Those are the very poor that "combine poor policy performance or low service capacity with a lack of responsiveness to their citizens."5
Clearly, what one might conclude about the intergovernmental and local revenue policy options of, say, Sudan vs. Slovenia (and, even more dramatically, of developed Korea vs. developing Kenya) may be quite different.
Notes from this section
1. The report goes on to argue that these twin forces are reinforcing, and stem from the same factors as, advances of information and technology (WDR, 1999-2000, pp. 31-33).
2. In this article, the terms "subnational" and "local" may be used interchangeably. They include intermediate governments (provinces, regions, states, oblasts) as well as counties, municipalities, city-states, districts, union territories, towns and villages, and special districts.
3. Those are: (1) eradicate extreme poverty and hunger; (2) achieve universal primary education; (3) promote general equality and empower women; (4) reduce child mortality; (5) improve maternal health; (6) combat diseases; (7) ensure environmental sustainability; and (8) develop a global partnership for development. United Nations Millennium Declaration (September 2000) and General Assembly Road Map (November 2002).
4. The World Bank Atlas ranked 208 economies using both the gross national income (GNI) per capita and purchasing power parity (PPP) approach. The most recent data are for 2002 and (some) 2001. World Bank, World Bank Atlas, 2002.
Note: This report is available in its entirety in the Portable Document Format (PDF).
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