## Vertical Fiscal Gap and Decentralization Mismatch

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### Introduction: role and risks of fiscal decentralization
- Fiscal decentralization can contain public sector growth and improve efficiency by:
  - bringing taxpayers and policymakers into closer proximity, enhancing accountability;
  - allowing local politicians to tailor policies to constituents; and
  - encouraging competition among jurisdictions that may drive cost-efficient delivery of public goods.
- Fiscal decentralization can also create macro-fiscal risks:
  - common-pool transfers may induce subnational overspending and moral hazard;
  - duplication and unclear assignment of functions can weaken accountability and lower service quality;
  - central government may be unable to monitor devolved tax bases and spending, risking excess subnational spending.
- Designing intergovernmental fiscal frameworks requires balancing taxation, spending assignments, transfers, borrowing controls, and institutional arrangements.

### Key concepts: vertical fiscal gap and vertical balance
- Vertical fiscal gap (VFG):
  - describes the financing structure of decentralization: the degree to which subnational governments rely on their own revenues to finance assigned spending.
  - typically equals the shortfall of subnational own-revenues relative to subnational spending (covered mostly by central transfers and possibly borrowing).
- Vertical fiscal balance:
  - achieved when transfers plus subnational own revenues (and borrowing) are sufficient to finance subnational expenditure responsibilities—i.e., transfers are adequate so spending mandates are neither underfunded nor overfunded.
  - inherently judgmental because it depends on what is considered the appropriate level of subnational expenditure and own-revenue effort.
- Distinction and interaction:
  - A system can have a large VFG but still be in vertical balance if transfers adequately finance mandates.
  - Conversely, an “optimal” VFG in efficiency terms can coexist with vertical imbalance if transfers are insufficient.

### Stylized facts on vertical gaps and decentralization
- Cross-country dispersion:
  - Average vertical gap in the OECD sample was around 40 percent in 2016; it ranged from 6 to 82 percent.
  - Australia is not available in the OECD fiscal decentralization database; its vertical gap was estimated at about 50 percent in 2011 (OECD, 2014).
- Federations vs. unitary countries:
  - On average, the vertical gap is lower in federations than in unitary countries, reflecting greater state-level revenue-raising ability.
  - Examples: Canada and Switzerland tend to have relatively low VFGs; Austria has a relatively large VFG.
- Correlations:
  - The vertical gap is strongly related to revenue decentralization, while correlation with expenditure decentralization is more elusive (analysis based on OECD database, years 1995 to 2016).
- Financing structure:
  - The VFG is primarily covered through central transfers, but subnational borrowing is an important source in some countries.

### Horizontal gap and horizontal balance (subnational heterogeneity)
- Horizontal gap:
  - Jurisdiction-specific differences between expenditure needs and own-revenues due to unequal tax bases and differing service costs.
  - Equalization transfers are the main instrument to fill horizontal gaps.
- Horizontal balance:
  - Achieved when each jurisdiction’s fiscal gap is adequately financed.
  - Aggregate vertical balance can mask horizontal imbalances—some jurisdictions may be overfunded and others underfunded.
- Practical interaction:
  - Transfers intended to cover the vertical gap often contain equalization features, and equalization systems may simultaneously address vertical and horizontal gaps.

### Determinants of the vertical fiscal gap
- Political, constitutional and historical drivers:
  - Decentralization choices are often political and shaped by constitutions, history, and culture.
  - Constitutional allocation of spending and taxing powers influences the VFG but may be too general to identify an “intended” gap precisely.
- Institutional and design features:
  - Whether transfers are formula-based or discretionary affects central freedom to set VFG.
  - Revenue-sharing formulas can be constitutionally imposed, recommended by independent commissions, or negotiated.
- Order of decisions and two approaches to decentralization:
  - Approach 1 — transfers decided proactively: center chooses taxes and transfers first; subnational governments respond by adjusting tax rates.
  - Approach 2 — transfers used to fill the gap: center and subnational governments choose taxes independently; the resulting gap is then filled by central transfers (residual role).
  - Real-world systems typically combine elements of both approaches; central decisions often have dominant influence, especially where common tax bases exist.

### Subnational borrowing
- Roles and motivations:
  - Borrowing is frequently used to smooth cyclical revenue shortfalls, especially where subnational governments operate automatic stabilizers (e.g., unemployment insurance in the United States, welfare in Canada and Spain).
  - Rapid healthcare cost growth at the subnational level (e.g., population ageing) contributes to subnational deficits in highly decentralized countries.
  - Borrowing is commonly used to finance public investment; many subnational governments follow a “golden rule” allowing deficits for capital expenditure but not for current spending.
- Constraints and mitigants:
  - Rainy day funds are an underused mitigation tool; where present they may be insufficiently funded (OECD, 2016a).
  - Countercyclical transfers from the center are rare in many federations (Foremny and von Hagen, 2012; Blöchliger and Égert, 2013).

### How large should the vertical fiscal gap be? (Normative perspectives)
- Two complementary perspectives for assessing an “optimal” VFG:
  A. VFG as a residual
    - Sequential framework: assign expenditure functions → assign own revenues → close the gap with transfers and borrowing.
    - Principles guiding expenditure decentralization:
      - Subsidiarity: services should be provided by the lowest government level compatible with the benefit area.
      - Economies of scale: centrally provided programs when scale benefits or uniform provision matter.
      - Risk-sharing: social insurance and interregional insurance favor central provision.
      - Macroeconomic stabilization: preferably centralized.
    - Scope for revenue decentralization:
      - Weaker case than for expenditures.
      - Benefits of local revenue: accountability, tailoring services, resistance to soft-budget constraints when marginal revenue-raising discretion exists.
      - Disadvantages: horizontal disparities, tax competition, coordination and harmonization challenges, and weaker central stabilization capacity.
    - Result: a compromise where subnational governments finance some, but not all, spending from own revenues—optimal VFG is country-specific.
  B. VFG as the desired level of transfers and subnational borrowing
    - Financing precedes own revenue decisions: set transfers and borrowing to achieve policy objectives, then allow subnational own revenues to fill remaining needs.
    - Three purposes for transfers:
      - Equalization: level net fiscal benefits across jurisdictions to reduce horizontal inequity and inefficient migration driven by fiscal incentives.
        - Caveats: equalization targets inter-jurisdictional fiscal capacity, not interpersonal redistribution; balanced equalization requires political solidarity; revenue-based equalization can dampen local base expansion incentives; equalization should not be a primary means for financing major infrastructure.
      - Spillovers: correct for spending that generates benefits beyond jurisdictional borders (roads, higher education, environment); typically done via conditional grants with state-specific matching rates.
      - National standards: use block transfers with conditions to induce subnational compliance with minimum national equity/efficiency standards while preserving substantial subnational discretion.
    - Transfers’ perils:
      - Excessive reliance on transfers can exacerbate soft-budget constraints and reduce subnational incentives to raise own revenues.
      - Central governments may cut transfers in shocks; formula-based transfers and oversight institutions (fiscal councils, commissions) can mitigate this risk.
    - Subnational borrowing considerations:
      - Borrowing for investment is often justified (golden rule) provided: appropriate project selection, strong PFM institutions across the investment cycle, and capacity for operating and maintenance costs.
      - Financing options for investment:
        - Subnational taxes: impractical and intergenerationally inequitable for large, lumpy projects.
        - Subnational borrowing: aligns costs with beneficiaries, exposes subnational governments to market discipline, but may fail to internalize externalities.
        - Central transfers: can internalize externalities and evaluate projects, but risk common-pool overstatement and lack of tailoring; ad hoc nature reduces formula-based predictability.
      - Borrowing for current expenditure is generally unwarranted and indicates fiscal imbalance or gaming; many jurisdictions require current budgets to be balanced or in surplus.
      - Independent assessments (e.g., fiscal councils) can help distinguish legitimate investment borrowing from misuse.
  C. Combining approaches and practical strategies
    - Potential tradeoffs: decentralization of revenue vs. ensuring national standards.
    - Practical strategies:
      - Prioritize decentralization objectives and calibrate VFG accordingly.
      - Policy sequencing matters: newly decentralizing countries may emphasize expenditure/revenue assignments first; mature systems may focus on transfer design.
      - Use both approaches sequentially: define desired expenditure/revenue splits (approach A), then assess transfers against equalization, spillover, and national standards criteria (approach B) and adjust assignments if needed.

### How should the vertical and horizontal gaps be covered? (transfer design principles)
- The VFG and horizontal gaps require a coherent mix of transfers, each designed for distinct objectives (equalization, spillovers, national standards), recognizing that in practice many transfers serve both vertical and horizontal purposes simultaneously.
- Transfer design should consider:
  - Balance between formula-based and discretionary components (formulas protect predictability but can be adjusted);
  - Use of conditional grants for spillovers and targeted objectives with state-specific matching rates;
  - Block transfers with broad, minimally intrusive conditions to achieve national standards while preserving decentralization benefits;
  - Equalization systems to address horizontal gaps while being mindful of political feasibility and potential disincentives for base expansion.
- Institutional complements:
  - Fiscal councils or commissions and clearer fiscal rules can strengthen commitments and oversight of transfer policies.

### Box 1. Taxonomy of Intergovernmental Transfers — key distinctions and mechanisms
- Overview: key distinctions in transfer design
  - Transfers financed from the central budget versus revenue-sharing scheme.
  - Purpose and conditionality: general-purpose, block, specific; unconditional versus conditional.
  - Allocation and discretion: formula-based versus discretionary; non-matching versus matching transfers.
- A. Revenue-Sharing
  - Revenue-sharing schemes allocate a share of revenues from particular taxes to subnational governments.
  - Example magnitudes: subnational share can be roughly half of personal and corporate income taxes and VAT revenues in Germany, and reach as high as 100 percent in the case of the Australian GST.
  - Three common allocation methods for the subnational share:
    - Principle of derivation (allocation where taxes are collected).
    - Equal per capita allocation.
    - Purposeful formula (equalization formula).
  - Key differences and risks:
    - Revenue-sharing subjects subnational budgets to business-cycle fluctuations; formula-based central transfers tend to shift risk to the central government.
- B. General-Purpose Transfers
  - Purpose: finance the vertical fiscal gap.
  - Equalization transfers:
    - Revenue equalization (representative tax system, RTS).
    - Expenditure equalization (accounting for needs and costs).
    - Macro-based equalization where data limits RTS/expenditure methods.
    - Full versus partial equalization; determination of equalization pool size.
    - Incentive effects and design considerations (minimizing manipulation and rewarding tax effort is difficult).
    - Response to shocks: formula-based equalization provides insurance; structural changes may be phased in.
- C. Block Transfers
  - Support broad subnational expenditure programs; conditions can be broad.
  - Trade-offs between specificity and subnational discretion.
  - Unconditional block transfers that are equal per capita and financed from central revenues are fully revenue equalizing by definition.
- D. Specific Transfers
  - Target specific programs or one-off infrastructure.
  - Recurrent program transfers can be phased into block/general transfers as programs mature.
  - Infrastructure transfers are appropriate for project-specific needs; O&M costs should be financed from subnational general revenues and transfers.

### How to achieve a suitable vertical fiscal balance?
- Definition: vertical fiscal balance achieved when transfers to subnational governments combined with their borrowing and own revenues are sufficient to finance their expenditure responsibilities.
- Assessment challenges:
  - No clear-cut definition of adequate levels of subnational and central public expenditures or acceptable tax effort; assessment is judgment-based and informed by indicators.
- Institutional arrangements:
  - Intergovernmental advisory councils can recommend structure and amounts of transfers, enhance transparency, and take longer-term views (examples: Commonwealth Grants Commission in Australia, Finance Commission in India). Councils are advisory; legislature decides aggregate transfers.
  - Fiscal rules and fiscal councils can mitigate soft-budget constraints and abusive central behavior if applied at the general government level; ill-designed rules can be counterproductive.
- Indicators to detect vertical imbalance:
  - Inadequate public services (e.g., number of physicians in the population, teacher-student ratios).
  - Wasteful spending (expenditure-efficiency indicators).
  - Persistent deficits of the current fiscal balance of subnational governments (current balance = government revenue − current expenditure).
  - Off-budget operations (use of special purpose entities per IMF Government Finance Statistics Manual 2014 criteria).
  - Arrears across liabilities (payments to contractors, tax refunds, debt service, wages, social benefits, pensions).
  - One-off revenue measures (asset sales, exceptional levies).
  - Bailouts: exceptional central transfers to prevent subnational insolvency.
- Interpretation:
  - Monitor indicators for each subnational entity; systemic problems indicate vertical imbalance, problems limited to some jurisdictions suggest horizontal imbalance.

### Conclusion: concepts to guide policy
- Two distinct policy questions:
  - Is the vertical structure (vertical gap) efficient?
  - Is the system in vertical balance (is the vertical gap adequately filled)?
- Independence of concepts:
  - A system can rely excessively on transfers (suboptimal vertical gap) yet provide adequate transfers to ensure fiscal balance.
  - Conversely, a system can have an efficient vertical gap but inadequate transfers, creating unfunded mandates.
- Policy aim: achieve both an optimal vertical gap and fiscal balance — essential for well-designed decentralization frameworks.
- Operational difficulty: both concepts are imprecise and require judgment informed by indirect indicators (excessive subnational borrowing, poor service quality, arrears).

### Appendix: accounting relationship between vertical fiscal gap and decentralization ratios
- Definition (as presented in the source):
  - 푉푉푉푉푉푉=1−
    푆푆푆푆푉푉 표표표표표표 푟푟푟푟푟푟푟푟표표  푟푟푟푟
    푆푆푆푆푉푉 표표표표표표 푠푠푠푠 푟푟표표 푠푠푠푠 표표푠푠
    [1]
  - with SNG own revenue = SNG spending − transfers received by SNG − SNG net borrowing; and SNG own spending = SNG spending − transfers paid by SNG.
  - Note: the VFG indicator in equation [1] imperfectly measures subnational control over financial resources because “own revenues” and “own spending” may not reflect discretion accurately.
- Link to decentralization (as presented in the source):
  - 푉푉푉푉푉푉=1−
    푟푟푟푟푟푟푟푟표표  푟푟푟푟 푠푠푟푟 푑푑푟푟표표 푑푑푟푟푑푑푑푑푠푠푑푑푑푑푑푑 푠푠표표표표
    푠푠푠푠 푟푟표표 푠푠푠푠 표표푠푠 푠푠푟푟 푑푑푟푟표표 푑푑푟푟푑푑푑푑푠푠푑푑푑푑푑푑 푠푠표표표표
    ∗
    (
    1−푉푉푉푉 푠푠푟푟 푑푑푠푠푑푑푠푠푑푑
    )
    [2]
  - where:
    - Revenue decentralization = SNG own revenue / GG revenue
    - Spending decentralization = SNG own spending / GG spending
    - GG deficit (as a share of spending) = (GG spending − GG revenue) / GG spending

*Italicized source: IMF Working Paper — “Vertical Fiscal Gap and Decentralization Mismatch” (chapter content provided).*

### References _______________________________________________________________ 42

### References _______________________________________________________________ 42

### Box
- 1.  Taxonomy of Intergovernmental Transfers ___________________________________ 26

### Figures
- 1. Vertical Fiscal Gaps Across OECD Countries __________________________________ 7
- 2. Revenue and Expenditure Decentralizations and Vertical Fiscal Gap ________________ 7
- 3. Financing Structure of Subnational Expenditure  _______________________________ 13
- 4. A Normative Model of Fiscal Decentralization ________________________________ 14
- 5. An alternative Model of Decentralization _____________________________________ 19
- 6. Typology of Transfers____________________________________________________ 26

*Source: wp18271 - References _______________________________________________________________ 42*

### 7. Vertical Fiscal Gap and Decentralization Mismatch  ____________________________ 41

### 7. Vertical Fiscal Gap and Decentralization Mismatch

### Introduction: role and risks of fiscal decentralization
- Fiscal decentralization can contain public sector growth and improve efficiency by:
  - bringing taxpayers and policymakers into closer proximity, enhancing accountability;
  - allowing local politicians to tailor policies to constituents; and
  - encouraging competition among jurisdictions that may drive cost-efficient delivery of public goods.
- Fiscal decentralization can also create macro-fiscal risks:
  - common-pool transfers may induce subnational overspending and moral hazard;
  - duplication and unclear assignment of functions can weaken accountability and lower service quality;
  - central government may be unable to monitor devolved tax bases and spending, risking excess subnational spending.
- Designing intergovernmental fiscal frameworks requires balancing taxation, spending assignments, transfers, borrowing controls, and institutional arrangements.

### Key concepts: vertical fiscal gap and vertical balance
- Vertical fiscal gap (VFG):
  - describes the financing structure of decentralization: the degree to which subnational governments rely on their own revenues to finance assigned spending.
  - typically equals the shortfall of subnational own-revenues relative to subnational spending (covered mostly by central transfers and possibly borrowing).
- Vertical fiscal balance:
  - achieved when transfers plus subnational own revenues (and borrowing) are sufficient to finance subnational expenditure responsibilities—i.e., transfers are adequate so spending mandates are neither underfunded nor overfunded.
  - inherently judgmental because it depends on what is considered the appropriate level of subnational expenditure and own-revenue effort.
- Distinction and interaction:
  - A system can have a large VFG but still be in vertical balance if transfers adequately finance mandates.
  - Conversely, an “optimal” VFG in efficiency terms can coexist with vertical imbalance if transfers are insufficient.

### Stylized facts on vertical gaps and decentralization
- Cross-country dispersion:
  - Average vertical gap in the OECD sample was around 40 percent in 2016; it ranged from 6 to 82 percent.
  - Australia is not available in the OECD fiscal decentralization database; its vertical gap was estimated at about 50 percent in 2011 (OECD, 2014).
- Federations vs. unitary countries:
  - On average, the vertical gap is lower in federations than in unitary countries, reflecting greater state-level revenue-raising ability.
  - Examples: Canada and Switzerland tend to have relatively low VFGs; Austria has a relatively large VFG.
- Correlations:
  - The vertical gap is strongly related to revenue decentralization, while correlation with expenditure decentralization is more elusive (analysis based on OECD database, years 1995 to 2016).
- Financing structure:
  - The VFG is primarily covered through central transfers, but subnational borrowing is an important source in some countries.

### Horizontal gap and horizontal balance (subnational heterogeneity)
- Horizontal gap:
  - Jurisdiction-specific differences between expenditure needs and own-revenues due to unequal tax bases and differing service costs.
  - Equalization transfers are the main instrument to fill horizontal gaps.
- Horizontal balance:
  - Achieved when each jurisdiction’s fiscal gap is adequately financed.
  - Aggregate vertical balance can mask horizontal imbalances—some jurisdictions may be overfunded and others underfunded.
- Practical interaction:
  - Transfers intended to cover the vertical gap often contain equalization features, and equalization systems may simultaneously address vertical and horizontal gaps.

### Determinants of the vertical fiscal gap
- Political, constitutional and historical drivers:
  - Decentralization choices are often political and shaped by constitutions, history, and culture.
  - Constitutional allocation of spending and taxing powers influences the VFG but may be too general to identify an “intended” gap precisely.
- Institutional and design features:
  - Whether transfers are formula-based or discretionary affects central freedom to set VFG.
  - Revenue-sharing formulas can be constitutionally imposed, recommended by independent commissions, or negotiated.
- Order of decisions and two approaches to decentralization:
  - Approach 1 — transfers decided proactively: center chooses taxes and transfers first; subnational governments respond by adjusting tax rates.
  - Approach 2 — transfers used to fill the gap: center and subnational governments choose taxes independently; the resulting gap is then filled by central transfers (residual role).
  - Real-world systems typically combine elements of both approaches; central decisions often have dominant influence, especially where common tax bases exist.

### Subnational borrowing
- Roles and motivations:
  - Borrowing is frequently used to smooth cyclical revenue shortfalls, especially where subnational governments operate automatic stabilizers (e.g., unemployment insurance in the United States, welfare in Canada and Spain).
  - Rapid healthcare cost growth at the subnational level (e.g., population ageing) contributes to subnational deficits in highly decentralized countries.
  - Borrowing is commonly used to finance public investment; many subnational governments follow a “golden rule” allowing deficits for capital expenditure but not for current spending.
- Constraints and mitigants:
  - Rainy day funds are an underused mitigation tool; where present they may be insufficiently funded (OECD, 2016a).
  - Countercyclical transfers from the center are rare in many federations (Foremny and von Hagen, 2012; Blöchliger and Égert, 2013).

### How large should the vertical fiscal gap be? (Normative perspectives)
- Two complementary perspectives for assessing an “optimal” VFG:
  A. VFG as a residual
    - Sequential framework: assign expenditure functions → assign own revenues → close the gap with transfers and borrowing.
    - Principles guiding expenditure decentralization:
      - Subsidiarity: services should be provided by the lowest government level compatible with the benefit area.
      - Economies of scale: centrally provided programs when scale benefits or uniform provision matter.
      - Risk-sharing: social insurance and interregional insurance favor central provision.
      - Macroeconomic stabilization: preferably centralized.
    - Scope for revenue decentralization:
      - Weaker case than for expenditures.
      - Benefits of local revenue: accountability, tailoring services, resistance to soft-budget constraints when marginal revenue-raising discretion exists.
      - Disadvantages: horizontal disparities, tax competition, coordination and harmonization challenges, and weaker central stabilization capacity.
    - Result: a compromise where subnational governments finance some, but not all, spending from own revenues—optimal VFG is country-specific.
  B. VFG as the desired level of transfers and subnational borrowing
    - Financing precedes own revenue decisions: set transfers and borrowing to achieve policy objectives, then allow subnational own revenues to fill remaining needs.
    - Three purposes for transfers:
      - Equalization: level net fiscal benefits across jurisdictions to reduce horizontal inequity and inefficient migration driven by fiscal incentives.
        - Caveats: equalization targets inter-jurisdictional fiscal capacity, not interpersonal redistribution; balanced equalization requires political solidarity; revenue-based equalization can dampen local base expansion incentives; equalization should not be a primary means for financing major infrastructure.
      - Spillovers: correct for spending that generates benefits beyond jurisdictional borders (roads, higher education, environment); typically done via conditional grants with state-specific matching rates.
      - National standards: use block transfers with conditions to induce subnational compliance with minimum national equity/efficiency standards while preserving substantial subnational discretion.
    - Transfers’ perils:
      - Excessive reliance on transfers can exacerbate soft-budget constraints and reduce subnational incentives to raise own revenues.
      - Central governments may cut transfers in shocks; formula-based transfers and oversight institutions (fiscal councils, commissions) can mitigate this risk.
    - Subnational borrowing considerations:
      - Borrowing for investment is often justified (golden rule) provided: appropriate project selection, strong PFM institutions across the investment cycle, and capacity for operating and maintenance costs.
      - Financing options for investment:
        - Subnational taxes: impractical and intergenerationally inequitable for large, lumpy projects.
        - Subnational borrowing: aligns costs with beneficiaries, exposes subnational governments to market discipline, but may fail to internalize externalities.
        - Central transfers: can internalize externalities and evaluate projects, but risk common-pool overstatement and lack of tailoring; ad hoc nature reduces formula-based predictability.
      - Borrowing for current expenditure is generally unwarranted and indicates fiscal imbalance or gaming; many jurisdictions require current budgets to be balanced or in surplus.
      - Independent assessments (e.g., fiscal councils) can help distinguish legitimate investment borrowing from misuse.
  C. Combining approaches and practical strategies
    - Potential tradeoffs: decentralization of revenue vs. ensuring national standards.
    - Practical strategies:
      - Prioritize decentralization objectives and calibrate VFG accordingly.
      - Policy sequencing matters: newly decentralizing countries may emphasize expenditure/revenue assignments first; mature systems may focus on transfer design.
      - Use both approaches sequentially: define desired expenditure/revenue splits (approach A), then assess transfers against equalization, spillover, and national standards criteria (approach B) and adjust assignments if needed.

### How should the vertical and horizontal gaps be covered? (transfer design principles)
- The VFG and horizontal gaps require a coherent mix of transfers, each designed for distinct objectives (equalization, spillovers, national standards), recognizing that in practice many transfers serve both vertical and horizontal purposes simultaneously.
- Transfer design should consider:
  - Balance between formula-based and discretionary components (formulas protect predictability but can be adjusted);
  - Use of conditional grants for spillovers and targeted objectives with state-specific matching rates;
  - Block transfers with broad, minimally intrusive conditions to achieve national standards while preserving decentralization benefits;
  - Equalization systems to address horizontal gaps while being mindful of political feasibility and potential disincentives for base expansion.
- Institutional complements:
  - Fiscal councils or commissions and clearer fiscal rules can strengthen commitments and oversight of transfer policies.

*Italicized source: IMF Working Paper — “Vertical Fiscal Gap and Decentralization Mismatch” (chapter content provided).*

### Box 1.  Taxonomy of Intergovernmental Transfers

### Box 1.  Taxonomy of Intergovernmental Transfers

### Overview: key distinctions in transfer design
- Transfers financed from the central budget versus revenue-sharing scheme:
  - Central budget financing: aggregate size of transfers chosen at the discretion of the central government.
  - Revenue-sharing: aggregate transfers determined by the size of the tax base being shared and the rate of sharing; allocation among states still required.
- Purpose and conditionality:
  - General-purpose transfers: can be spent on any programs of the subnational government’s choice.
  - Block transfers: intended for a given broad area of spending (e.g., health or education).
  - Specific transfers: targeted at more specific areas or spending (e.g., highways).
  - Unconditional versus conditional: general-purpose transfers are generally unconditional; block and specific transfers are more often conditional, with specific transfers having more detailed conditions.
- Allocation and discretion:
  - Formula-based versus discretionary: formula-based allocations follow predetermined rules (can specify aggregate pool and allocation among subnational governments); discretionary allocations are chosen by the central government.
  - Non-matching versus matching: transfers may be independent of subnational spending levels (non-matching) or match subnational spending at some rate; matching can be open-ended or closed-ended; matching may instead target indicators (e.g., number of social assistance recipients, number of students completing school).

### A. Revenue-Sharing
- Definition and mechanics:
  - Revenue-sharing schemes allocate a share of revenues from particular taxes to subnational governments.
  - The share can be specified constitutionally or by the central government; shared taxes are typically broad-based (income tax or VAT).
  - Example magnitudes: subnational share can be roughly half of personal and corporate income taxes and VAT revenues in Germany, and reach as high as 100 percent in the case of the Australian GST.
  - Subnational governments cannot alter amounts received (cannot change base or rate on the shared tax).
- Similarities with transfers from central budget:
  - Funds are often unconditional and can be allocated among jurisdictions according to prescribed formulas.
- Three common allocation methods for the subnational share:
  - Principle of derivation: allocate according to where shared taxes are collected (example: allocation of state GST revenues in India). Consequence: jurisdictions with higher revenue-raising capacity receive higher per capita shared revenues, increasing horizontal disparity; larger subnational share increases disparity. Some federations equalize state funds after derivation.
  - Equal per capita allocation: aggregate subnational share allocated equally per capita (similar to Germany), redistributing from higher to lower per capita tax-base jurisdictions; moves toward per capita equalization.
  - Purposeful formula (equalization formula): aggregate share allocated based on formula combining revenue-raising capacity and expenditure needs (example: Australia) or macro-indicators.

- Key differences and risks:
  - Revenue pool size in revenue-sharing determined by total revenue collected from shared tax source; central-budget transfers can be formula-based or discretionary.
  - Revenue-sharing subjects subnational budgets to business-cycle fluctuations, creating fiscal risk for subnational governments; formula-based central transfers tend to shift risk to the central government.
  - Central government behavioral response: may rely more on non-shared tax sources if only a share is shared.

### B. General-Purpose Transfers
- Purpose: finance the vertical fiscal gap (provide financing rather than correct externalities).
- Characteristics:
  - Generally unconditional and similar to subnational own tax revenues from the recipient perspective.
  - Choice between revenue-sharing and general-purpose transfers depends on trade-offs:
    - Revenue-sharing: easier administration, predictable for subnational governments, but more procyclical, reduces central budget flexibility, can lead to regional inequalities, and may bias the central government toward non-shared taxes.
    - General-purpose transfers: generally less cyclical but less predictable (predictability can be improved if formula-based).

- Equalization transfers (to address horizontal gaps):
  - Purpose: enable comparable levels of public services at comparable tax rates across subnational governments; typically unconditional.
  - Broad approaches to equalization formulas:
    - Revenue equalization: based on ability to raise revenues; best-practice uses the representative tax system (RTS) method (applies national average tax rates to jurisdictional tax bases to compute per capita entitlements). Examples: Australia, Canada, Switzerland.
    - Expenditure equalization: estimates per capita money required to provide comparable public services, accounting for needs (demographics) and costs (wage, land costs); can be combined with revenue equalization (example: Australia).
    - Macro-based equalization: based on macro indicators (regional income or GDP, population structure, urbanization) where data limitations preclude RTS or expenditure equalization (example: India relies on macro-based approach; Switzerland combines RTS for revenue with macro-based for expenditure).
  - Full versus partial equalization:
    - Partial equalization can mean applied only to revenues or expenditures, partial compensation for below-average deficiencies, omission of some tax bases/expenditures, or gross equalization where only below-average jurisdictions receive transfers (example: Canada avoids negative payments from above-average states).
  - Determination of equalization pool size:
    - Pool can be formula-derived (e.g., gross equalization pool equals funds required to bring below-average jurisdictions to average) or exogenously determined (e.g., Australia, India determine pool first, then allocate).
  - Incentive effects and design considerations:
    - Equalization formulas should minimize incentives for subnational governments to manipulate tax bases or tax effort.
    - RTS may discourage economic development if perceived as reducing benefits; partial equalization can mitigate disincentives.
    - Rewarding tax effort is difficult due to measurement challenges.
  - Relation to other transfers:
    - Equalization effectiveness depends on all transfers taken together; revenue-sharing based on derivation can leave horizontal gaps if not equalized.
    - Block transfers that are equal per capita and financed from central revenues (Canadian case) are revenue equalizing.
    - Specific matching transfers may be equalizing if expenditure differences reflect needs.
  - Response to shocks:
    - Equalization provides insurance against idiosyncratic shocks if formula-based and stable.
    - Structural changes (e.g., population changes) may justify phasing in changes in equalization entitlements over a few years to avoid abrupt losses where spending needs remain temporarily high.

### C. Block Transfers
- Purpose: support broad subnational expenditure programs (education, health, transportation, welfare) and complement equalization transfers to close vertical and horizontal fiscal gaps.
- Conditions:
  - Conditions can be attached to encourage national-standard program design; block conditions are typically broad and vary in specificity.
  - Trade-offs: more specific conditions reduce subnational discretion and accountability and risk reducing effectiveness; broadly worded conditions are harder to enforce and rely on central government judgment.
- Compliance and dispute settlement:
  - Dispute settlement mechanisms (appeal to tribunals) can discourage preemptive central actions and incentivize agreement-seeking.
- Unconditional block transfers:
  - Allow subnational discretion and can supplement equalization; equal per capita block transfers financed from central general revenues are fully revenue equalizing by definition.
  - Allocation could account for need factors (e.g., education block transfers based on number of school-age children).

### D. Specific Transfers
- Distinguishing features:
  - Target specific programs rather than broad sectors.
  - Conditions are generally more restrictive and detailed; often contingent on spending in the supported area and may match subnational spending at a chosen rate.
- Two types: recurrent programs and one-off spending (infrastructure/public investment).
- Recurrent programs:
  - Specific transfers with program-design conditions can modify subnational incentives and encourage expansion or adoption of programs with interregional spillovers or national interest (e.g., transportation, environmental protection, social insurance).
  - As programs mature, conditions can be loosened and funding shifted to block or general transfers.
- One-off spending (infrastructure):
  - Issues in designing transfers for infrastructure:
    - Infrastructure needs vary across jurisdictions; equalization system is ill-suited for periodic, project-specific infrastructure financing.
    - Specific transfers are appropriate for financing infrastructure because: (1) they allow project-by-project discretion reflecting unique needs; (2) they can be used to incentivize strategic investments and regional development; (3) they can be deployed to address backlogs of infrastructure needs.
    - Infrastructure requires capital expenditures plus ongoing operation and maintenance (O&M) costs; O&M is preferably financed from subnational general revenues and transfers rather than specific transfers. Risk of deterioration or strategic behavior (attempts to elicit transfers) exists and reflects soft-budget constraint problems.

### How to achieve a suitable vertical fiscal balance?
- Definition: vertical fiscal balance achieved when transfers to subnational governments combined with their borrowing and own revenues are sufficient to finance their expenditure responsibilities (vertical fiscal gap covered by appropriate transfers).
- Assessment challenges:
  - No clear-cut definition of adequate levels of subnational and central public expenditures or acceptable tax effort; assessment is necessarily judgment-based and informed by indicators.
- Institutional arrangements:
  - Intergovernmental advisory councils can recommend structure and amounts of transfers, enhance transparency, and take longer-term views (examples: Commonwealth Grants Commission in Australia, Finance Commission in India). Councils are advisory; legislature decides aggregate transfers.
  - Countries without councils rely on internal government expertise.
- Country practice and decentralization effects:
  - Centralized countries: vertical balance determined more directly by central government decisions; need for built-in flexibility to adjust transfers while avoiding soft-budget constraints.
  - Decentralized countries: subnational governments have greater discretion over taxes and spending and can address vertical imbalances through their own policy changes; decentralization of revenue-raising mitigates soft-budget constraints but may also lead the center to reduce transfers when facing fiscal difficulties.
  - Fiscal rules and fiscal councils:
    - Can mitigate soft-budget constraints and abusive central behavior if applied at the general government level.
    - Ill-designed rules (e.g., rules limited to one level) can be counterproductive (example: central budget-balance rule may encourage the center to cut transfers).
- Indicators to detect vertical imbalance (tailored to country circumstances):
  - Inadequate public services: indicators of quality and access (e.g., number of physicians in the population, teacher-student ratios).
  - Wasteful spending: expenditure-efficiency indicators comparing amounts spent to outcomes (e.g., education spending vs. school enrollment ratios; health spending vs. life expectancy and infant mortality).
  - Persistent deficits of the current fiscal balance of subnational governments: current balance = government revenue − current expenditure (current expenditure excludes capital spending); persistent current deficits financed by borrowing may indicate insufficient resources for current expenditures.
  - Off-budget operations: use of special purpose entities to carry fiscal/quasi-fiscal operations without proper recording may indicate low budgeted resources (see IMF Government Finance Statistics Manual 2014 criteria).
  - Arrears: accumulation of arrears across liabilities (payments to contractors, tax refunds, debt service, wages, social benefits, pensions) can reflect vertical imbalance.
  - One-off revenue measures: sale of assets or exceptional levies indicate lack of sustainable financing.
  - Bailouts: exceptional central transfers to prevent subnational insolvency may reveal mismatches between spending needs and allocated resources.
- Interpretation of indicators:
  - Indicators should be monitored for each subnational entity; a vertical fiscal imbalance is indicated when many or most subnational governments show these problems.
  - Problems limited to some jurisdictions suggest horizontal imbalance and should be addressed by adjusting equalization.

### Conclusion: concepts to guide policy
- Two distinct policy questions:
  - Is the vertical structure (vertical gap) efficient (do transfers have adequate size and design to achieve objectives and align with optimal decentralization degrees)?
  - Is the system in vertical balance (is the vertical gap adequately filled)?
- Independence of concepts:
  - A system can rely excessively on transfers (suboptimal vertical gap) yet provide adequate transfers to ensure fiscal balance.
  - Conversely, a system can have an efficient vertical gap but inadequate transfers, creating unfunded mandates.
- Policy aim: achieve both an optimal vertical gap and fiscal balance — essential for well-designed decentralization frameworks.
- Operational difficulty: both concepts are imprecise and require judgment informed by indirect indicators (excessive subnational borrowing, poor service quality, arrears).

### Appendix: accounting relationship between vertical fiscal gap and decentralization ratios
- Definition (as presented in the source):
  - 푉푉푉푉푉푉=1−
    푆푆푆푆푉푉 표표표표표표 푟푟푟푟푟푟푟푟표표  푟푟푟푟
    푆푆푆푆푉푉 표표표표표표 푠푠푠푠 푟푟표표 푠푠푠푠 표표푠푠
    [1]
  - with SNG own revenue = SNG spending − transfers received by SNG − SNG net borrowing; and SNG own spending = SNG spending − transfers paid by SNG.
  - Note: the VFG indicator in equation [1] imperfectly measures subnational control over financial resources because “own revenues” and “own spending” may not reflect discretion accurately.
- Link to decentralization (as presented in the source):
  - 푉푉푉푉푉푉=1−
    푟푟푟푟푟푟푟푟표표  푟푟푟푟 푠푠푟푟 푑푑푟푟표표 푑푑푟푟푑푑푑푑푠푠푑푑푑푑푑푑 푠푠표표표표
    푠푠푠푠 푟푟표표 푠푠푠푠 표표푠푠 푠푠푟푟 푑푑푟푟표표 푑푑푟푟푑푑푑푑푠푠푑푑푑푑푑푑 푠푠표표표표
    ∗
    (
    1−푉푉푉푉 푠푠푟푟 푑푑푠푠푑푑푠푠푑푑
    )
    [2]
  - where:
    - Revenue decentralization = SNG own revenue / GG revenue
    - Spending decentralization = SNG own spending / GG spending
    - GG deficit (as a share of spending) = (GG spending − GG revenue) / GG spending

*Source: Box 1. Taxonomy of Intergovernmental Transfers, wp18271.*

### REFERENCES

### REFERENCES

### Full references
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*Source: wp18271 - REFERENCES*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18271.pdf_