## 1. Revenue Transferred from Federal Government to States, 2006

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---

### A. Introduction and Rationale for Needs-Based Transfers
- Purpose of needs-based design:
  - establish the proper basis for special purpose transfers;
  - provide a basis for performance contracts between the center and subnational governments (actionable conditionality).
- For equalization systems, spending needs factors provide a better basis than revenue capacities alone to ensure comparable public-service provision at comparable own-tax effort.

### B. Political-Economy Context in Mexico
- Vertical imbalance:
  - almost 90 percent of states' total revenues are derived from federal transfers;
  - 65 percent for municipalities.
- Transfers represent 8.1 percent of GDP in 2006, up from 6.8 percent in 1998.
- Federal transfers include:
  - general transfers (participaciones);
  - specific transfers (aportaciones);
  - revenue from federal taxes administered and collected by the states.
- General transfers: all revenues whose use by recipient government is unconditional.

### C. Structure and Mechanics of General Transfers (Participaciones) and Related Pools
- Recaudacion Federal Participable (RFP): common pool composed of main federal taxes and petroleum revenues (personal and corporate income tax, tax on assets, VAT, excises, oil and mines), subject to some deductions.
- A share of 21.06 percent of the RFP is transferred to the states; formula components:
  - 45.17 percent of the pool distributed according to population;
  - 45.17 percent allocated on a historical basis—the previous year’s allocation—corrected by a tax effort indicator;
  - 9.66 percent allocated according to the inverse of the per capita allocations of the previous two components.
- Contingency Reserve: 0.25 of RFP; distribution compensates states that lost shares in 1991.

### D. Key Revenue Transfers and Amounts (2006; amounts in millions of pesos)
- Total: 627,795.9
- General Transfers
  - National Transfer Fund: 21.06% of RFP — 274,305.9 — Unconditional, but at least 20% to municipalities — Allocation: Formula
  - Contingency reserve: 0.25% of RPF — 13,023.0 — Formula
- Shared taxes
  - Excise on alcoholic drinks: 20% of collections — 5,246.5 — Unconditional, but at least 20% to municipalities
  - Excise on beer: 20% of collections — (amount not separately listed)
  - Excise on tobacco: 8% of federal collections — (amount not separately listed)
- Federal taxes administered by states (Derivation)
  - Vehicle tax: 100% of collections — 31,357.0
  - Tax in new vehicles: 100% of collections — (included in 31,357.0 group)
- Earmarked funds
  - FAEB: 186,461.5 — Education — Historical expenditure
  - FAM: 0.815% of RFP — 9,300.6 — Education — Infrastructural needs
  - FAETA: Share of RFP — 3,738.2 — Education — Personnel and other factors
  - FASSA: 38,972.9 — Health — Historical expenditure
  - FAIS: 0.303% of RFP — Social infrastructure — Poverty indicator
  - FASP: Discretional — 5,000.0 — Public order and security — Discretional
  - FAFEF: 1.4% of RFP — 22,500.0 — Multipurpose — Formula
- Cofinancing schemes (Convenios): 27,129.9 — Multisector — Mainly projects — Discretional
- Supplementary allocations
  - Supplementary oil revenue: 23,770.3 — Multipurpose
- Table source: SHCP

### E. Observed Distributional Outcomes and Incentive Effects
- System is not redistributive: higher per capita income states receive higher transfers.
- Small states (Baja California Sur, Campeche, Colima) receive favorable per capita treatment because the population component is additive, producing higher participaciones per capita in smaller states.
- Consequences:
  - transfers provide little incentive for tax effort or increased efficiency in spending;
  - participaciones per capita still depend on population, producing unintended per-capita advantages to small states.

### F. Special Purpose Transfers—Education and Health
- Aportaciones for education and health constitute bulk of special purpose transfers and largely pay teachers’ and doctors’ salaries (FAEB and FASSA).
- Current allocation basis: largely historical rather than needs-based.
- Labor-market constraint: strong unions; local governments have little jurisdiction over hiring, firing, or salaries.
- Implementation implications if reallocated by needs:
  - states would need sufficient own-source revenues to absorb employment adjustments; or
  - an explicit equalization program that builds on needs factors.
- Accountability and monitoring weaknesses:
  - states are not obligated to use additional resources for intended purposes nor sanctioned for not doing so;
  - incentives to use additional funds for education or health care are relatively weak.

### G. Reform Options Considered (illustrative)
- Purpose: evaluate redistribution and tax-effort performance; options not mutually inconsistent with special purpose transfer reform.
- Option 1 — Simple reform emphasizing tax effort:
  - Combine participaciones and aportaciones, except those funding education and health;
  - Redistribute according to (equally weighted) tax effort and inverse income per capita.
- Option 2 — Simple equalization:
  - Combine participaciones and aportaciones, except those funding education and health;
  - Redistribute according to (equally weighted) population and inverse income per capita.
- Option 3 — Full equalization based on fiscal capacity and needs (detailed in Section 3).

---

### 3. An equalization transfer based on spending needs and fiscal capacities

### Overview and Reform Options (2005 data; exact amounts preserved)
- Three options examined with available funds equal to actual participaciones and relevant aportaciones in 2005.
  - Option 1: Marginal changes that ring-fence aportaciones funding education and health (FAEB, FAETA, FASSA) and emphasize tax effort.
  - Option 2: Intermediate simple equalization based on population and inverse per capita income.
  - Option 3: Full equalization based on standardized fiscal capacities and expenditure needs; combines participaciones and all aportaciones into a single fund.
- Available funds (2005; exact amounts):
  - Total state participaciones minus FFM: MEX$242,733.6 million.
  - Option 3: total aportaciones (all of Ramo 33) minus municipal aportaciones (FORTAMUN and FISM): MEX$239,044 million.
  - Options 1 and 2 pot: Option 3 (MEX$239,044 million) minus FAEB, FAETA, and FASSA = MEX$16,902 million.
  - Comparative pots:
    - Options 1 and 2 available pot: MEX$259,635 million.
    - Option 3 available pot: MEX$481,777 million.
- Note: federal municipal funds are taken out before redistribution; states legally obliged to pay 20 percent of participaciones to municipalities (this 20 percent not subtracted in analysis). FAFEF, Convenios de Descentralización and excedentes excluded.

### Sequencing and Scenarios
- Two scenarios per option:
  - Static: full implementation without compensating losers (“big bang”).
  - Dynamic: gradual introduction with “hold harmless” provision (compensation of losses in nominal terms).
- Hold-harmless mechanism:
  - Each post-reform year each state receives: (i) fixed payment equal in nominal terms to total transfer in year preceding reform; plus (ii) transfer of additional funds based on new formula.
  - Additional fund growth arises from inflation, real growth, and increased tax collection efficiency (unless constrained by declining revenues).
- Long-run: relative allocation converges toward static scenario as time → ∞ if region characteristics remain stable.

### Option 1 — Design, Mechanics, and Findings
- Emphasizes tax effort (TE) measured by incentivos (federally set taxes collected by states and retained by them).
- TE calculation: percentage increase in revenue from incentivos over 2000–2005 for each state; compute population-weighted share in total increase.
- Distribution: half of MEX$259,635 million distributed according to TE shares; half distributed according to inverse of GSP per capita shares.
- Findings:
  - If states have same rate of increase of incentivos, allocation defaults to population shares (equal per capita).
  - Strong explicit tax-effort incentives (“super incentives”): states effectively keep more than 100 percent of additional pesos raised.
  - Limited equalization: empirical regression y = -0.1046x + 3.4346, R^2 = 0.2564 (a 10,000 peso increase in per capita income → average 100 peso decrease in per capita grant).

### Option 2 — Design, Mechanics, and Findings
- Simple equalization: overall share = 0.5 POP_i + 0.5 (inverse per capita income share).
- Findings:
  - Highly equalizing across the income distribution (convex negative relationship).
  - Implicit incentives for revenue mobilization persist because states keep virtually 100 percent of additional own revenues.
  - Strong candidate as an interim approach where data limit full needs-based design.

### Option 3 — Full Equalization: Construction Steps, Indicators, and Results
- Step 1: Fiscal capacity (FC_i)
  - FC_i defined as tax revenue each state could raise if it set the federation’s average tax rates on its tax bases; assume tax bases proportional to GSP; add incentivos.
  - Formula (in source): FC_i = OR_i + (GSP_i / Σ GSP) × Σ OR.
- Step 2: Expenditure needs (N_ij and N_i)
  - Three expenditure categories: education (ED), health (H), other (O).
  - Indices N_ij normalized to add to 1 across states for each category.
  - Overall need N_i = N_i,H × E_H + N_i,ED × E_ED + N_i,O × E_O.
  - Total expenditures (2005, million pesos):
    - E_H = 241,687
    - E_ED = 53,117
    - E_O = 671,851
  - Need-factor indicators and weights:
    - Education: share of population 0-14 (weight 0.5); average years of schooling of males and females over 15 (weights 0.25, 0.25).
    - Health: infant mortality rate (weight 0.5); share of population over 65 (weight 0.5).
    - Other: inverse of GSP per capita (weight 0.84); square root of population density (weight 0.16).
  - Cost-of-living adjustment: state living-cost index from Bank of Mexico city price indices (February 2007, normalized to 100 in January 1995); state index = average of cities within state.
- Step 3: Fiscal gap and grant
  - Fiscal gap FG_i = N_i − FC_i.
  - If P < Σ FG_i: TR_i = (FG_i / Σ FG_i) × P.
  - Empirical totals:
    - Sum of needs (Σ N_i) = 652,435.12 million pesos.
    - Fiscal capacity total (Σ FC_i) = 98,859.69 million pesos.
    - Aggregate fiscal gap (Σ FG_i) = 553,575.44 million pesos.
    - Available transfers in analysis (P) = 481,777.21 million pesos (87 percent of aggregate fiscal gap).
- Findings:
  - Transfers are quite equalizing; clearer negative relationship with per capita income than Option 1.
  - Empirical regression: y = -0.2871x + 6.7358, R^2 = 0.6879 (a 10,000 peso increase in per capita income → average 280 peso decrease in per capita grant).
  - Option 3 is less variable, more equalizing, and rests on explicit needs and fiscal capacity criteria—facilitating accountability and signaling.

### Dynamic Phase-In and Hold-Harmless Examples (numeric illustrations preserved)
- Example setup: Year 0 federal transfers = MEX$1 million; nominal growth rate g = 0.05, 0.075, 0.1 per year.
- Observation: with nominal hold-harmless, new equalization fund grows slower than g because part of additional revenue holds harmless prior transfers.
- Table 4 (g = 0.1; years 0–8; relative values preserved in source):
  - After 8 years total tax revenue > doubled; funds in old and new schemes still about equal.
  - Example numeric excerpt: Equalization at year 8 = 1.1436; Total at year 8 = 2.1436 (relative to base 1).
- Table 5 (hold harmless = 1 in all years; exact values preserved):
  - Years shown: 0, 5, 10, 15.
  - Equalization (10 percent): 0, 0.61, 1.59, 3.18.
  - Equalization (7.5 percent): 0, 0.44, 1.06, 1.96.
  - Equalization (5 percent): 0, 0.28, 0.63, 1.08.
  - Equalization (declining oil revenues): 0, 0.24, 0.60, 1.12.
- Contextual assumptions and implications:
  - Recent nominal income growth averaged around 8 percent (inflation + real growth).
  - Around 40 percent of government revenues derive from oil. Example: oil revenues decline by 1 percent nominally; remaining 60 percent grows at 7.5 percent → equalization fund growth in first 10 years is worse than the 5 percent pure-growth case.
  - Conclusion: hold-harmless provisions create significant inertia; higher nominal growth accelerates phasing-in; lower or declining revenues greatly slow it.

### Main Empirical and Policy Findings
- Relative pot sizes:
  - Options 1 and 2 pot: MEX$259,635 million.
  - Option 3 pot: MEX$481,777 million.
- Option assessments:
  - Option 1: preserves strong tax-effort incentives; reproduces random features of existing grants; limited equalization; high variability among similar-income states.
  - Option 2: highly equalizing, simple to implement; suitable interim approach when data are limited.
  - Option 3: best aligns redistribution with explicit needs and fiscal capacities; less variable and more equalizing; strengthens accountability and incentives for efficient spending and own-revenue mobilization.
- Political economy and sequencing:
  - Gradual introduction recommended due to political constraints and administrative capacity.
  - Estimation procedures for needs factors should be refined over time.
  - Hold-harmless clause aids political acceptability but generates inertia and must be coupled with reforms to assignment and own-revenue bases for subnational governments.
  - Special purpose programs cannot be moved to needs-based formulations without (1) significant own-source revenues and/or (2) an equalization framework from which SPPs are deducted.
- Signaling and accountability:
  - Needs-based equalization provides a yardstick for electorates and for federal discussion of minimum standards and responsibilities.
  - Explicit needs factors can focus recipient administrations on efficiency relative to assigned responsibilities.

*Source: _wp07252 - 1. Revenue Transferred from Federal Government to States, 2006*

### 1. Revenue Transferred from Federal Government to States, 2006 ..........................................4

### 1. Revenue Transferred from Federal Government to States, 2006

### A. Introduction and Rationale for Needs-Based Transfers
- Focusing on spending needs factors in designing fiscal transfer systems supports:
  - establishing the proper basis for special purpose transfers;
  - providing a basis for performance contracts between the center and subnational governments (actionable conditionality).
- For equalization systems, spending needs factors provide a better basis than revenue capacities alone in ensuring subnational governments can provide a similar level of public services at a comparable level of own-tax effort.

### B. Political-Economy Context in Mexico
- Vertical imbalance in intergovernmental finance:
  - almost 90 percent of states' total revenues are derived from federal transfers;
  - 65 percent for municipalities.
- Transfers represent 8.1 percent of GDP in 2006, up from 6.8 percent in 1998.
- Federal transfers to subnational governments include:
  - general transfers (participaciones);
  - specific transfers (aportaciones);
  - revenue from federal taxes presently administered and collected by the states.
- General transfers, as used in Mexican budget documents, include all revenues whose use by the recipient government is unconditional.

### C. Structure and Mechanics of General Transfers (Participaciones) and Related Pools
- The Recaudacion Federal Participable (RFP) is the common pool composed of main federal taxes and petroleum revenues (personal and corporate income tax, tax on assets, VAT, excises, oil and mines), subject to some deductions.
- A share of 21.06 percent of the RFP is transferred to the states according to a formula that separates three components:
  - 45.17 percent of the pool is distributed according to population;
  - 45.17 percent is allocated on a historical basis—the previous year’s allocation—corrected by a tax effort indicator (rate of growth over previous years of revenue from shared taxes and federally owned but state-administered taxes);
  - 9.66 percent is allocated according to the inverse of the per capita allocations of the previous two components.
- A minor general transfer, the Contingency Reserve, corresponds to 0.25 of RFP; its distribution formula compensates states that lost their share of participaciones in 1991.

### D. Table of Revenue Transferred from Federal Government to States, 2006 (key items and amounts)
- Total: 627,795.9 (In millions of pesos)
- General Transfers
  - National Transfer Fund: 21.06% of RFP — 274,305.9 — Unconditional, but at least 20% to municipalities — Allocation: Formula
  - Contingency reserve: 0.25% of RPF — 13,023.0 — Formula
- Shared taxes
  - Excise on alcoholic drinks: 20% of collections — 5,246.5 — Unconditional, but at least 20% to municipalities
  - Excise on beer: 20% of collections — (amount not separately listed)
  - Excise on tobacco: 8% of federal collections — (amount not separately listed)
- Federal taxes administered by states (Derivation)
  - Vehicle tax: 100% of collections — 31,357.0
  - Tax in new vehicles: 100% of collections — (included in 31,357.0 group)
- Earmarked funds
  - FAEB: 186,461.5 — Education — Historical expenditure
  - FAM: 0.815% of RFP — 9,300.6 — Education — Infrastructural needs
  - FAETA: Share of RFP — 3,738.2 — Education — Personnel and other factors
  - FASSA: 38,972.9 — Health — Historical expenditure
  - FAIS: 0.303% of RFP — Social infrastructure — Poverty indicator
  - FASP: Discretional — 5,000.0 — Public order and security — Discretional
  - FAFEF: 1.4% of RFP — 22,500.0 — Multipurpose — Formula
- Cofinancing schemes (Convenios): 27,129.9 — Multisector — Mainly projects — Discretional
- Supplementary allocations
  - Supplementary oil revenue: 23,770.3 — Multipurpose
- Source noted in table: SHCP

### E. Observed Distributional Outcomes and Incentive Effects
- The transfer system is not redistributive: higher per capita income states receive higher transfers (Figure 1).
- Small states (Baja California Sur, Campeche, Colima) receive favorable treatment per capita because of the “linearity” of the current formula:
  - the population component is added to other parts of the formula, producing higher participaciones per capita in smaller states.
- Consequences:
  - transfers do not provide much incentive for tax effort or increased efficiency in spending;
  - participaciones per capita still depend on population, producing unintended per-capita advantages to small states.

### F. Special Purpose Transfers—Education and Health
- Aportaciones for education and health form the bulk of special purpose transfers and are used largely to pay teachers’ and doctors’ salaries (FAEB and FASSA used to pay for “federalized” teachers and doctors).
- Current allocation basis:
  - largely based on historical trends rather than current needs.
  - public sector workers belong to strong unions; local governments have little jurisdiction over hiring, firing, or salaries.
- Implementation challenges:
  - If transfers were reallocated based on needs (e.g., teacher shortages/excesses), states would need either:
    - sufficient own-source revenues to absorb employment adjustments; or
    - an explicit equalization program that builds on needs factors.
  - Neither condition is currently met in Mexico.
- Weak accountability and monitoring:
  - states are not obligated to use additional resources for intended purposes (education/health), nor are there sanctions for not doing so.
  - incentives to use additional funds for education or health care are relatively weak.

### G. Reform Options Considered (three illustrative options)
- Purpose: evaluate how each reform performs in redistribution and tax effort in the Mexican case; options are not mutually inconsistent with special purpose transfer reform.
- Option 1 — A simple reform of the existing system:
  - Combines participaciones and aportaciones, except those funding education and health;
  - Redistributes according to (equally weighted) tax effort and inverse income per capita criteria.
- Option 2 — A simple equalization transfer:
  - Combines participaciones and aportaciones, except those funding education and health;
  - Redistributes according to (equally weighted) population and inverse income per capita.
  - Variant of Option 1 where the tax effort component is replaced by a population-based transfer.
- Option 3 — (referenced later in contents list) An equalization transfer based on fiscal capacity and needs (details in subsequent sections).

*Source: _wp07252 - 1. Revenue Transferred from Federal Government to States, 2006*

### 3.      An equalization transfer based on spending needs and fiscal capacities. As in

### _wp07252 - 3.      An equalization transfer based on spending needs and fiscal capacities. As in

### Overview and reform options
- Three reform options examined (using 2005 data), with available funds chosen to equal actual participaciones and relevant aportaciones in 2005.
- Options:
  - Option 1: Marginal changes that ring-fence aportaciones funding education and health (FAEB, FAETA, FASSA) and emphasize tax effort.
  - Option 2: Intermediate, simple equalization based on population and inverse per capita income.
  - Option 3: Full equalization based on standardized fiscal capacities and expenditure needs (revenue capacities and needs factors), combining participaciones and all aportaciones into a single fund in the Mexican context.

### Available funds for redistribution (2005; exact amounts preserved)
- Total state participaciones minus FFM (sum of Fondo General de Participaciones, Reserva de Contingencia, Impuesto Especial Sobre Producción y Servicios, 0.136 percent of the Recaudación Federal Participable, Derecho Adicional Sobre la Extracción de Petróleo): MEX$242,733.6 million.
- For Option 3: total aportaciones (all of Ramo 33) minus municipal aportaciones (FORTAMUN and FISM). These sum to MEX$239,044 million.
- For Options 1 and 2: the sum for Option 3 (MEX$239,044 million) minus the sum of FAEB, FAETA, and FASSA = MEX$16,902 million.
- Comparative pots:
  - Options 1 and 2 available pot: MEX$259,635 million.
  - Option 3 available pot: MEX$481,777 million.
- Note: federal funds for municipalities are taken out before redistribution to states; states are legally obliged to pay 20 percent of participaciones to municipalities (this 20 percent is not subtracted from the pot in the analysis). FAFEF, Convenios de Descentralización and excedentes are excluded for data reasons.

### Sequencing of reforms and scenarios
- Two scenarios evaluated for each option:
  - Static scenario: option implemented fully without compensating losers (a “big bang” reform).
  - Dynamic scenario: gradual introduction with a “hold harmless” provision (compensation of losses in nominal terms).
- “Hold harmless” mechanism:
  - In each year after reform each state receives: (i) a fixed payment equal in nominal terms to the total transfer from the federal government in the year preceding the reform; plus (ii) a transfer of additional funds based on the new formula.
  - Growing pool of additional funds arises from inflation, real economic growth, and increased tax collection efficiency (unless constrained by declining revenues, e.g., oil).
- Long-run relation: as time → ∞ (and region characteristics remain relatively stable), relative allocation converges toward the static scenario allocation.

### Option 1 (design and mechanics)
- Emphasizes tax effort measured by incentivos (federally set taxes collected by states and retained by them).
- Tax effort (TE) measure:
  - Calculate percentage increase in revenue from incentivos over 2000–2005 for each state (data from SHCP); compute population-weighted share in total increase.
  - TE formula (as in source): TE_i = (population-weighted share of Δ_i) — see equation (1).
- Distribution rule:
  - Half of the total funds (i.e., half of MEX$259,635 million) distributed according to TE shares.
  - The other half distributed according to the inverse of GSP per capita shares (equation (2)).
- Interpretation and findings:
  - If all states have same rate of increase of incentivos, allocation defaults to population shares (equal per capita).
  - Option 1 yields strong explicit tax-effort incentives (“super incentives”) — states effectively keep more than 100 percent of additional pesos raised — but provides limited equalization.
  - Empirical relationship: an increase in per capita income of 10,000 pesos leads on average to only a 100 peso decrease in per capita grant under Option 1 (regression: y = -0.1046x + 3.4346, R^2 = 0.2564).

### Option 2 (design and mechanics)
- Simple equalization: equal weight on population share and inverse per capita income share.
  - POP_i = population share (equation (3)).
  - Overall share for state i = 0.5 POP_i + 0.5 (inverse per capita income share).
- Findings:
  - Highly equalizing across the income distribution (convex negative relationship with per capita incomes).
  - Even without an explicit tax-effort reward, implicit incentives exist because states keep virtually 100 percent of additional own revenues.
  - Strong candidate as an intermediate approximation when data constraints prevent full needs-based calculations.

### Option 3 (full equalization: construction steps, indicators, and results)
- Step 1: Fiscal capacity (FC_i)
  - Defined as the tax revenue each state could raise if it set the federation’s average tax rates on its tax bases.
  - Assume tax bases proportional to GSP; add incentivos because federally set rates are same across states.
  - Formula (as in source): FC_i = OR_i + (GSP_i / Σ GSP) × Σ OR  (see equation (4) in source).
- Step 2: Expenditure needs (N_ij and overall N_i)
  - Three expenditure categories due to data constraints: education (ED), health (H), other (O).
  - Indices N_ij normalized to add to 1 across states for each category.
  - Overall need for state i: N_i = N_i,H × E_H + N_i,ED × E_ED + N_i,O × E_O (equation (5)).
  - Total expenditures (2005, million pesos):
    - E_H = 241,687
    - E_ED = 53,117
    - E_O = 671,851
  - Need factors and weights (Table 2 in source):
    - Education indicators: Share of population 0-14 (weight 0.5); Average years of schooling of males and females over 15 (weights 0.25, 0.25).
    - Health indicators: Infant mortality rate (weight 0.5); share of population over 65 (weight 0.5).
    - Other indicators: Inverse of GSP per capita (weight 0.84); square root of population density (weight 0.16).
  - Cost-of-living adjustment: state living-cost index derived from Bank of Mexico city price indices (February 2007, normalized to 100 in January 1995); state index is average of cities within the state.
- Step 3: Fiscal gap and grant
  - Fiscal gap FG_i = N_i − FC_i.
  - If pool of resources P < Σ FG_i, each state receives TR_i = (FG_i / Σ FG_i) × P.
  - Empirical totals from Table 3 (state-level calculations; totals preserved):
    - Sum of needs (total N across categories) = 652,435.12 million pesos.
    - Fiscal capacity total (Σ FC_i) = 98,859.69 million pesos.
    - Aggregate fiscal gap (Σ FG_i) = 553,575.44 million pesos.
    - Available transfers in analysis (P) = 481,777.21 million pesos (87 percent of aggregate fiscal gap).
- Findings for Option 3:
  - Transfers are quite equalizing overall; transfers decline with per capita income with a clearer negative relationship than Option 1.
  - Empirical relationship: an increase in per capita income of 10,000 pesos leads on average to a 280 peso decrease in the per capita grant under Option 3 (regression: y = -0.2871x + 6.7358, R^2 = 0.6879).
  - Option 3 is less variable, more equalizing, and rests on explicit needs and fiscal capacity criteria — facilitating accountability and signaling for local governments.

### Dynamic phase-in and “hold harmless” quantitative examples
- Simple example setup: Year 0 federal transfers = MEX$1 million; nominal growth rate g = 0.05, 0.075, 0.1 per year.
- Key observation: with nominal hold-harmless, new equalization fund grows slower than compound growth rate g because part of additional revenue is used to hold-harmless prior transfers.
- Table 4 (example with g = 0.1; years 0–8; exact values preserved in source):
  - After 8 years total tax revenue > doubled; funds in old and new schemes still about equal.
  - Example numeric excerpts (as in source table): Equalization at year 8 = 1.1436; Total at year 8 = 2.1436 (relative to base 1).
- Table 5 (effect of different growth rates; exact values preserved):
  - Years shown: 0, 5, 10, 15 (hold harmless = 1 in all years).
  - Equalization (10 percent): 0, 0.61, 1.59, 3.18.
  - Equalization (7.5 percent): 0, 0.44, 1.06, 1.96.
  - Equalization (5 percent): 0, 0.28, 0.63, 1.08.
  - Equalization (declining oil revenues): 0, 0.24, 0.60, 1.12.
- Contextual growth assumptions and implications:
  - Recent nominal income growth averaged around 8 percent (inflation + real growth).
  - Around 40 percent of government revenues derive from oil. Example scenario: oil revenues decline by 1 percent in nominal terms; remaining 60 percent grows at 7.5 percent. Result: equalization fund growth in first 10 years worse than the 5 percent pure-growth case (last row in Table 5).
  - Conclusion: hold-harmless provisions create significant inertia; higher nominal growth accelerates phasing-in, lower or declining revenues greatly slow it.

### Main empirical and policy findings
- Relative sizes of redistribution pots:
  - Options 1 and 2 pot: MEX$259,635 million.
  - Option 3 pot: MEX$481,777 million.
- Option performance:
  - Option 1: preserves strong tax-effort incentives but reproduces random features of existing grants; limited equalization; high variability across similar-income states.
  - Option 2: highly equalizing, simple to implement, may serve as interim approach where data are limited.
  - Option 3: best aligns redistribution with explicit needs and fiscal capacities; less variable and more equalizing; strengthens accountability and incentives for efficient spending and own-revenue mobilization.
- Political economy and sequencing:
  - Need careful sequencing due to political constraints and administrative capacity.
  - Introduction of needs factors in equalization should be gradual; estimation procedures may be refined over time.
  - Hold-harmless clause can help political acceptability by ensuring no nominal losers, but it generates substantial inertia and must be coupled with reforms to assignments and own-revenue bases for subnational governments.
  - Special purpose programs (SPPs) cannot be moved to needs-based formulations without (1) significant own-source revenues and/or (2) an equalization framework from which SPPs are deducted.
- Signaling and accountability:
  - Needs-based equalization provides a yardstick for electorates to judge local governments and for federal discussions about minimum standards and responsibilities.
  - Explicit needs factors can focus recipient administrations on efficiency relative to assigned responsibilities.

*Source: IMF working paper chapter text (2005 data) as provided in the content unit.*

### REFERENCES

### _wp07252 - REFERENCES

### References

- Ahmad, Ehtisham and Giorgio Brosio, 2006a, Handbook of Fiscal Federalism, (Cheltenham:  
  Edward Elgar Publishing).

- ——————, and Bob Searle, 2006b, “On the Implementation of Transfers to Subnational 
  Governments,” in Ahmad and Brosio (op cit).

- ——————, Jun Ma, Bob Searle, and Stefano Piperno, 2002, “Intergovernmental Grants 
  Systems and Management: Applications of a General Framework to Indonesia,” (with Jun 
  Ma,), IMF Working Paper 02/128 (Washington: International Monetary Fund).

- ——————, 1998,  
  Financing Decentralized Expenditures—Grants in an International 
  Context, Edward Elgar.

- Dafflon, Bernard, 2007, “Fiscal Capacity Equalization in Horizontal Fiscal Equalization 
  Programs,” in Robin Boadway and Anwar Shah, Intergovernmental Fiscal Transfers 
  (Washington: The World Bank Group).

- Reschovsky, Andrew, 2007, “Compensating Local Governments for Differences in 
  Expenditure Needs in a Horizontal Fiscal Equalization Program,” in Boadway and 
  Shah (op cit.).

* _wp07252 - REFERENCES*

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