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Fiscal Decentralization

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Practice Advice on Public Financial Management

Fiscal Decentralization (IMF) 

Summary Advice (IMF - Public Financial Management and Its Emerging Architecture): The IMF neither advocates nor discourages decentralization but instead takes the position that different types and degrees of decentralization are appropriate in different circumstances. In addition, it recognizes that once decentralization is undertaken, often for political reasons, backtracking to any substantial degree is difficult. One critical role of public financial management (PFM) reform is to help ensure that sub-national governments conscientiously execute their new responsibilities as they evolve under decentralization, but how exactly this happens will differ from case to case. The analysis highlights that more robust contextual assessment than is normally undertaken can help analysts understand the implications of country context for links between decentralization and PFM.

Summary Advice (IMF - IMF Fiscal Monitor): Given a country’s decentralization level choices, key elements of its decentralization framework could support the effective implementation of spending reforms, including, in particular, the distribution of taxing and spending responsibilities, rules governing transfers to subnational governments, and the quality of local public financial management.

Main Points (IMF - Public Financial Management and Its Emerging Architecture):

Trying to ensure that PFM and decentralization reforms are coordinated and not independently developed, as is typically the case, can yield potential benefits. Making this coordination happen, however, is not straightforward, even in the best of circumstances. A number of factors complicate the coordination of PFM and decentralization reforms, including

  •  Diffferences in the nature and objectives of PFM and decentralization
    • The commonly weak links between the two types of reforms are not difficult to understand. First, the two reforms differ somewhat in their nature. The key elements of PFM are similar for all governments and concentrate on the management of public finances and the budget process (budget preparation, approval, and execution).
    • Decentralization involves a greater variety of diverse reforms related not only to fiscal, but also to political (subnational elections and accountability) and administrative (territorial, organizational, and nonfinancial procedural) concerns. Fiscal decentralization cannot be meaningfully divorced from these other dimensions because it cannot work effectively without them.
  •  Contrasting institutional frameworks for developing reforms, and variations in the form of the intergovernmental system;
    • Decentralization reforms are more typically, although again not always, managed by other agencies, such as the ministry of local government (e.g., Kosovo and Uganda), the ministry of interior (e.g., Cambodia), or the ministry of home affairs (e.g., Indonesia). Rather than the ministry of finance or national treasury.
  • Diversity of starting points for reform;
    • Decentralization may take various forms, including deconcentration, in which subnational administrative entities report primarily to higher levels of government; delegation, in which subnational entities are contracted to perform specific functions; and devolution, in which subnational administrative entities report primarily to locally elected councils. The latter type of reform has been the preferred practice in recent years, but many countries have or aspire to a mixed system that blends these various approaches, and different levels (intermediate versus local) can be given different roles.
  • Prioritizing, timing, and sequencing of reform processes as driven by political, technical, and other considerations;
    • When considering the relationship between PFM and decentralization reforms is the relative primacy of each from the perspective of the national government and external entities supporting reform programs. On the one hand, PFM is often seen as a building block or a precondition for fiscal decentralization, the contention being that PFM reform should lead fiscal decentralization reform. The argument is that as new (or expanded) responsibilities for managing public functions and resources are assigned and shared among various levels under decentralization reform, a sound PFM system ensures that these functions and resources can be properly managed and monitored—thus contributing to the success and sustainability of decentralization itself.
    • This approach is more likely to be more feasible in countries where an orderly program of public sector reforms is being rolled out by a reform-minded government. But where decentralization was initially undertaken for broader and, from the government’s perspective, more urgent, often political, objectives, it may not be feasible to postpone subnational reforms until sound PFM reforms and systems are substantially developed. Where some key decentralization parameters are already in place when PFM reform begins, the PFM agenda would ideally at least partially respond to the decentralization agenda rather than the adaptation being fully reversed.
  • Commonly excessive focus on normatively sound design of reforms relative to pragmatic implementation;
    • Emphasizing implementation in no way minimizes the importance of using normative principles to envision and design the eventual intergovernmental system. It simply advocates framing the implementation of the desired system in the context of a well-considered process. So, for example, a key decentralization concern, such as obtaining an appropriate balance between legitimate national priorities and a degree of subnational autonomy that meets the basic requirements of decentralization, need not have a single, one-time resolution. Reformers may intend to allow significant subnational autonomy eventually, but in the early stages of reform, when subnational accountability and capacity are low, greater national control would be warranted. The issue, then, is how to prevent the system from stagnating in a centralized form that precludes subnational governments from exercising the autonomy associated with the potential benefits of decentralization.
    • One potential solution is to adopt an implementation process in which sub-national governments are allowed to exercise greater fiscal autonomy or receive additional resources as they meet certain criteria. The implications for PFM reform, for example, might be to impose greater ex ante control on subnational fiscal decisions in the early stages of decentralization. As subnational governments demonstrate improved fiscal performance, the system can evolve toward greater reliance on ex post controls.
    • If capacity and readiness vary across jurisdictions at the same level, an asymmetric approach could be used, such that entities with demonstrated capacity are allowed to move faster toward greater autonomy than peers with less capacity. Asymmetric arrangements are often well suited to larger or more advanced urban centers, which are often better prepared to take on additional responsibilities. PFM-related triggers, such as complying with specific reporting and auditing requirements, could be used to guide such processes.
    • Another type of strategic approach ties funding levels to compliance with certain financial or administrative requirements. More broadly, performance-based grants have been used in countries such as Uganda to create various broader performance and capacity-building incentives for local governments. None of these examples involves the adoption of an overall strategic approach, but the strategic elements inherent in each can provide guidance to reformers contemplating more comprehensive reforms.
  • The role of international development and financial institutions, particularly in aid-dependent countries.
    • The development partner efforts have had two particularly pronounced effects. First, they have often been the driving force behind the imbalance discussed in the preceding subsection between attention to design and attention to implementation. Although more attention is now given to implementation, few countries seem able to create strategic implementation processes and use them effectively.
    • Second, international development partners are diverse and have their own objectives and priorities. In pursuing their respective objectives, it is not uncommon for them to generate new tensions or reinforce existing tensions between government agencies in charge of various aspects of public sector reform. Development partners have occasionally pursued PFM reform with little attention to decentralization reforms being supported by other development partners or different departments of the same agency. Individual aspects of reform are difficult enough to deal with, and better coordination across reform areas is even more challenging. However, without improving coordination, the danger of wasting resources and placing reform programs on a collision course becomes even greater.

General Lessons Learned

This section highlights strategic considerations that could help analysts understand the interconnections between PFM and fiscal decentralization and how they might be improved to yield better results. Generalizations are difficult, given the diversity of context discussed in the case studies and the limited empirical evidence about what works well in practice. Still, this section offers a few simple principles for consideration, with the caveat that they involve a certain amount of simplification and need to be used and developed as appropriate for specific cases. Some of these points may appear intuitive, but despite how obvious they may seem, they are rarely adequately considered in policy circles. Even though the recommendations are general, much can be gained from this type of analysis, and those responsible for decentralization and PFM reforms have a responsibility to undertake such efforts. Further work is needed to develop a more robust framework.

First, Pay More Attention To Context When Considering How To Frame And Implement Normatively Desirable PFM And Decentralization Reforms

PFM and decentralization reforms have frequently been pursued in a way that is too heavily based on purist principles or on borrowed approaches from other countries. Moreover, the reforms have often been undertaken without an assessment of broader international experience or an in-depth diagnosis of the prevailing country-specific political and institutional context and its implications for workable subnational PFM and decentralization reform options. This was clearly the case in Uganda. Gaining an understanding of the underlying motivations for and objectives of both types of reform is crucial, as is determining which entities (across and within levels of government) will be receptive to these reforms and have the capacity to bring them to fruition.

Equally valuable is assessing whether existing PFM and subnational government systems can be reformed or whether a completely new system needs to be developed. In either case, some positive features of the existing system may be working well, but are sometimes lost as reforms and new systems are developed. Although it may be easier—and tempting—to turn the page and start new, normatively inspired reforms from square one, in practice, using and adapting existing systems may secure more rapid, more robust, and ultimately more sustainable results.

Second, As Much As Possible, Embed Technical PFM Reforms In Broader Public Sector And Decentralization Reforms

Decentralization involves a broad array of roles and reforms beyond the fiscal arena—administrative, political, and regulatory, among others. PFM reformers commonly tend to perceive technical PFM reform as a prerequisite for other reforms. For decentralization, they may even argue that no functions and resources should be given to local governments until the necessary systems, procedures, and capacity to manage them effectively are fully in place. National agencies generally have stronger technical expertise and do need to ensure that the evolving intergovernmental system follows established procedures and standards. Developing sufficient local capacity requires resources and time, suggesting an inherent tension between this overarching PFM approach and the rapid adoption of decentralization.

The normative position that PFM reform should always precede decentralization will sometimes be at odds with political reality—countries with a strong political imperative for decentralization (for example, when emerging from conflict) do not have the luxury of waiting for an ideal PFM system to be developed before advancing decentralization (as the experience of Kosovo shows). Moreover, from a local government and citizen perspective, if local governments are going to be created, they need to be doing something, even if very basic, to establish their credentials in delivering services to meet the needs of the citizens they represent. A neat, orderly, sequenced comprehensive PFM reform process in advance of empowering local governments does not meet this need, and electing and paying local councils simply to learn how to budget and keep financial records is unlikely to be politically viable and may even undermine decentralization efforts.

However, linking PFM reform to broader decentralization reform should be possible, giving local governments simpler but visible functional responsibilities early and allowing them to learn commensurate basic PFM skills. Cambodia is an example in which initial piloted (and parallel) reforms at the local level were progressively formalized and rolled out. As the system develops and capacity is enhanced, a higher level of PFM skills can be built along with the devolution of additional service functions and resources. In short, the scope and pace of decentralization could proceed in tandem with the capacity of subnational governments to perform functions assigned to them, and new PFM initiatives could be aligned and embedded in broader decentralization reforms. This is a win-win approach in which local governments are not given functions without adequate PFM safeguards but are able to perform some functions that establish their legitimacy and create a foundation for further fiscally responsible reform. The failure to adopt such an approach was one of the critical factors that led to the recentralization in Uganda.

Third, Ensure That A Well-Grounded Strategy For Pursuing Reform Programs Is In Place

Building on the notion that PFM reforms can be linked to specific functions undertaken by local governments as decentralization proceeds, such as service delivery or revenue generation, identifying the appropriate steps becomes important. A good starting point would be reforms that can be executed with a high probability of success, which may be simpler types of functions and processes, although the decision ultimately depends on the systems and capacity in a particular country.

A second step would be to build on these initial functions strategically in successive rounds of reform, subsequent to careful monitoring and assessment of initial steps. Appropriate incentives for local governments to adopt new functions and more advanced PFM processes can be usefully employed. Creative ways of structuring reforms and partnerships that hold some promise for learning and results should be sought. An example is working with spending ministries to devise plans for the progressive functional devolution in a particular sector or partnering with nongovernmental organizations or private firms in ways that assist local governments to better meet their assigned functions.

Fourth, Build Capacity Necessary For The Specific Steps Of The Implementation Strategy

Although only mentioned in passing in the preceding analysis, much capacity building in decentralization and local government PFM is generic, classroom-based training. Such training is often so different from what local government officials are used to and so poorly reinforced through subsequent support that concepts and skills taught in training courses are frequently lost or muddled when officials get back on the job. A more productive approach would be to target capacity building to the more limited functions and tasks that will be immediately used. Once these skills are mastered and institutionalized, additional skills can be developed as more significant and challenging functions and tasks are assumed. Providing periodic, on-site follow-up technical assistance can also help to keep learning on track and to deepen and reinforce skills and capacities.

In decentralization, two additional considerations must be recognized. First, as emphasized in the country cases, central government officials implementing decentralization and supporting or regulating local governments also require training to fulfill their new roles effectively.

Second, local capacity building needs to be both technical and governance oriented. Local governments must receive training to meet their functional responsibilities and maintain fiscal discipline. And citizens, elected officials, and local government staff must be trained to work with each other under new accountability relationships generated by decentralization. The best system and greatest technical capacity do not result in the expected advantages of decentralization unless the behavioral changes underpinning the attainment of these advantages occur. Local government staff, who may have previously looked to the center for direction, must learn to work effectively with elected local councils, who must be able to engage with budgeting and financial management processes and be responsive to their constituents. Similarly, citizens need to understand how local government resources are managed and accounted for. Citizens may even be involved in this process directly, through participatory planning, budgeting, or monitoring.23 The experience in Uganda highlights how failure to establish adequate accountability channels and capacity at the local level can undermine decentralization reform and require later redressing.

Fifth, Consider Innovative Mechanisms And Approaches That May Help To Facilitate Successful Implementation Of Reforms

Public sector reform tends toward standardization, but asymmetric approaches can sometimes be valuable. The possibility was noted above that decentralization and PFM reforms can be differentially targeted to specific types of local governments (e.g., large metropolitan areas versus small rural districts) or based on specific performance or capacity measurement (see Chapter 7). Local governments may also be allowed a degree of choice in defining and pursuing specific reform trajectories, so that they assume responsibility for what they agree to do rather than simply being told what to do by the center.24

Enforceable accountability mechanisms, such as central government contracts with local governments to undertake certain reforms, hold promise. Financial incentives for adoption of reforms and improvement in performance, for example, the emerging wave of compliance or performance-based grants being adopted in the developing countries referred to above, may also be used to increase the effectiveness of decentralization and subnational PFM reforms.

Sixth, Identify And Work With The Supporters And Opponents Of Reform And Take Steps To Coordinate The Various Actors

PFM and decentralization reforms are staged in a crowded arena: multiple national agencies are typically at odds, pursuing disparate agendas (often with support from different external donors). The ministry of finance is positioned to play the leading role in ensuring that subnational PFM systems are robust and adhered to even where subnational levels have substantial fiscal autonomy, but many other actors are relevant. These significant players include ministries involved in local government oversight and support as well as those in charge of civil service regulations and those responsible for ensuring that standards are met in the delivery of specific public services with national significance (such as health, education, public works, or other sectors). All of these actors need to be keenly involved in the political discourse surrounding the development of decentralization and the process of reform itself.

Given the large number of actors, the creation of effective coordination mechanisms for decentralization by itself is difficult enough and, of course, decentralization is seldom the only or most important driving force in public sector reform (Smoke, 2010). The problems caused by weak coordination of public sector reforms can be so significant, however, that the potential benefits of improving coordination mechanisms are great. 

Main Points (IMF - IMF Fiscal Monitor):

Fiscal decentralization is relevant for expenditure rationalization for at least four reasons.

  1. A large part of public expenditure is incurred by regions and municipalities. This share has trended upward in all country groups, although since the onset of the Great Recession it has leveled off in many advanced economies, mostly as a result of the large increases in countercyclical expenditure carried out by central governments.
  2. The involvement of subnational entities is essential to rationalizing and improving the quality of public services.
  3. Decentralization itself, if properly designed, can help contain public sector growth and improve spending efficiency. Decentralization creates closer proximity between taxpayers and policymakers, thereby enhancing the information available to both parties: taxpayers are in a better position to identify decision makers and sanction their performance, making them more accountable, while local politicians can better tailor policies to the preferences of their constituents. Furthermore, the competition among jurisdictions may encourage cost-efficient delivery of public goods: if the taxpayers are not satisfied with the tax-benefit mix proposed by the local authorities, they can move to another jurisdiction or use the electoral system to pressure local officials.
  4. Reforms that seek to reduce waste generated by duplication and overlap of functions are particularly warranted and beneficial in decentralized settings, where the division of responsibilities among government levels are not always well defined, and where some of the responsibilities transferred to the subnational government may continue to be carried out by the central government

A decentralized setting may, however, increase risks to the success of spending reforms, or for that matter to stronger public finances (Oates, 2006). For instance, when local governments finance expenditure from a common pool of intergovernmental transfers, they may fail to internalize the cost of expenditure and thus overspend. And the central government may find it difficult to press spending containment on local governments when—as often is the case—the local level delivers politically sensitive public services such as education, social housing, and waste management.

Empirical evidence suggests that certain key aspects of decentralized arrangements matter for spending control (IMF, 2009c). Although each framework is country specific, four main elements stand out:

  1. The distribution of spending responsibilities across government levels should be assigned to maximize service delivery efficiency. The challenge is to find the right balance between delegating responsibilities to subnational entities to benefit from the efficiency gains of decentralization while avoiding duplicating functions and dissipating limited resources. Specific programs may need to be recentralized when agency problems, negative externalities, coordination difficulties, and loss of economies of scale are too pronounced. In this regard, it is interesting to note the trend toward recentralization of health spending in several European countries (Saltman, 2008). Alternatively, countries have attempted to address these issues through a gradual increase in the average size of municipalities (either by reducing their number, or by encouraging mergers) and the creation of intermunicipal associations to jointly provide certain services.
  2. The degree of revenue autonomy of subnational governments should be optimized. Empirical evidence shows that giving sufficient revenue autonomy to subnational governments is a critical condition for the success of expenditure containment efforts. The reason is simple: subnational governments are encouraged to spend and reform efficiently when they have to tax their citizens and be accountable to them. Local tax powers generate tax competition between jurisdictions, which may foster expenditure control. Eyraud and Lusinyan (2013) show that in OECD members, the general government fiscal balance improves, on average, by 1 percent of GDP for each 10 percentage point reduction in vertical fiscal imbalance (VFI)—that is, when financing equivalent to one-tenth of subnational expenditure shifts from transfers or subnational borrowing to subnational taxes. This result is confirmed by Aldasoro and Seiferling (forthcoming) in a broader sample including emerging market economies and low-income countries. In practice, reducing VFIs may be challenging, as it requires identifying tax bases well suited for local management—some have suggested raising property taxes or introducing personal income tax surcharges (Norregaard, 1997, 2013)—and addressing many practical difficulties, including tax base mobility, higher administrative costs at the local level, and horizontal disparities in revenue-raising capacity.
  3. Improving the design of the transfer system also matters for successful spending reforms. Well-designed transfers are generally based on objective criteria, such as geographic or demographic indicators, that are out of the control of governments as far as possible. This minimizes the risk of manipulation provided that allocation formulas are simple and transparent. Output-based transfers, linking grant finance to service delivery performance, may help improve program monitoring, reporting, and management, thereby enhancing accountability for results (Boadway and Shah, 2007).
  4. Sound budget management and well-designed fiscal governance frameworks at  the subnational level are necessary (IMF, 2009c). In many countries, subnational PFM frameworks do not meet minimum adequacy standards, hindering the drive for reform. There is significant room for improvement in this area, including preparing realistic budgets, introducing effective means for audit and control, better disclosing fiscal risks, and improving transparency and reporting.

Source: IMF (2013) "Public Financial Management and Its Emerging Architecture" edited by Cangiano, M., Curristine, T., and Lazare, M. in Chapter 12: "Bridging Public Financial Management And Fiscal Decentralization Reforms In Developing Countries" authored by Fedelino, A., Smoke, P. (accessed April 24, 2014) and IMF (2014). IMF, “Public Expenditure Reform: Making Difficult Choices” IMF Fiscal Monitor, at http://www.imf.org/external/pubs/ft/fm/2014/01/pdf/fm1401.pdf (accessed 26 April 2014).

Page Created By: Matthew Seddon on 24 April 2014. The content presented on this page is drawn directly from the source(s) cited above, and consists of direct quotations or close paraphrases. This material does not necessarily reflect the official view of the publishing organization.


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