## _wp05130

## Source details

**Canonical URL:** [_wp05130](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05130.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05130.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05130.pdf.json)

---

### I. OBJECTIVES AND CONTEXT
- Grants instruments vary by context and depend on the extent subnational administrations have access to adequate own-source revenues relative to their constitutional or assigned responsibilities.
- Political economy considerations play a significant role in the design of grants systems; poorly designed grants can harm incentives for efficient public finance management and macroeconomic outcomes.
- Multiple, sometimes conflicting, goals of grants:
  - equity considerations and reduction (or elimination) of vertical and horizontal imbalances;
  - correction of spillovers;
  - implementation of centrally determined standards for public services;
  - enhancement of tax effort and expenditure efficiency.
- Typical instrument mix:
  - revenue sharing for vertical imbalances;
  - general-purpose (unconditional) grants for horizontal disparities;
  - special-purpose (conditional) grants for national priorities and efficiency-enhancing goals.
- Focus of the paper: transfer instruments and their implementation; complements Boadway’s analysis of efficiency and equity in transfer design.

Equalization transfers or transfers to individuals
- Argument: avoid equalizing personal incomes across regions; instead aim to facilitate provision and access to public services by subnational governments at similar levels of tax effort.
- Special-purpose grants (SPPs) can address some distributional objectives (e.g., pensions, family allowances, unemployment assistance) but excessive reliance on SPPs may circumscribe subnational decision making.

### II. LEGAL AND INSTITUTIONAL FRAMEWORK FOR TRANSFERS
- Legal embedding:
  - Transfer design often enshrined in constitutions or higher laws; details set out in regulations or pronouncements.
  - Constitutions may provide for periodic assessments (example: Indian and South African quinquennial assessments by dedicated Finance Commissions).
  - Overly detailed constitutional specifications (for example, formulae or floors) can create undesirable rigidity for macroeconomic adjustment.
- Specific legislation:
  - Framework legislation used to support decentralization; supplemented by annual budget laws and specific laws for SPPs.
- Institutions:
  - When vertical imbalance in favor of center is small, central government has little scope to redress horizontal imbalances.
  - Where vertical imbalance favors center, checks and balances and predictable transfer design are important to assure subnational fairness.

### III. TYPOLOGY OF TRANSFERS
- Gap-filling transfers:
  - Finance deficits between own-revenues and spending; if unrestricted, remove effective budget constraint and incentives to manage spending and raise revenues (historical prevalence in South Asia).
- Revenue sharing:
  - Used to offset vertical imbalances (example: VAT sharing in Germany on per capita basis).
  - Origin-based sharing (example: China) can exacerbate horizontal inequalities.
- Special-purpose grants (SPPs):
  - Conditional, open-ended or close-ended; may include matching requirements.
  - Matching grants can induce effort but may distort spending elsewhere; in Denmark matching grants were criticized for greater spending and additional taxation.
  - Excessive earmarking reduces subnational accountability; trend in developed countries toward looser sectoral conditionality/block grants.
  - Monitoring weaknesses in developing countries can render SPPs ineffective or distort local accountability.
- Equalization transfers:
  - Observed approaches:
    - equalization over revenues (Representative Tax System, RTS; Canada historically);
    - equalization over needs (South Africa: provinces raise about 5 percent of their revenues; use of “cost-based” approach advocated by Financial and Fiscal Commission (FFC));
    - combined revenue capacities and expenditure needs (Australia, Denmark, China, Ethiopia).
  - Considerations:
    - revenue-only equalization may ignore cost differences of service provision;
    - needs-only equalization may weaken budget constraints and discourage efficiency;
    - combined approach aims to equalize capacity to provide comparable access at similar revenue effort but is more complex and less transparent.

### IV. MECHANISMS FOR THE DETERMINATION OF EQUALIZATION GRANTS
- Objectives of unconditional grants: allow beneficiary governments to provide comparable levels of public services given relative financing capacity, accounting for service costs and demand (need).
- Rationale for separating recurrent and capital transfers in low- and middle-income countries to address capital stock backlogs.
- Design principles:
  - transparent formulae;
  - indicators should not reflect discretionary recipient policy choices (to avoid perverse incentives).
  - use of expenditure-needs and revenue-capacity frameworks promotes efficiency, accountability, and known vertical allocation basis.
- Magnitude of grants:
  - pool size must be related to fiscal capacity inequalities;
  - countries often target less than “full” equalization; legislative floors exist (example: Indonesia 1999 law guaranteeing at least 25 percent of total central government revenue to lower levels).
- Minimum standards:
  - choice between input-based standards (for example, teacher/pupil ratios) and output/outcome-based standards; input-based standards are more commonly applied given data and management constraints.
- General model for equalization grants (as presented in the source):
  - G_i = E_i^s − R_i^s  (equation (1))
    - E_i^s represents relative expenditure needs of region i;
    - R_i^s represents own-revenue raising capacity relative to a “standard.”
  - Decomposition of expenditure needs:
    - population and factor adjustments presented in the source (presentation includes P, E, P_s terms and factors v_i);
    - v_i defined as v_i = (u_i . s_i . d_i . e_i − 1)  (equation (3))
      - u_i = differential coverage of the population eligible for services relative to the total population;
      - s_i = differential costs arising out of “scale” factors;
      - d_i = differential costs arising out of concentration or dispersion of the eligible population;
      - e_i = differences in cost arising out of social, physical and economic factors.
  - Own revenue capacity:
    - presented in the source using q_i and relations between Yi and Ys (equations (4) and (5) in the source).
  - Treatment of SPPs and tax sharing:
    - equation (6) in the source expands equation (1) to account for differential SPPs and shared taxes (presentation retained in the source).
    - Shared central tax shares can be treated either as part of own revenues (and equalized) or as nonequalizing grants deducted from resources available when assessing fiscal capacity.
  - Fiscal effort adjustment:
    - optional adjustment reducing entitlement if actual own-source collections fall short of capacity, or increasing it if collections exceed standard; can be limited to penalties (negative adjustments) only.
  - Phasing-in:
    - use indicative standards versus historically determined standard during structural change; regions already above indicative standards may be left at actual standard while equalization is phased in.

### V. INSTITUTIONAL CONSIDERATIONS
- Institutional arrangements:
  - Options: independent, arm’s length commissions (for example, Australia’s Grants Commission, India’s Finance Commissions) or Ministry of Finance-led processes; hybrid options possible (Ministry sets envelope; independent agency decides relative distribution).
  - Key design features for independent agency:
    - members beyond reproach, not representing specific recipients;
    - politicians set rules but should not change recommended distributions to favor interest groups.
  - Ministry of Finance advantages:
    - access to cooperation, data, and macroeconomic control; better placed to judge macroeconomic stability implications.
  - Transparency and participation by subnational governments are critical to acceptance.
- Australia Grants Commission practice highlights (examples of consultative and transparent processes):
  - simultaneous discussion papers to states and national treasury;
  - successive rounds of submissions;
  - conferences for exchange among experts;
  - visits to states and service providers;
  - simultaneous report distribution and extensive working papers, software for alternative calculations;
  - public conferences and free reports/working paper extracts.
- Information and data requirements:
  - Two data types: recipient accounts; assessments of expenditure needs and revenue capacities.
  - Prefer audited past period data to avoid biases.
  - Desirable attributes of assessment data:
    - available for each unit of government or acceptable proxies;
    - comparable across units;
    - sourced to an independent authority where possible;
    - updated annually or at known frequency (for example, national census).
  - Revenue assessments should be tailored to legislative revenue bases; where direct measures absent, proxies like GDP per capita may be used cautiously.
  - Expenditure needs assessments: demand-side data (for example, counts of school-age children, elderly) more readily available than unit-cost differentials.
  - Reality checks prior to finalizing assessments are important to justify detrimentally affected regions and preserve transparency.

### VI. CONCLUSIONS
- Grant system design and instrument mix reflect constitutional, institutional, political constraints, and the division of responsibilities and resources.
- Magnitude of grants should be determined by overall fiscal sustainability for “general government”; distribution across regions often shaped by political economy.
- Special-purpose grants remain important for central objectives but can foster game-playing, monitoring shortfalls, and adverse horizontal effects, especially with matching conditions.
- A combination of revenue capacities and expenditure needs is often preferable to enhance fairness and incentives for effective resource use; the first design question is whether assessments should cover both elements.
- Appropriate approaches to measuring regional differences evolve as data and information systems improve; flexibility in design is important as fiscal policy and circumstances change.
- Cooperative administration involving subnational interests minimizes arbitrariness; choice between Ministry of Finance and independent commission depends on country circumstances.

*Source: _wp05130 - References..............................................................................................................*

### References..............................................................................................................

### _wp05130 - References..............................................................................................................

### I. OBJECTIVES AND CONTEXT
- Grants instruments vary by context and depend on the extent subnational administrations have access to adequate own-source revenues relative to their constitutional or assigned responsibilities.
- Political economy considerations play a significant role in the design of grants systems; poorly designed grants can harm incentives for efficient public finance management and macroeconomic outcomes.
- Multiple, sometimes conflicting, goals of grants:
  - equity considerations and reduction (or elimination) of vertical and horizontal imbalances;
  - correction of spillovers;
  - implementation of centrally determined standards for public services;
  - enhancement of tax effort and expenditure efficiency.
- Typical instrument mix:
  - revenue sharing for vertical imbalances;
  - general-purpose (unconditional) grants for horizontal disparities;
  - special-purpose (conditional) grants for national priorities and efficiency-enhancing goals.
- This paper focuses on transfer instruments and their implementation and complements Boadway’s analysis of efficiency and equity in transfer design.

### Equalization transfers or transfers to individuals?
- Argument against equalizing personal incomes across regions; instead:
  - a defensible objective is to facilitate provision and access to public services by subnational governments at similar levels of tax effort.
  - special-purpose grants can meet some distributional objectives (e.g., pensions, family allowances, unemployment assistance) but excessive reliance on SPPs may circumscribe subnational decision making.

### II. LEGAL AND INSTITUTIONAL FRAMEWORK FOR TRANSFERS
- Legal embedding:
  - Transfer design often enshrined in constitutions or higher laws; details in regulations or pronouncements.
  - Constitutions may provide for periodic assessments (e.g., Indian and South African quinquennial assessments by dedicated Finance Commissions).
  - Overly detailed constitutional specifications (e.g., formulae or floors) can create undesirable rigidity for macroeconomic adjustment.
- Specific legislation:
  - Used to support decentralization (examples include Indonesia, France, Peru).
  - Framework legislation supplemented by annual budget laws and specific laws for SPPs.
- Institutions:
  - When vertical imbalance in favor of center is small, central government has little scope to redress horizontal imbalances.
  - Where vertical imbalance favors center, checks and balances and predictable transfer design are important to assure subnational fairness.

### III. TYPOLOGY OF TRANSFERS
- Gap-filling transfers:
  - Finance deficits between own-revenues and spending; if unrestricted, remove effective budget constraint and incentives to manage spending and raise revenues (historical prevalence in South Asia).
- Revenue sharing:
  - Used to offset vertical imbalances (e.g., VAT sharing in Germany on per capita basis).
  - Origin-based sharing (e.g., China) can exacerbate horizontal inequalities.
- Special-purpose grants (SPPs):
  - Conditional, open-ended or close-ended; may include matching requirements.
  - Matching grants can induce effort but may distort spending elsewhere; in Denmark criticized for greater spending and additional taxation.
  - Excessive earmarking reduces subnational accountability; trend in developed countries toward looser sectoral conditionality/block grants.
  - Monitoring weaknesses in developing countries can render SPPs ineffective or distort local accountability.
- Equalization transfers:
  - Approaches observed:
    - equalization over revenues (Representative Tax System, RTS; Canada historically);
    - equalization over needs (South Africa: provinces raise about 5 percent of their revenues; use of “cost-based” approach advocated by Financial and Fiscal Commission (FFC));
    - combined revenue capacities and expenditure needs (Australia, Denmark, China, Ethiopia).
  - Considerations:
    - revenue-only equalization may ignore cost differences of service provision;
    - needs-only equalization may weaken budget constraints and discourage efficiency;
    - combined approach aims to equalize capacity to provide comparable access at similar revenue effort but is more complex and less transparent.

### IV. MECHANISMS FOR THE DETERMINATION OF EQUALIZATION GRANTS
- Objectives of unconditional grants: allow beneficiary governments to provide comparable levels of public services given relative financing capacity, accounting for service costs and demand (need).
- Rationale for separating recurrent and capital transfers in low- and middle-income countries to address capital stock backlogs.
- Design principles:
  - transparent formulae;
  - indicators should not reflect discretionary recipient policy choices (to avoid perverse incentives).
  - use of expenditure-needs and revenue-capacity frameworks promotes efficiency, accountability, and known vertical allocation basis.
- Magnitude of grants:
  - pool size must be related to fiscal capacity inequalities;
  - countries often target less than “full” equalization; legislative floors exist (example: Indonesia 1999 law guaranteeing at least 25 percent of total central government revenue to lower levels).
- Minimum standards:
  - choice between input-based standards (e.g., teacher/pupil ratios) and output/outcome-based standards; input-based standards are more commonly applied given data and management constraints.
- General model for equalization grants:
  - G_i = E_i^s − R_i^s   (equation (1))
    - E_i^s represents relative expenditure needs of region i;
    - R_i^s represents own-revenue raising capacity relative to a “standard.”
  - Decomposition of expenditure needs:
    - P E = E_i^s P_s / P_s ??? (presentation in source—see equations below)
    - P_E_P: P_i = population of region i, E_s/P_s average expenditure standard, v_i represents factors such as:
      - u_i = differential coverage of the population eligible for services relative to the total population;
      - s_i = differential costs arising out of “scale” factors;
      - d_i = differential costs arising out of concentration or dispersion of the eligible population;
      - e_i = differences in cost arising out of social, physical and economic factors.
    - v_i = (u_i . s_i . d_i . e_i − 1)   (equation (3))
  - Own revenue capacity:
    - q P R P = R_i^s s_i P_s / P_s ??? (presentation in source—see equations below)
    - q_i = differential revenue raising capacity of region i (Yi and Ys relations; see equations (4) and (5)).
  - Treatment of SPPs and tax sharing:
    - Expand equation (1) to account for differential SPPs and shared taxes:
      - σ_i^s s_i P_O − q P R . P v . P E . P = G_i −  (equation (6)) (presentation in source).
    - Shared central tax shares can be treated either as part of own revenues (and equalized) or as nonequalizing grants deducted from resources available when assessing fiscal capacity.
  - Fiscal effort adjustment:
    - Optional adjustment reducing entitlement if actual own-source collections fall short of capacity, or increasing it if collections exceed standard; can be limited to penalties (negative adjustments) only.
  - Phasing-in:
    - Use indicative standards versus historically determined standard during structural change; handling of regions already above indicative standards by leaving them at actual standard while phasing in equalization.

### V. INSTITUTIONAL CONSIDERATIONS
- Institutional arrangements:
  - Options include independent, arm’s length commissions (e.g., Australia’s Grants Commission, India’s Finance Commissions) or Ministry of Finance-led processes; hybrid options possible (Ministry sets envelope; independent agency decides relative distribution).
  - Key design features for independent agency:
    - members beyond reproach, not representing specific recipients;
    - politicians set rules but should not change recommended distributions to favor interest groups.
  - Ministry of Finance advantages:
    - access to cooperation, data, and macroeconomic control; better placed to judge macroeconomic stability implications.
  - Transparency and participation by subnational governments are critical to acceptance.
- Australia Grants Commission practice highlights (examples of consultative and transparent processes):
  - simultaneous discussion papers to states and national treasury;
  - successive rounds of submissions;
  - conferences for exchange among experts;
  - visits to states and service providers;
  - simultaneous report distribution and extensive working papers, software for alternative calculations;
  - public conferences and free reports/working paper extracts.
- Information and data requirements:
  - Two data types: recipient accounts; assessments of expenditure needs and revenue capacities.
  - Prefer audited past period data to avoid biases.
  - Desirable attributes of assessment data:
    - available for each unit of government or acceptable proxies;
    - comparable across units;
    - sourced to an independent authority where possible;
    - updated annually or at known frequency (e.g., national census).
  - Revenue assessments should be tailored to legislative revenue bases; where direct measures absent, proxies like GDP per capita may be used cautiously.
  - Expenditure needs assessments: demand-side data (e.g., counts of school-age children, elderly) more readily available than unit-cost differentials.
  - Reality checks prior to finalizing assessments are important to justify detrimentally affected regions and preserve transparency.

### VI. CONCLUSIONS
- Grant system design and instrument mix reflect constitutional, institutional, political constraints, and the division of responsibilities and resources.
- Magnitude of grants should be determined by overall fiscal sustainability for “general government”; distribution across regions often shaped by political economy.
- Special-purpose grants remain important for central objectives but can foster game-playing, monitoring shortfalls, and adverse horizontal effects, especially with matching conditions.
- A combination of revenue capacities and expenditure needs is often preferable to enhance fairness and incentives for effective resource use; the first design question is whether assessments should cover both elements.
- Appropriate approaches to measuring regional differences evolve as data and information systems improve; flexibility in design is important as fiscal policy and circumstances change.
- Cooperative administration involving subnational interests minimizes arbitrariness; choice between Ministry of Finance and independent commission depends on country circumstances.

*Source: _wp05130 - References..............................................................................................................*

### References

### _wp05130 - References

### Edited volumes and books
- Ahmad, Ehtisham, 1993, “Poverty, Demographic Structure and Social Protection Policy,” in On the Role of Budgetary Policy during Demographic Changes, ed. by B. Wolfe, Public Finance, Vol. 48.
- Ahmad, Ehtisham, ed., 1997, Financing Decentralized Expenditures, an International Comparison of Grants (Cheltenham, United Kingdom; Brookfield, Vermont: Edward Elgar).
- Ahmad, Ehtisham, Gao Qiang, and Vito Tanzi, eds., 1995, Reforming China’s Public Finances (Washington: International Monetary Fund).
- Ahmad, Ehtisham, and Vito Tanzi, eds., 2002, Managing Fiscal Decentralization (London: Routledge).
- Ahmad, Ehtisham, and Giorgio Brosio, Handbook of Fiscal Federalism (Cheltenham, United Kingdom; Brookfield, Vermont: Edward Elgar) (forthcoming).
- Ter-Minassian, Teresa, eds.,1997, Fiscal Federalism in Theory and Practice (Washington: International Monetary Fund).

### IMF and related working papers, chapters, and policy pieces
- Ahmad, Ehtisham, and Eric Mottu, 2003, “Oil Revenue in Federal Systems: Issues and Country Experience,” in Fiscal Policy Formulation and Implementation in Oil Producing Countries, ed. by J. Davis, R. Ossowski, and A. Fedelino (Washington: International Monetary Fund).
- Ahmad, Ehtisham, Mario Fortuna, and Raju Singh, 2004, “Towards More Effective Redistribution: Reform Options for Intergovernmental Fiscal Relations in China,” IMF Working Paper 04/98 (Washington: International Monetary Fund).
- Brosio, G., 1995, “Local Taxation in an International Context,” in Reforming China’s Public Finances, ed. by Ehtisham Ahmad, Gao Qiang, and Vito Tanzi (Washington: International Monetary Fund).
- Shah, Anwar, 1995, “Theory and Practice of International Transfers,” in Reforming China’s Public Finances, ed. by Ehtisham Ahmad, Gao Qiang, and Vito Tanzi (Washington: International Monetary Fund).

### Country studies, equalization, grants, and fiscal relations
- Aubut, Julie, and Robert Sample, “Decentralization: the Canadian Experience,” in Managing Subnational Fiscal Operations, ed. by Ehtisham Ahmad and others (Washington: International Monetary Fund) (forthcoming).
- Boadway, R, “Intergovernmental Transfers and Equity,” in Handbook of Fiscal Federalism, ed. by Ehtisham Ahmad and Giorgio Brosio (Cheltenham, United Kingdom; Brookfield, Vermont: Edward Elgar) (forthcoming).
- Boadway, R., and P. Hobson, 1993, Intergovernmental Fiscal Relations in Canada (Toronto: Canadian Tax Foundation).
- Clark, Douglas H., 1997, “The Fiscal Transfer System in Canada,” in Financing Decentralized Expenditures, an International Comparison of Grants, ed. by Ehtisham Ahmad (Cheltenham, United Kingdom; Brookfield, Vermont: Edward Elgar).
- Commonwealth Grants Commission, 2004, Report on State Revenue Sharing Relativities, 2004 Review (Commonwealth of Australia).
- Commonwealth Grants Commission, Report on State Revenue Sharing Relativities, 2004 Review, Supporting Information (Commonwealth of Australia).
- Govinda, Rao, 2002, “Fiscal Decentralization in Indian Federalism,” in Ahmad and Tanzi (2002).
- Levtchenkova, S., and J. Petchey, “A Model for Public Infrastructure Equalization,” in Challenges in the Design of Fiscal Equalization and Intergovernmental Transfers, ed. by J. Martinez-Vazquez, R. Bahl, and R. Searle, forthcoming.
- Lotz, J., 1997, “Denmark and Other Scandinavian Countries: Equalization and Grants,” in E. Ahmad (ed.), 1997.
- Lotz, J., 2005, Danish Grant Policy: How Best to Influence Local Authority Behavior, (Copenhagen: Ministry of Finance).
- Searle, R., Federal Fiscal Relations in Australia—2001, 2002, ICER Working Paper No. 01/2002 (Torino, Italy: International Centre for Economic Research).
- Searle, R., The Australian Fiscal Equalisation System and Capital Transactions, the Final Step, 2002, ICER Working Paper No. 02/2002 (Torino, Italy: International Centre for Economic Research).
- Searle, R., 2004, “Revenue Sharing, Natural Resources and Fiscal Equalization,” in Challenges in the Design of Fiscal Equalization and Intergovernmental Transfers, ed. by J. Martinez-Vazquez, R. Bahl, and R. Searle.

*Source: _wp05130 - References*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05130.pdf_