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The ongoing wave of decentralization in developing countries invariably includes fiscal reforms—the assignment of expenditure and revenue responsibilities to subnational governments.1 Many efforts, however, even those that closely follow key reform principles, are usually at best modestly successful. In this chapter I consider why this has been a difficult area of reform and argue that analysts need to think about it differently. The concept of fiscal decentralization is somewhat artificial in the sense that it cannot be isolated from broader reforms. Subnational governments with weak political accountability and institutional capacity are unlikely to use resources well. The reverse, however, is also true. Citizens who participate in such local processes are likely to disengage if these governments have inadequate resources to deliver services. The various fiscal elements are also interrelated but too often are treated separately. Redundant subnational government revenues abound, confusing citizens about what they pay for and why. Intergovernmental transfer systems have commonly undermined subnational incentives to raise revenues through taxes, borrowing, and so forth, even if they have the capacity to do so. Thus linkages are critical in decentralization reforms. Understanding context is another key to effective fiscal decentralization. As I illustrate below, the political and institutional characteristics of a country create both constraints on and opportunities for decentralization reform. A common Fiscal Decentralization and Intergovernmental Fiscal Relations: Navigating a Viable Path to Reform paul smoke 8 131 10491-08_Ch08.qxd 5/3/07 2:54 PM Page 131 failure by decentralization analysts to understand the nature and relevance of these characteristics can result in inappropriate and unworkable reform efforts. In what follows I briefly summarize key aspects of fiscal decentralization, outline common constraints on reform, and highlight the role of context in designing it. I then selectively review a few cases in which relative progress has been made, illustrating how context matters and suggesting how to improve linkages among fiscal, political, and institutional reform. The immediate challenge is often how to initiate a viable path to sustainable reform in complex and diverse environments. Fiscal Decentralization and Subnational Fiscal Structures Several key elements are considered necessary for an effective intergovernmental fiscal system.2 They have traditionally been treated in a very standardized way, with a focus on normatively desirable design. Recently there has been more explicit—although as argued below, inadequate—recognition of the need to focus more on implementation. Role of Subnational Governments: Decentralization of Functions and Revenues Decentralization is expected to improve efficiency in resource use because residents in each subnational government can choose the mix of public services and revenues that best meets their preferences. Thus many services, except those more efficiently provided at a larger scale or that generate externalities, should be subnational functions.3 Countries generally follow this basic logic, but there is often vagueness in service assignment. Recent reform efforts have focused on how to work out operational details. Principles for revenue decentralization are also well defined; for example, the revenue bases for subnational governments should be relatively immobile, should not compete with central bases, and should establish a link between payments and benefits.4 Many developing countries do often follow these principles. Public finance specialists typically advocate a variety of own-source revenues for subnational governments, including property taxes, user charges, and various licenses and fees. But assigned revenues invariably fail to match expenditure needs, subnational governments commonly use too many unproductive revenues, and they tax bases already taxed by higher levels. In addition, some sources suffer from design flaws, such as stagnant bases, complex structures, and ineffective administration. Thus there has been a move toward consolidation, harmonization , and restructuring of subnational government revenue sources. Offsetting Fiscal Imbalances: The Intergovernmental Transfer System Most countries use intergovernmental transfers, which help to cover fiscal imbalances or revenue inadequacy at the subnational level. They also serve redistribu132 paul smoke 10491-08_Ch08.qxd 5/3/07 2:54 PM Page 132 tional objectives, reducing fiscal capacity differences, and they can encourage expenditures on national priority services. Most transfer systems are intended, at least officially, to meet these objectives, but several design issues commonly plague developing countries.5 A key concern is the need for a stable transfer pool to allow medium-term planning for subnational government service delivery; however, fiscal problems can be created if a large percentage of central resources is guaranteed to these governments . Thus there is a need to balance these two concerns. Another challenge is adopting an appropriate mix—conditional transfers encourage expenditures on national priorities, while unconditional transfers...


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