The Assignment of Revenues and Expenditures in Intergovernmental Fiscal Relations* By Charles E. McLure & Jorge Martinez-Vazquez

I. Introduction Countries throughout the world are increasingly recognizing the benefits of fiscal decentralization. In theory – if not always in fact – decentralization makes it possible for people to have greater influence on the decisions of government that affect their lives. In countries as varied as the republics of the former Soviet Union, the nations of Central and Eastern Europe, South Africa, Australia, and various developing countries (e.g., Argentina, Bolivia, and Colombia), many see decentralization as an important component of a strategy designed to increase the political power of people, as expressed through local governments.1 Decentralization may, at the least, be important for political reasons, and it may also improve the welfare of the populace.2

The first fundamental step in the design of a system of intergovernmental fiscal relations should be a clear assignment of functional responsibilities among different levels of government. Instability and controversy in the practice of decentralized systems has followed when the law was silent or unclear about the competencies and expenditure obligations of different levels of government. A stable and meaningful decentralization requires an unambiguous and well defined institutional framework in the assignment of expenditure responsibilities among the different levels of government together with the sufficient budgetary autonomy to carry out the assigned responsibilities at each level of government.

Designing the other important pieces of a system of decentralized finances, revenue assignments and transfers, in the absence of a clear expenditure assignment is to put the car before the horse. The decentralization movement in many countries of Latin America over the past decade made this fundamental mistake. Revenues were assigned to subnational governments and transfers put into place before it was decided what functional competencies would be transferred from the central government to subnational governments. These experiences led to weak decentralized systems and fiscally overburdened central governments, which in many cases continued to take on most expenditures responsibilities with fewer resources. The focus on the revenue side of decentralization and the neglect of a clearer assignment of expenditure responsibilities has also been a common theme of the decentralization process in countries in transition over the past five years.

*This report draws from "The Tax Assignment Problem: Conceptual and Administrative Considerations in Achieving Subnational Fiscal Autonomy" by Charles E. McLure and "The Assignment of Expenditure Responsibilities" by Jorge Martinez-Vazquez, papers prepared for the World Bank Institute's Decentralization Homepage (www.worldbank.org/decentralization). 1See Boadway (1997b) and Oates (1997) on Argentina, James (1992), Collins (1993), and Warren (1997) on Australia, McLure (1993b) on Brazil, Wong (1993) and Bahl (forthcoming) on China, McLure (forthcoming, a) on Kazakhstan, Wallich (1994) and McLure (1995b) on Russia, McLure (1995a) on South Africa, McLure (1994a) and Martinez, McLure, and Wallace (1995) on Ukraine, Bird, Litvack, and Rao (1995) and McLure and Martinez (forthcoming) on Vietnam, and Bird, Ebel, and Wallich (1995) on countries in transition from socialism. Prud'homme (1995) provides a more extensive list of country studies. 2For a more skeptical appraisal, see Prud'homme (1995). McLure (1995c) and Sewell (1996) question Prud’homme’s analysis. See also Litvack, Ahmad, and Bird (1998). If fiscal decentralization is to be a reality, subnational governments must control their "own" sources of revenue.3 Subnational governments that lack independent sources of revenue can never truly enjoy fiscal autonomy; they may be – and probably are – under the financial thumb of the central government.4 The question, then, is which revenue sources can and should be assigned to subnational levels of government and how these assignments are to be effected. This group of questions is commonly called "the tax assignment problem.”5 They are closely related to “the expenditure problem,” because of the importance of benefit taxation in the finance of subnational government and the need to assure that subnational governments have revenues that are adequate to finance the expenditures assigned to them.

In the second section of this report a general theory of public finance is reviewed in other to give the theoretical background of the subject. Section III describes general principals of expenditure assignment. Section IV discusses tax assignment problem and concludes the report with some remarks.

II. Narrowing the Scope of Inquiry: Musgrave's Three-Function Framework In his classic treatise, The Theory of Public Finance, Richard Musgrave (1959) suggests that, for conceptual purposes, the functions of government should be separated into three functions or "branches," macroeconomic stabilization, income redistribution, and resource allocation.

The stabilization branch is to assure the achievement of high employment and price stability, the distribution branch is to achieve an equitable distribution of income, and the allocation branch is to see that resources are used efficiently.6

This conceptual division of the responsibilities of government allows us to narrow the scope of inquiry into tax assignment, by indicating which of the three functions are most appropriately assigned to various levels of government. The remainder of this section focuses on the implications of the three-branch framework for the assignment of revenue sources among levels of government, especially the assignment between the central government and second-tier governments.7

3The term “subnational” is used to describe all levels of government below the national level. “Second-tier” is used for the highest level of subnational government-- the states of the United States, Australia, and Brazil, the provinces of Argentina and Canada, the laender of Germany, and the oblasts of the new republics of the former Soviet Union--and “local” is used for all governments below the second tier. 4Much of the discussion of this paper is more appropriate for a federal system of government than for a unitary system. None-the-less, interest in tax assignment is not confined to federations. It is necessary that, under either system, the central government have a real commitment to devolution of power if tax assignment is to be meaningful. 5Musgrave (1983) asks, “Who Should Tax , Where, and What?” The tax assignment problem is part of a larger set of questions that might be called “the revenue assignment problem." The latter includes the design of intergovernmental grants and the framework for borrowing by subnational governments. I ignore these two issues. 6The stabilization branch would presumably be responsible for maintaining external balance (an acceptable balance of trade under a regime of fixed exchange rates or a satisfactory exchange rate in a world of flexible exchange rates). Policies for economic development or growth (reflected in the choice between present and future consumption) might be assigned to the allocation branch, on the assumption that the stabilization branch achieved its objectives. 7See also Oates (1968), (1972), and (1994) and Musgrave (1983), especially pp. 10-17. Bird (1993a) provides an extremely useful discussion of issues of fiscal decentralization. A. Macroeconomic Stabilization The stabilization function – the maintenance of high employment and price stability – is ordinarily assigned to the central government.8 This is true for several reasons. First, subnational governments commonly cannot much affect macroeconomic conditions within their boundaries, and thus have little reason to try, because most of the effects of macroeconomic policy attempted by subnational government will "leak" out of the area.9 A simple Keynesian multiplier analysis can be used to illustrate the problem. Suppose that the marginal propensity to consume is 0.6. An increase in central government expenditures of $100 will have a second round impact of $60, a third round impact of $36, and a multiplier of 2.50. Suppose, by comparison, that the residents of a subnational government considering the use of stabilization policy import half of their consumption from other areas. Even if all the initial government spending of $100 is reflected in increased incomes within the subnational jurisdiction--likely an unrealistic assumption--the second-round impact is only $30 (50 percent of $60) and the third-round impact is only $9; the overall multiplier is only 1.43. Thus, the local multiplier effects beyond the first round are 150 percent of the initial expenditure by the central government, but only 43 percent of the initial subnational spending.

The second problem with subnational macroeconomic policy is the limited power to borrow and the lack of the power to print money. Even if subnational governments had the ability and incentive to attempt stabilization, they would have difficulty in engaging in the deficit financing that is often required to implement expansionary policy, unless their borrowing is supported by the central government. Where central governments do support subnational borrowing, the result is commonly irresponsible behavior that threatens the macroeconomic stability of the nation.

The taxes commonly thought to have the most powerful stabilizing effects are the corporate income tax and the progressive individual income tax--the former because profits fluctuate more than general economic conditions and the latter because of the stabilizing effects of graduated rates (including tax-free amounts).10 This suggests that these two taxes should be assigned to the central government. Note, however, that this reasoning does not imply that subnational governments should not levy taxes on the income of individuals; such taxes may have advantages that offset any disadvantage created by cyclical fluctuations in revenues. Other considerations to be discussed below suggest that subnational governments should rely heavily on corporate income taxes only if other suitable alternatives are not available – and that access to revenues from these taxes should be made available to subnational governments only subject to rigid controls.

Cyclical swings in revenues and expenditure requirements create problems even for subnational governments that do not attempt to implement stabilization policies. If subnational governments cannot much affect macroeconomic conditions nor easily adjust to wide swings in revenues, it is appropriate for them to rely relatively heavily on revenue

8Sewell (1996) suggests that there may be more latitude for subnational stabilization policy than in Musgrave’s view. 9Some may argue that no government can be effective in influencing macroeconomic conditions. This debate need not divert our attention. If any macroeconomic policy is to be effective, it is more likely to be that of the central government. 10Progressive taxation takes a percentage of income that rises as income rises; regressive taxation takes a percentage that falls. Proportionate taxation takes the same fraction of income at all income levels. sources that are relatively insensitive to macroeconomic conditions. These include taxes on consumption, such as general sales taxes, excises, and property taxes.11

B. Redistribution of Income The distribution function is also commonly assigned primarily to the central level of government. Again, this is true for several reasons. First, subnational attempts at redistribution may not be successful, and they are likely to distort the geographic allocation of economic resources. Progressive taxation intended to “soak the rich” may drive out capital and high-income individuals. If this occurs, taxation that appears progressive may actually be regressive. For example, the long-run incidence of property taxes levied on mobile capital by one subnational jurisdiction may be on immobile factors, land and labor, rather than on the owners of property.12

Corporation income taxes that are apportioned among subnational jurisdictions on the basis of formulas may, in the first instance, burden whatever is in the formula, instead of profits; see McLure (1981b). Thus a corporate income tax that is apportioned on the basis of payroll, property and sales is equivalent to taxes on these three apportionment factors. The portions that are equivalent to taxes on payrolls and sales are not likely to be progressive, and even the portion that is equivalent to a tax on property may not be progressive, for reasons noted in the previous paragraph.

The contrary problem occurs on the expenditure side: the payment of transfer payments by subnational governments is likely to attract the poor. This may discourage use of such policies.13

The theory just presented relies heavily on mobility of factors of production and of people for its results. Mobility may, in fact, be less than commonly assumed, for a variety of reasons. Most basically, models that assume mobility of people that have their intellectual roots in the United States may be less applicable in other countries, where ties of family, culture, and tradition are stronger. If subnational jurisdictions coincide with racial groupings, redistributive policies are less likely to induce migration. Also, in countries in transition from socialism (CITs) the fact that housing is not readily available and housing markets are less well-developed limits mobility. Under these circumstances there may be more latitude for subnational policies to redistribute income than in the Musgrave model.

11Property owners may have more difficulty in paying property taxes during times of economic stagnation than those who pay taxes related to income or consumption. Whereas consumption can be reduced in order to reduce the burden of taxes based on consumption, liability for property taxes is essentially independent of consumption decisions in the short run. In addition, because of inertia in the assessment process, property taxes sometimes tend to be relatively insensitive to secular trends in property values. 12See Mieszkowski (1972). Note that this analysis of the incidence of a tax levied by one jurisdiction is conducted holding the tax policy of other jurisdictions constant; see McLure (1977) and the discussion of section III. 13Sewell (1996) reviews evidence that subnational governments do, in fact, engage in income redistribution. It should be noted that in Musgrave’s three-branch system, only transfers and taxes would be used to modify the distribution of income; other types of expenditure policies would not be used. While tax policy can “level down,” they cannot reduce poverty or “level up;” that must be done on the expenditure side. If problems of implementation prevent use of transfers, as is common in LDCs, it may be appropriate to use expenditure policy, related, for example, to health and education, to reduce poverty. Considerations discussed in the text suggest that, while these may best be implemented locally, they should be financed nationally. Even if subnational taxation achieves some redistribution within a given subnational jurisdiction, interpersonal inequalities may persist across jurisdictions. These can be addressed only by national policies. In some cases it may be better to use intergovernmental grants to address differences in average income levels in various subnational jurisdictions than to use taxes and transfers to individuals.14 This possibility is not examined in detail here, as such an examination is well beyond the scope of the present analysis; but Section IV does note explicitly this advantage of one form of revenue assignment.

The tax instruments that are most commonly used in the attempt to reduce differences in incomes are the corporate income tax and progressive individual income taxes. If, as suggested, subnational use of these taxes is not likely of achieve the intended goals of income redistribution, but distorts the geographical allocation of resources, the corporate income tax and progressive individual income taxes should be assigned to the central government. As with the assignment of the individual income tax to the central government for stabilization purposes, this does not, however, mean that subnational governments should not use proportionate taxes on the income of individuals.

C. Resource Allocation The third function of governments is efficient allocation of resources. With respect to resource allocation function, Musgrave argues that policies of subnational branches of governments should be permitted to differ in order to reflect the preferences of their residents. Decentralization of taxing and spending power allows subnational governments to tailor schemes that match the demand of their constituency which will increase efficiency ultimately because local governments have better information about their residents' needs than the central government.

III. General Principles of Expenditure Assignments Most countries in transition have been carrying out in one form or another decentralization policies. But typically, there has been a lack of clearly designed decentralization strategy. It has been quite common to give regional (when these exist) and local governments autonomy to formulate budgets and spend their funds any way they wish. This is a practice similar to that followed in decentralized government systems. But on the other hand, the typical situation is for revenues and the overall level of the budget of subnational governments to be determined by the central government as in a unitary state. From a governance viewpoint, regional and local governments have autonomously elected legislative powers but often the heads of the executive powers continue to be appointed by the center, an institution associated with centralized unitary states. The present confusion in institutions has led in many transition countries to an unwieldy mix of deconcentration and decentralization of government activities. One way to examine the adequacy of expenditure assignments is to analyze how well the actual assignment of responsibilities fits the fundamental rules for the ideal assignment of responsibilities in a decentralized system of government.

There is no absolute best way for deciding which level of government should be responsible for particular public services. The adequacy of any assignment has to be judged in terms of how well it achieves the goals or objectives set up by the government in its decentralization strategy. The fact that it is up to the government to set these objectives

14See Sewell (1996) and literature cited there. should not be interpreted to mean that a murky assignment is acceptable. Clearly, without a specific assignment of expenditure responsibilities it will not be possible to assess the adequacy of the revenue and tax assignment to different levels of government, or the need and effectiveness of a system of intergovernmental transfers. As we argued above, expenditure assignment needs to be the first and fundamental step in the design of a decentralized system of intergovernmental finances.

Commonly accepted objectives for fiscal decentralization include those of an efficient allocation of resources via a responsive and accountable government, an equitable provision of services to citizens in different jurisdictions, and preservation of macroeconomic stability and promotion of economic growth (see Box 1).

The critical role of the efficiency criterion: The efficient provision of government services requires that government satisfy the needs and preferences of taxpayers as well as possible. This is best achieved by the “subsidiary” principle. Responsibility for the provision of services should be at the lowest level of government compatible with the size of the “benefit area” associated with those services. The benefit area for sanitation services is clearly the local community, but for air traffic control the benefit area is the entire national territory. Leaving the supply of public services with wider benefit areas to smaller units of government is likely to result in the inefficient under-provision of services; e.g., a tertiary hospital providing regional services is solely financed by a single municipality. Efficiency in the provision of public services is enhanced if consumption benefits are linked to costs of provision via fees, service charges, or local taxes.

The objectives of redistribution and stability best pursued by the central government: Expenditures undertaken by government for equity or income equalization reasons, such as social welfare or low income housing, is generally thought to be the domain of the central government. Local or regional governments will not be able to sustain independent programs of this nature because they will attract the needy from other areas while they will have to tax their (potentially mobile) residents more heavily. While funding for these expenditures should be a central government responsibility, implementation can very well be left to local governments which may have informational and other comparative advantages. Expenditures undertaken for the stabilization of the economy such as massive investment or unemployment compensation are by their scale naturally ascribed to the central government.

No Single Best Assignment: The application of these rules largely facilitates the assignment of expenditure responsibilities to different levels of government. However, the rules do not always yield an unequivocal answer. Some public services, e.g., primary education and primary health services, may be of a local nature by the size of their benefit area, but because of their relevance in welfare and income redistribution they may also be considered a responsibility of the central government. It is in this sense that it is not meaningful to talk about the best assignment of expenditure responsibilities. What is considered the best assignment is likely to change over time with changes in costs and technological constraints, as well as changes in preferences. However, there is a need at any given moment in time to have a concrete assignment of expenditure responsibilities among the various assignments that could be considered optimal. Failure to have a concrete assignment may lead to instability in intergovernmental relations and to the inefficient provision of public services.

Importance of a Clear and Stable Assignment: The lack of clear assignment of expenditure responsibilities may be less burdensome in practical terms in centralized systems. For example, under the Soviet Union, because all government budgets were integrated with the federal budget, additional resources could be counted on when there was an unexpected shortfall for subnational governments. As unitary systems become more decentralized, and clearly in the case of federal systems, the failure to establish by law a clear assignment of expenditure responsibilities for each government level can become a source of conflict between the central and subnational governments and can lead to an inefficient provision of public services. In situations where government budgets are tight, which is almost always, the lack of clear assignments may lead to the underprovision of key public services.

Also important to note is that the lack of specific and clear assignments of expenditure responsibilities necessarily conditions the adequacy of any tax revenue assignment and fiscal equalization mechanism. Clearly, both systems can be inadequate for different expenditure assignments and can easily become obsolete as soon as expenditure assignments are significantly changed.

The experience of many economies in transition shows that without a specific expenditure assignment, it is revenue availability that dictates the responsibilities of each government level. This leads to institutional instability and again to an inefficient provision of public services.

In the design of a decentralized system of intergovernmental finances, there is an obvious need for a policy decision on concrete assignment of expenditure responsibilities between the central government and the regions and between the regions and the local governments. The explicit and systematized assignment of functions and expenditures to the different levels of governments still needs to be a priority in transition countries’ strategy for decentralization. A specific assignment protects subnational government budgets by making the ad hoc transfer of responsibilities from the central government harder and by helping to guarantee the continued provision of services. A specific and concrete assignment of expenditure responsibilities, of course, should not detract from the flexibility needed to adapt government budgets to major changes in policy.

3.1 Most Common Problems with Expenditure Assignments and the Need for Reform Lack of Formal Assignment: A common problem in countries in transition is the lack of a formal assignment of responsibilities. While a great deal of attention has been given to issues of revenue sharing and government transfers in the first years of the transition, much less attention has been given to the first logical first step in a system of intergovernmental finances: an efficient and stable assignment of expenditure responsibilities to particular levels of government. A formal assignment of responsibilities also contributes to the stability of the system of intergovernmental finances. The experiences of countries such as Kazakhstan, the Russian Federation, and Ukraine show how the lack of formal assignments may be a destabilizing factor in intergovernmental relations. In these countries, early in the transition, expenditure assignments had been continuously reworked by the central authorities simply for fiscal convenience as a tool of fiscal deficit containment. It has been the lack of formal assignment that has made this possible. From a fiscal management perspective, a formal expenditure assignment also introduces an important element of certainty for budget planning at all levels of government.

Inefficient Assignments: A second common problem in the assignment of expenditure responsibilities is the inefficiency of the assignments. First is the issue of capital expenditure responsibilities. The problem in the early years of the transition, which has been slowly solved, but also common to other countries, has been the assignment of all capital expenditure responsibilities at the central level, independently of the level of government responsible for the provision of the services associated with the capital infrastructure. This assignment is guided either by the capacity to finance large projects or by the belief that only central government officials are qualified to make capital investment decisions. However, the full assignment of capital expenditure responsibilities is wrong. Given the importance of this issue, it will be discussed separately below.

A second important set of problems comes from the assignment of expenditure responsibilities for social protection and welfare to local governments. This is especially wrong when the responsibility for funding is assigned to regional and local governments out of general budgets. There is much less of a problem if social protection services are provided by the subnational governments but financed by the central government. Local governments may have a comparative advantage for the efficient delivery of these services, given their proximity to local residents. But regional and local government financing responsibility for these services runs against the ultimate objective of helping the most needy because the need for social welfare and assistance is so much higher in poorer jurisdictions, which are at the same time the least able to provide the necessary funds to cover social protection needs.

Other areas where there have been problems with expenditure assignments include the responsibility for public utilities such as water and sewerage at the central level when these services should be assigned at the subnational level. Ideally this type of service would be provided by corporate entities dependent upon or regulated by subnational authorities and with full-cost-recovery pricing. Another common problem has been the assignment of responsibilities to subnational governments for national defense, which should be reassigned to the central level.

Ambiguity in Certain Assignments: Despite the ambiguity in assignments, remarkably few open conflicts or disputes have taken place between the central and subnational governments in terms of assignment of expenditure responsibilities. From the operational side, conflict and negotiations vary from country to country. For example, in the case of Kazakstan, only three types of services were recently the object of negotiations among the central and subnational governments: the maintenance of specialized education establishments, certain defense expenditures, and transfers to low-income families.

Co-sharing of responsibilities: The actual assignment of functional responsibilities is often quite different from what it appears to be in the “formal” assignment established by law or practice. Take the case of education. Even though, in terms of actual expenditures going through the budget, education would appear to be for the most part a local (or regional) activity, many key decisions in educational policies are carried out at the central level in many countries. More in particular the Ministry of Education may be responsible for the construction of school buildings, curriculum design, teacher training, and design and production of textbooks. Activities that are preserved at the local level may be the recruitment and hiring of teachers. At times, the local government may be given the authority for appointing principals, school inspectors and teaching specialists. However, even in these cases local authority is limited because of the dual subordination of school officials to both the Ministry of Education and to the subnational government. In many countries in transition, even the head of the rayon administration is ultimately a central government appointee. Similar issues to those in the education sector arise in other sectors such as health.

The co-sharing or fragmentation of responsibilities within a particular public service has the disadvantage that it is likely to cause confusion leading to inefficiencies. In an ideal world, all inputs for the delivery of a particular service would be simultaneously decided by one single authority. With the fragmentation of duties within a service it is more likely that a relative disproportion of funds will be spent on salaries and much less on other operation expenditures; similarly, maintenance may be reduced to a minimum.

On the other hand, in reality the co-sharing of responsibilities for a single service may be inescapable. This may be the case for example for education where national governments may take on the responsibility for higher education while subnational governments take on the responsibility for primary and secondary education. Co-sharing of responsibilities may also take place within a particular function. Thus, for example, while subnational governments are responsible for primary and secondary education, curricula and textbook production may be carried out by the national government.

Co-sharing of responsibilities may not be a problem when particular functions and tasks in a common area are clearly assigned to different levels of government. However, it is a common practice to leave responsibilities unclear when they are assigned to more than one level of government. These are the so called common competencies or functions which often has led to conflicts in service approach and to less than adequate coverage. In difficult fiscal conditions, spending less or even withdrawing from common competencies is more defensible for both central and subnational governments.

3.2 Examples of Current Assignment of Expenditure Functions The assignment of responsibilities among the three levels of government for a variety of countries are summarized in the tables attached to these notes. The most important feature in this table is the variety of expenditure assignment across countries. This variety reflects both different approaches to decentralization, as in federal and more decentralized countries, and unitary and more centralized countries.

In those transition countries that were a part of the Soviet Union (the CITs) the current assignments tend to agree in many ways with the principles of expenditure assignment in public finance, which are reviewed below. In these countries in particular there is a broad correspondence between the geographical dimension of benefits from a particular service and the level of government responsible for its provision. Most often, by and large, the functions allocated to the central government have a national dimension. These include defense and internal security, the justice system, foreign relations, and research. Some of the expenditures with macroeconomic and redistribution implications such as pensions and unemployment compensation are also the responsibility of the central government. These are financed by extra-budgetary funds. Correspondingly, most of the expenditure responsibilities of subnational governments involve services with regional or local “benefit areas” such as tertiary hospitals, primary education, fire protection, or sanitation. However, appearances are misleading and many of these countries have several important problems in expenditure assignments.

The shares of subnational governments in the consolidated budget have remained constant in some cases (e.g., Russia and the Baltic states) but have fluctuated significantly in other countries (for example Ukraine and Kazakhstan). These fluctuations reflect both the additional shifting of expenditure responsibilities to subnational governments and the relative budgetary priority given by the government to services provided at the central and subnational levels. Instability is also a characteristic of fundamental changes in decentralized systems. For example, in the face of shrinking real resources accruing to the public sector, tough decisions had to be made regarding priorities for public expenditures in countries in transition.

A significant feature of expenditure assignments is that the functions and the relative expenditure shares of subnational governments vary significantly from country to country and they reflect tradition and inertia as much or more than best principles. For example, a peculiarity of CIT countries is that subnational governments finance most social welfare or social protection expenditures. This goes against bets principles and the practice of most other countries. On the other hand, another predominant characteristic of CIS countries is the concentration of education and health expenditures at the subnational level is shared with many other countries, specially in the case of education.

3.3 General Recommendations for reform in Expenditure Assignments Establishment of a formal assignment of expenditure responsibilities: Expenditure responsibilities should be specified in the law. Some countries do so in the Constitution but many others do so in particular laws such as the law on the budgetary system or the law on subnational budget and self-government. The latter is the preferred alternative because changing the Constitution is much harder, and it should be expected that as technology and conditions change in a country there will be a need to change expenditure assignments.

Reassignment of selected expenditure responsibilities: The central government should assume full financial responsibility for social welfare expenditures when these are assigned at the subnational level. Delivery of these services can still be performed via local governments on a reimbursement basis, a grant program, or another of several means. The central government should also assume 100 percent responsibility for expenditures in national defense, including the national guard. Finally, subnational governments should assume responsibility for public utilities.

Reassignment of Capital Investment Responsibilities: Responsibilities for capital infrastructure should be placed at the level of government responsible for the delivery of the specific services including the operation and maintenance of those facilities. This will encourage a more efficient use of resources. Only those capital infrastructure facilities actually desired by subnational governments will be built and subnational governments will have an interest in maintaining and repairing the capital infrastructure.

Facilitating capital investment at the subnational level: All types of subnational borrowing should be closely regulated by the central authorities. Besides enforcing the debt limits established by the law, there should be a certification process of the conditions for any bond issues. The central government as a general policy should not act as guarantor of regional and local government debt issues. Special circumstances such as the borrowing in foreign currency from international lending institutions which may require central government guarantees should be handled directly by the Ministry of Finance. In these cases, the central government should institute mechanisms to ensure repayment by the local government. Borrowing by local governments to invest in commercial operations should be especially discouraged.

Subnational development funding: There is considerable merit to the establishment of a subnational development fund to promote lending to subnational governments for long-term capital investment. This may be the only effective way to allow small local governments to fulfill their capital investment responsibilities. Other sources of financing include local bond issues. Both should be encouraged. However, direct access to capital markets by subnational governments is premature and will take time to develop.

Designing a development fund: The desirable structure for the subnational development fund is that of an autonomous institution that takes direct and final responsibility for borrowing and investment projects. The bulk of funds for this institution should come from direct bond issues in the capital market. The central and local governments could contribute initial capital shares. The institution should be managed by independent professionals who answer to a managing board composed of central and local government representatives.

Bond issuance Local governments should be allowed to issue non-guaranteed or limited liability debt for investment in public utilities. These “revenue bonds” will be repaid from revenue proceeds associated with tariffs set at full cost-recovery levels.

Establishment of a coordinated national policy to facilitate the divestiture of social responsibilities by state enterprises: Lessons learned from other countries in this area should be helpful in developing national programs to deal with this problem. The multiple strategy should contain a combination of policies including complete privatization and absorption into subnational budgets accompanied by rationalization, greater efficiency and cost recovery measures. The central government should provide adequate budgetary adjustments at the subnational level for these new responsibilities.

The need to address minimum standards: Central governments should consider introducing policies that guarantee desired minimum levels of provision for certain services at the local level. National standards can be enforced in several ways such as enticing local governments with a matching grant program. But national standards may also be enforced by denying full receipt of block grant money unless certain minimum expenditures and provisions established by the central government are met. Programs in which national standards may be required include not only social welfare but also education, health, sanitation, and the environment. But restrictions should be imposed sparingly to protect local autonomy which, in general, is very desirable.

The need for sectoral policies in key areas: Clearly the priority for public expenditures in most countries should remain in investment in human resources through good levels of education and health, and strengthening the safety net so that in effect there is less friction to the readjustment in the economy. However, there are also significant changes that need to be made in these sectors to increase the efficiency of operations. Several measures in key sectors will also help increase the efficiency of public expenditures. However, all these measures should be considered within the context of well defined sectoral policy objectives now lacking in many transition countries. For this reason governments should proceed with comprehensive reviews of the housing, education, health, and social welfare sectors.

IV. Realizing the Political Benefits of Tax Assignment The allocation function in Musgrave's three-branch system involves the provision and financing of public services.15 To the extent possible, services provided by government should be financed by user charges and fees; this is both fair and efficient, in the sense of encouraging responsible use of the nation's economic resources. An approach that allow beneficiaries to pay for identifiable public services that might otherwise not be provided, often by self assessment by a group of beneficiaries, is called betterment levies, valorización, or special levies.

Where strict compliance with the dictations of benefit finance is not feasible, because of the difficulty or undesirability of exclusion from the benefits of public spending, the principle is, none-the-less, instructive.16 For both equity and efficiency, tax payments should reflect costs and benefits of public services, to the extent possible. Among the best examples of benefit-related taxes are those levied on motor vehicles and motor fuels and used for the construction and maintenance of roads and highways. Each level of government should be assigned taxes that are related to the benefits of its spending. Thus, the proper assignment of taxes that are related to benefits depends on the assignment of expenditure functions. The central government should be responsible for expenditures having benefits that extend across subnational boundaries or that are characterized by economies of scale not realized at the subnational level. Subnational government comes into its own in the provision of goods and services characterized by limited economies of scale and limited spillovers of benefits to other jurisdictions.

User charges, fees, and taxes related to the benefits of public spending are likely to be regressive, or at most proportionate to income; they are not likely to reduce the inequality in the pre-tax distribution of income.17 According to the Musgrave three-branch view of government, this is not a defect, since income redistribution lodged in the central government, where it can be implemented most effectively, is available to offset the regressivity of benefit-related taxes, including those of subnational governments.

The above discussion of tax assignment in the allocation branch focused on the economic benefits of tax assignment – the resource allocation benefits of relating taxes to benefits paid. There is also a political dimension to the issue that needs to be discussed briefly.18 It is useful to divide the discussion of the political benefits of tax assignment into the related topics of a) subnational sovereignty and b) accountability and c) tax competition.

15Although not explicitly included in Musgrave’s analysis, avoidance of tax-induced misallocation of resources seems to fall naturally within the allocation branch. This would presumably be a responsibility of all levels of government. 16Public finance of activities can be justified where there is inability of exclusion and/or lack of rivalry in consumption; see Musgrave (1959). Even if exclusion is technically possible, it may be inefficient to exclude potential consumers from services characterized by non-rivalry in consumption. 17This statement is incomplete, if income distribution is seen in terms of the distribution of welfare, instead of the only the distribution of income, and if the benefits of public spending, as well as tax burdens, are considered. Taxes related closely to marginal benefits may finance expenditures that involve substantial inframarginal benefits. These inframarginal benefits may have special value to low-income families. Obvious examples include the provision of safe drinking water. Many consumers would probably consider themselves better off if they had access to safe water, even if they had to pay for it. The problem is often access, not cost. 18This is not to suggest that the economic and political aspects can be neatly identified and separated; they are inextricably intertwined. a. Subnational Sovereignty A rational assignment of taxing powers helps provide each level of government control over its fiscal destiny.19 In particular, it allows choice in the level of public spending at each level by government. To do this, tax assignment should exhibit the following characteristics. (Of course, a rational system also has other desirable features; these are described in subsequent sections.)

Own revenues: First, subnational governments must have enough “own” revenues to finance the services they provide. If a subnational government legislates and collects its own taxes, protected by meaningful constitutional safeguards of its right to do so, it clearly has a source of own revenues. Even if such a government must rely on grants from a higher-level government, it may reasonably be considered to have own revenues, provided the grants are determined in an objective way and are guaranteed by the constitution or legislation of long- standing. By comparison, own revenues may not exist in any real sense, if grants are made at the sole discretion of the higher government, perhaps on an ad hoc, arbitrary, and unpredictable basis, and even well into the fiscal year and subject to renegotiation.20 Between these extremes lies a variety of arrangements that provide more or less complete subnational ownership of revenues. Shared taxes and tax surcharges collected by higher level governments might properly be seen as own revenues; but where there is substantial risk that the higher level government collecting the revenues will not remit them to the subnational government, effective ownership is reduced.

Marginal revenues: Even if subnational governments have own revenues, they may not be able to affect the amount of revenue they receive. This is true, for example, if the central government shares revenues from certain taxes with subnational governments. In such a case, the own revenues of subnational governments are not marginal revenues.21 By comparison, if subnational governments legislate and implement their own taxes – or even if they are allowed to impose surcharges on the taxes levied by the central government at rates they choose, they can affect the amount of revenues they receive. This distinction is crucial, because subnational governments must be assigned sources of marginal own revenues--own

19A rational assignment of taxing powers is necessary, but it is not sufficient. As noted below, an otherwise rational system of tax assignment may produce patterns of vertical imbalance and horizontal disparities that are unacceptable. Moreover, subnational governments may lack fiscal sovereignty, even if they are assigned taxes that, at first glance, seem adequate. In principle, subnational governments may have substantial discretion over how they spend revenues raised through taxes they legislate and implement, tax surcharges, and shared taxes. (Of course, at any particular time, expenditures may be largely "uncontrollable," because of prior commitments.) But the central government may mandate spending by subnational governments, or it may provide grant funds that can be spent only for very narrowly specified purposes. In either case, there may be little subnational autonomy. Between these two extremes is a spectrum of discretion in the use of funds. The more discretion, the more fiscal autonomy a subnational government has. Mandated spending is ignored in what follows. 20It is difficult for a subnational government to exercise fiscal autonomy if it cannot predict its revenues with an acceptable degree of certainty. Revenues may be unpredictable for any number of reasons. First, they may depend on economic conditions, as well as the state of taxpayer compliance and tax administration, whether from taxes legislated and implemented by subnational governments or from taxes imposed by the national government. Second, funds from grants are unpredictable if they are provided on an ad hoc basis. By comparison, grants based on population and specified in advance are predictable, at least in principle. While it is more or less inevitable that subnational governments experience the first type of predictability (that resulting from variability in economic conditions and the success of enforcement), they should not be forced to experience the second (ad hoc adjustments in grants). The second type of variability can be reduced through the process of tax assignment. See also the discussion of macroeconomic stabilization below. 21This terminology is not totally satisfactory; revenues provided by the central government may be incremental, but not the result of actions taken by the subnational government. revenues whose level they can control--if they are to be truly autonomous. Only by choosing to pay higher or lower taxes can residents of subnational jurisdictions choose the level of public services they want. An important prerequisite for the exercise of subnational fiscal autonomy is thus the ability to choose tax rates.

Subsidiarity in taxation: It is commonly accepted that expenditure responsibility should be assigned to the lowest level of government that simultaneously reflects the geographic scope of benefits of public services and achieves economies of scale; this is commonly called the principle of subsidiarity. A similar principle can be evoked in the area of tax assignment: a given tax should be assigned to the lowest level of government that can implement it (or for which it can be implemented) and for which it is not inappropriate.22 Compliance with this principle is important to minimize the tendency towards vertical imbalance, which exists because subnational governments have difficulty implementing many taxes, but higher levels of government can implement almost any tax that a lower level of government can implement b. Accountability and Tax Competition The fact that subnational governments enjoy sovereignty does not mean that they are accountable. Even in a democracy, the political forces that support accountability commonly encounter self-interested politicians and entrenched bureaucracies that may blunt these forces.24 In less democratic societies, people may have even less power, because their leaders are less accountable to them. Rational tax assignment may help to increase accountability. In this regard, tax competition between subnational jurisdictions deserves special mention. Although sometimes thought to be an unmitigated evil, tax competition can have positive effects. Just as competition in the marketplace protects consumers from the rapaciousness of business, so tax competition protects citizens from the rapaciousness of politicians and bureaucrats. It helps assure that taxpayers are getting what they pay for.25

Tax competition takes several forms. In its most effective form, high-income individuals and investors controlling the capital needed for economic development threaten to leave--or take their money from--jurisdictions where taxes exceed the value of the benefits of government spending--or never to come or invest there.26 This helps assure that the

22Similarly, Musgrave (1983, p. 11) notes that the assignment rules he suggests “place narrower constraints on the lower levels of government, so that the latter might be accorded prior claim on the use of taxes suitable to them.” The notion of subsidiarity in taxation was introduced to the EU with the Maastricht Treaty amendments to the Treaty of Rome (Article 3B). Subsidiarity requires that Member States should be able to determine their own fiscal policies unless those policies have negative spill-over effects on the entire Union. The Commission of the European Communities (1991, p. 7) explained that subsidiary requires that “Member States should remain free to determine their tax arrangements, except where these would lead to major distortions.” See also McLure and Weiner (forthcoming). 24The literature of “public choice” deals with such issues. It is well beyond the scope of this paper. See, however, Brennan and Buchanan (1980). 25Brennan and Buchanan (1983) provide a strong argument for tax competition. See also McLure (1986). This is only part of the story, although an important part. Because those who enjoy public goods cannot be excluded from enjoying the benefits, they have little incentive the reveal their preferences for such goods. There is thus a tendency to under-provision of public goods that may be aggravated by tax competition. See Gordon (1983) for a theoretical analysis of the inefficiencies that can result from decentralization, including tax competition. Benefit taxation helps to combat this source of market failure. See also Wildasin (1986). Tax competition makes it difficult for subnational governments to tax mobile factors--capital and highly educated or skilled labor--and thus to engage in progressive taxation. 26Even where factors of production are not mobile, tax competition may have a beneficial effect, by making over-taxed industries uncompetitive. In this case the result may be disinvestment and unemployment, instead of composition of government spending, as well as the level, is appropriate. The pressure exerted by potential investors is likely to be extremely important in developed countries (LDCs) and countries in transition from socialism (CITs), both of which seek foreign investment.27 c. More on the Role of Benefit Taxation Many services provided by governments, including subnational governments, produce what may be described as "generalized benefits," benefits that cannot be closely related to taxes on the beneficiaries. While generalized benefits may not be conducive to the use of charges and fees, or even taxes closely related to benefits, such as taxes on motor transport, they can be related in a general way to taxes payed.28 Thus, for example, the general benefits of government spending may be thought to be loosely related to income or to private consumption. Unless there is some reason to believe that benefits rise more or less rapidly than income or consumption, it may be reasonable simply to rely on flat-rate taxes on income or consumption for the finance of such services.29

At the subnational level, an additional inquiry is necessary when people do not work where they live (or if they do not invest their savings where they live): whether production or consumption (income earned or income spent) is the better measure of generalized benefits.30 If benefits of public spending are more closely related to production or the earning of income than to consumption or the spending of income, origin-based taxes on value added and payroll taxes levied where employment occurs would be superior to destination-based value added taxes, retail sales taxes, and residence-based income taxes as measures of benefits received.31

migration of capital and labor. This, too, may have political costs. Of course, it is difficult to imagine a contemporary setting in which capital is not mobile. Thus the model implicit in the text is generally more relevant. 27This pressure is strongest for investors from countries taxing only foreign-source income. It is diminished to the extent the home countries of investors provide foreign tax credits for source-country taxes, unless taxpayers have excess (unused) foreign tax credits. See Slemrod (1995) for a masterful exposition of this complicated topic. 28The world-wide trend of privatizing activities formerly provided by government and financed by taxes not closely related to benefits suggests that the latitude for benefit-related charges is probably greater than traditionally thought. In making such a statement one must be careful to distinguish between services that are now provided privately but financed publicly from general revenues, those that are now provided and financed privately, and those that are still provided publicly but financed on a basis related to benefits. 29Whether income or consumption is the better measure of benefits is, of course, an important question, but not central to the present discussion. In many countries consumption does not differ much from income, especially labor income, except at the very top of the income distribution. 30This issue arises most commonly and most conspicuously in the case of workers commuting across the boundaries between jurisdictions. It also arises when workers spend long periods in employment away from home, as in much of Sub-Saharan Africa. It is quite possible in such a case that three jurisdictions might reasonably make claims to revenues from taxes on the earnings of such workers: the jurisdiction of residence of the employee, the jurisdiction of employment, and the jurisdiction where the employee's family lives. The last arguably has the greatest claim to tax revenues, because of the expense of education and health care for the family. 31Under a destination-based VAT, tax is applied to the goods imported into the taxing jurisdiction and exports from the jurisdiction occur tax-free. Under an origin-principle VAT, exports are subject to tax, and tax is applied only to the value that is added after importation. The retail-sales tax is inherently a destination-based tax, except to the extent that it is applied to sales to businesses producing for export. For further elaboration, see McLure (1987). In principle, this is an empirical issue, though a difficult one, given the inherent difficulty of relating benefits of public spending to private actions. Yet a priori reasoning suggests that consumption (the spending of income) is probably more closely related to the benefits of public spending than is production (the earning of income). For example, education for one’s children is provided where one lives, not where one works; the same is predominantly true of health care. The implications of this reasoning concerning generalized benefits of public services for the problem of tax assignment are clear: in principle, residence-based income taxes are probably superior to employment-based payroll taxes, and destination (consumption)-based sales taxes are better than origin (production)-based ones. If, as seems likely, production is more mobile than the residence of households, the use of origin-based taxes that do not reflect the generalized benefits of public spending are more likely to distort the location of economic activity than are residence-based taxes. Moreover, as noted below, they are likely to contribute to horizontal fiscal disparities.

4.1 Alternative Methods of Revenue Assignment A variety of methods of assigning revenues to subnational governments can be distinguished. These methods differ in the degree of fiscal autonomy they provide subnational governments, their ease of compliance and administration, the fairness and neutrality they are likely to produce, and the degree of interjurisdictional redistribution they can accommodate. In discussing these alternatives, it is convenient to distinguish four features: (a) which level of government chooses the taxes from which subnational governments receive revenues, (b) which defines the tax base(s), (c) which sets the tax rate(s), and (d) which administers the tax(es). From the viewpoint of subnational fiscal sovereignty, the capacity to set rates is clearly the most important of these; it is what allows subnational governments to choose the level of public services. Subnational governments clearly cannot be allowed total discretion in the choice of the taxes they will levy; for example, they should not be allowed to levy import duties on international trade or trade between subnational jurisdictions or to impose taxes likely to be exported in large part. Excessive subnational latitude in the choice of tax bases and in tax administration can create unacceptable complexity and administrative burdens, as well as inequities and distortions in the allocation of resources.

Independent subnational legislation and administration provides subnational governments the most fiscal autonomy. Under this approach subnational governments choose the taxes they levy, define the tax base(s), set the tax rate(s), and administer the tax(es).56 This is the approach followed in the United States; subject only to very general constitutional limitations (e.g., due process and non-interference with interstate and international commerce) and almost no statutory limitations, the states can do virtually anything they want in these four areas.57

Carried to the extreme, this approach is vulnerable to inconsistency, duplication of effort, and excessive complexity of compliance and administration. These problems can occur if different jurisdictions choose radically different taxes (e.g., if some levy retail sales taxes, but others levy value added taxes), define their tax bases in different ways (as in the

56Subnational constitutions or laws may limit any of these, as in the United States. If such limitations are sufficiently restrictive, it may make little sense to speak of subnational discretion in the affected areas. But self- imposed restrictions in constitutions of subnational governments are different from restrictions imposed from above by law or as part of a national constitution. 57Duncan and McLure (1997) describes the American system of tax assignment. Local governments, being legally dependent on the states, generally do not have the same degree of fiscal sovereignty. case of the state corporate income taxes and retail sales taxes in the United States), or administer the same taxes in different ways. Inequities and economic distortions can also occur if the tax systems of various subnational governments do not mesh, resulting in gaps or overlaps in taxation. Within limits, these problems – which differ in importance from tax to tax – can and should be tolerated in the interest of gaining the benefits of decentralized government. But serious complexities, inequities, and distortions can and should be avoided. This objective can be achieved, without greatly compromising the fiscal autonomy of subnational governments, through intergovernmental compacts among subnational governments or the imposition of uniform ground-rules by a higher level of government, for example, rules for the definition and division of the corporate income tax base.58 Alternatively, subnational surcharges on national taxes can be employed.

Subnational surcharges provide most of the important fiscal autonomy of independent subnational legislation and administration, without the inequities, distortions, complexities, and problems of compliance and administration just described. Under this approach a higher level of government defines the tax base and collects both its own tax and surcharges set by subnational governments.59 This approach ideally avoids the problems that occur when different subnational jurisdictions define the tax base in conflicting ways, use different apportionment formulas, and administer the tax in different ways. Because of their power to set surcharge rates, subnational governments retain the most important attribute of fiscal sovereignty in the tax field; the ability to define the tax base and administer taxes are much less important.

There is no reason, in principle, that the tax rate of the central government cannot be zero for a particular tax; in such a case the central government would simply administer the tax of subnational governments, thereby assuring uniformity and avoiding duplication of effort. There is, however, a problem of providing incentives for the central government to collect a tax that it does not keep – and, indeed, of trusting it not to keep the revenues it ostensibly collects for subnational governments. These problems exist in any system of surcharges.

58In 1957 in the United States, the National Conference of Commissioners on Uniform State Laws prepared a model statute, the Uniform Division of Income for Tax Purposes Act (UDITPA), and urged its adoption by states imposing corporate income taxes. Since then more than 25 states – of the 45 that impose corporate income taxes – have adopted UDITPA, some with important modifications. Because UDITPA does not cover all aspects of corporate income taxation, there would be substantially differences in state laws, even if all states were to adopt it. The situation is even worse in the sales tax area, where each of the 46 states (including the District of Columbia) defines the tax base as it wishes. Because of the complexity of state sales and use taxes, the U.S. Supreme Court has ruled that the states cannot require a mail-order vendor to collect use taxes unless the vendor has a physical presence in a state. In order to simplify their systems, in hopes of gaining an agreement under which mail-order vendors and their equivalents in electronic commerce would voluntarily collect use tax, the states are considering adopting uniform definitions of products, so that a given state’s sales and use tax base could be defined simply by choosing whether or not to tax given identically defined products. See McLure (1998b). 59It is sometimes suggested (commonly where the national government is considering levying a type of tax already imposed by subnational governments) that subnational governments could administer national surcharges on their taxes. Although similar system is employed successfully in some countries (the administration of the national VAT by the German laender and the VAT of the Canadian government by the province of Quebec being the best-known examples), it does not seem to deserve serious consideration in most. Aside from the need to harmonize tax bases and administration in all jurisdictions, subnational governments can have an incentive to be lax in administering taxes that raise money, at least in part, for the national government at the expense of local taxpayers. Surcharges should, of course, be limited to that portion of the tax base reasonably deemed to arise in, or be attributed to, the taxing jurisdiction. This objective is relatively easy to implement for some taxes (e.g., payroll taxes). In some (e.g., company income taxes) it may be necessary to use formulas to divide the tax base among subnational jurisdictions.

Subnational surcharges appear to be the most appropriate means of providing subnational governments with own marginal revenues in many countries, especially LDCs and CITs, where administrative resources are scarce. While some Canadian provinces (the largest and wealthiest) implement their own individual and corporate income taxes, others rely on surcharges on the national taxes. In both cases tax bases and apportionment formulas are quite similar, if not identical.

Tax sharing is generally much less attractive than subnational surcharges. Under this approach subnational governments receive fixed fractions of revenues from particular national taxes originating within their boundaries; commonly the sharing rates are uniform across jurisdictions (though not across taxes), but this is not necessarily the case. As with surcharges, formulas may be needed to determine the deemed origin of tax revenues. In many less developed countries (LDCs) and countries in transition (CITs) the data needed to share revenues (e.g., data on consumption, by subnational jurisdiction, needed to divide revenues from the VAT) may not exist or may not be reliable.

This approach also avoids the problems that arise from extreme subnational independence in tax policy. But it does so in a way that severely restricts fiscal autonomy of subnational governments. Individual subnational governments have autonomy over how to spend a given amount of revenue, but not the power to alter the amount of revenue they receive from shared taxes; thus they cannot control the level of public spending. (While all subnational governments, acting as a group, can attempt to affect their share of revenues from these taxes, no subnational government, acting unilaterally, can hope to do so. The harmonized sales tax employed in several of the maritime provinces of Canada, which combines federal and provincial VATs, illustrates the problem. All of the provinces that participate in the scheme must implicitly adopt the same VAT rate. In Germany the central and subnational governments engage in an annual struggle over the split of revenues from certain taxes. )

Revenue sharing assigns revenues of higher levels of government to lower levels of government on the basis of formulas. Though the origin of revenues can be reflected in such formulas, it is more common for formulas to be based, inter alia, on population, tax capacity (inversely), or measures of need, such as per capita income. Since revenue sharing is not based on the origin of revenues, this approach offers an alternative that does not exist (or exists only in attenuated form) under the three methods of revenue assignment just discussed: redistribution of fiscal resources between jurisdictions. By comparison, under the previous three approaches, revenues flow to the jurisdiction where economic activities occur; thus there is no redistribution of income between subnational jurisdictions. (A minor qualification should be made in the case of tax sharing; sharing rates could be set at higher levels for poor jurisdictions than for more affluent ones. It is more convenient to classify that approach as revenue sharing, rather than tax sharing.)

Since subnational governments need to exercise little or no independent fiscal effort in order to receive funds from revenue sharing, this is generally not a source of marginal own funds. The only fiscal autonomy lies in how to spend the money. (These statements should be qualified by noting that revenue sharing formulas sometime contain a measure of "own tax effort." Of course, if subnational governments are to be able to exert tax effort, meaningful marginal sources of revenues--and the latitude to use them as they wish--must be assigned to them.)

In summary, it appears that subnational surcharges generally dominate both independent subnational taxation (legislation and administration) and tax sharing as means of providing subnational governments with fiscal autonomy in the tax area; this is especially true in LDCs and CITs, where the resources needed for compliance and administration are quite scarce. Surcharges provide almost as much fiscal autonomy as independent taxation, but are much simpler. They provide more autonomy than tax sharing, and are scarcely more complicated. None of these provides for redistribution among subnational jurisdictions; for that, some form of revenue sharing (or grants) is needed.

Transition from tax sharing, which is now found in many countries, to a system of surcharges, in which subnational governments choose tax rates, could be achieved as follows. First, tax sharing rates could be made uniform, if uniformity does not now exist. (It might also be necessary to rationalize the basis of tax sharing, if the present basis makes no sense, as when excises are shared with the jurisdiction of origin, instead of he jurisdiction of destination, as in much of the former Soviet Union.) Then tax sharing could be converted to a uniform-rate subnational surcharge on the national tax. Finally, subnational governments could be given authority to decide surcharge rates.

4.2 Vertical Imbalance and Horizontal Disparities A system of tax assignment designed in accord with the principles outlined above may produce vertical imbalance in the revenues available to various levels of government or horizontal fiscal disparities among governments at a given level.88 a. Vertical Fiscal Imbalance Vertical fiscal imbalance is likely because many of the taxes that, from a conceptual point of view, are appropriately assigned to subnational governments cannot easily be administered in a way that implements this assignment. It is especially difficult to find taxes that can be implemented in a way that provides subnational governments with marginal sources of own revenues.89 As noted earlier, neither revenue sharing nor tax sharing provides marginal sources of own revenues for subnational governments.

The likelihood of vertical fiscal imbalance explains the earlier emphasis on subsidiarity in taxation: the view that subnational governments should generally be assigned any tax that they can administer (or that can be administered for it) that is not inappropriate for their use. Also, it explains why many nations may need to assign the corporation income tax to subnational governments, despite the manifest disadvantages of such an assignment. Box 1 illustrates the results of alternative choices in tax assignment. Whereas the Canadian

88See Bird (1993). 89The version of this paper delivered at the Vienna Workshop in March 1998 contained the following sentence: “The most obvious example of this problem is the value added tax; while a VAT can provide revenues that can be shared with subnational governments on the basis of a formula, it cannot very well form the basis of tax surcharges or even tax sharing based on the origin of revenues (and even less can it be administered by subnational governments acting independently).” The omission of this sentence from the present draft indicates the change in the author’s thinking since the Vienna Workshop--and the importance he ascribes to the dual VAT. For further discussion, see the paper by McLure at www.decentralization.org. provinces and the states of the United States are fiscally quite strong, the Australian states and the provinces of South Africa are fiscally weak. b. Horizontal Fiscal Disparities Even if tax assignment follows the principles outlined here, horizontal fiscal disparities are likely, unless taxable capacity is evenly distributed across subnational jurisdictions.90 Unequal fiscal capacity generally occurs where income levels are quite different. Inequalities in income levels make it difficult for poor jurisdictions to collect as much tax revenue as their more affluent counterparts from income and sales taxes. But particular industrial structures and tax assignments can create or aggravate horizontal disparities. The assignment of taxes on important and geographically concentrated natural resources to subnational governments is perhaps the most obvious example of this phenomenon. The assignment of the corporate income tax to subnational governments can have a similar effect, especially if the tax base is apportioned primarily on the basis of origin- related factors such as payrolls and property. Including destination-based factors in the apportionment formula may help to offset this tendency.

Where tax assignment does not follow the principles set forth here, horizontal disparities may be even worse. One of the most egregious cases involves the assignment of excise taxes to the jurisdiction where production or importation occurs, instead of the jurisdiction of consumption. The combination of an origin-based VAT, differentiation of production on a geographic basis, and exemptions for food can also produce horizontal disparities. Finally, as noted above, the combination of triangular trade and an origin-based VAT can cause horizontal disparities. c. A Caveat on the Design of Intergovernmental Grants At the end of the day, it is likely that, in many countries, taxes reasonably assigned to subnational governments will not be adequate to finance the provision of services assigned to those governments or that they will result in horizontal fiscal disparities. If so, it may be desirable to use grants from higher level governments to compensate for vertical fiscal imbalance or to offset horizontal fiscal disparities. While a complete discussion of the design of such grants is beyond the scope of this paper, one point deserves emphasis. Grants intended to offset vertical imbalance or horizontal disparities should provide infra-marginal funding for subnational governments, so as not affect the marginal decisions of those governments regarding the choice between public and private spending.91 It is especially important that subnational governments not be penalized for raising additional revenues, by reducing grants.92

90This discussion is limited to horizontal disparities that occur even if taxes are assigned in a rational manner. Disparities are even more likely if tax assignments are not rational, as when excises are assigned to the subnational jurisdictions where importation and production occurs. 91Grants may be appropriate because of interjurisdictional spillovers of benefits of services provided by subnational governments. By their nature this type of grant should be designed to change the terms on which private income can be exchanged for public services characterized by spillovers (and, indeed, the terms of the trade-off between these and other public expenditures). 92Section 227 of the Constitution of South Africa reflects this thinking; it provides (Paragraph 2): “Additional revenue raised by provinces or municipalities may not be deducted from their share of revenue raised nationally, or from other allocations made to them out of national government revenue. Equally, there is no obligation on the national government to compensate provinces or municipalities that do not raise revenue commensurate with their fiscal capacity and tax base.” Some favor including provisions in grants that reward greater subnational tax effort. This policy is unattractive, unless there are reasons to believe that the choices of subnational governments are being artificially constrained

4.3 Concluding Remarks: Tax Competition Revisited The discussion flowing through this paper indicates the difficulty of achieving fiscal autonomy of subnational governments, especially in LDCs and CITs, and highlights a problem. On the one hand, subnational governments need the ability to vary tax rates, in order to exercise fiscal autonomy and engage in healthy tax competition. On the other hand, it may be difficult to vary many of the most important tax rates, without inducing taxpayers to take steps that would artificially minimize their tax burdens, at the expense of revenues in the high-tax jurisdiction. This may be true of the individual income tax (to the extent people do not work where they live), sales taxes (because of cross-border shopping), certain excises (because of smuggling and cross-border shopping), and corporate income taxes based on separate accounting (because of manipulation of transfer prices). It is possible to vary rates of subnational surcharges on corporate income, if the tax base is apportioned on the basis of a formula. But excessive variation of rates of business taxes, origin-based sales taxes, and source-based income taxes not matched by differences in benefits provided to taxpayers is likely to distort the location of business. This suggests the need to rely as heavily as possible on fees, charges, and taxes that can be linked closely to the benefits of public services, destination-based sales taxes, and residence-based income taxes.

It is useful to distinguish between healthy tax competition and what might be called predatory tax competition. In healthy tax competition there is pressure for taxes to be no higher than justified by the benefits of public spending. Pressure for responsible taxation comes from those who threaten (perhaps implicitly) to migrate from jurisdictions where taxes exceed the benefits of public activities. The only way to avoid the taxes is to leave the jurisdiction and cease consuming the services it provides. There is relatively little reason for taxes to fall below benefits in this model.

Predatory tax competition is very different. It is not necessary for taxpayers to leave the jurisdiction and forego benefits of public spending in order to benefit from smuggling, cross-border shopping, false statements of residence, or manipulation of transfer pricing; they can stay in the high-tax jurisdiction, but not pay its taxes. Pressure for tax reduction comes, in part, not from healthy tax competition, but from predatory behavior of jurisdictions that can finance their public services, with little cost to their own residents, by providing a haven for residents of other jurisdictions who would engage in smuggling, cross-border shopping, misstatement of residence, or shifting of corporate income. This type of tax competition is potentially destructive, instead of healthy. Rather than being welcomed, like healthy tax competition, it should be suppressed. Use of formula apportionment minimizes the possibility of manipulating transfer prices to shift corporate income between jurisdictions. The other forms of abuse just described are more difficult to prevent.

to suboptimal levels. Even then, it seems more appropriate to remove the obstacles than to reward tax effort, per se.

Box 1: Some Principles for Expenditure Assignment There is no one best way for deciding which level of government should be responsible for the provision of particular government services. The adequacy of any assignment has to be judged in terms of how well it achieves the goals or objectives set up by the central government in its decentralization strategy. Commonly accepted objectives of fiscal decentralization include an efficient allocation of resources via a responsive and accountable government, an equitable provision of services to citizens in different jurisdictions, and macroeconomic stability and economic growth. These objectives are also incorporated in the European Charter of Self-Government. An efficient provision of government services requires that government satisfy the needs and preferences of taxpayers as closely as possible. This is best achieved by keeping the provision of services at the lowest level of government compatible with the size of "benefit area" associated with those services. For example, the benefit area for sanitation services is clearly the local community, but for air traffic control the benefit area is the entire national territory. Assigning public services with wider benefit areas to smaller units of government is likely to result in the inefficient underprovision of services; e.g., a tertiary hospital providing regional services is financed only by a single municipality, with other municipalities free-riding. Efficiency in the provision of public services is enhanced if consumption benefits are linked to costs of provision via fees, service charges, or local taxes. Expenditures undertaken by government for equity or income equalization reasons, such as social welfare or low-income housing, are generally thought to be the domain of the central government. The general belief is that local or regional governments would not be able to sustain independent programs of this nature, because they would attract the needy from other areas while requiring that they tax their (potentially mobile) residents more heavily. While funding for these expenditures should be a central government responsibility, implementation can be left to local government, which may have informational and other comparative advantages. To the extent that mobility of households is limited, local governments may be effectively able to carry their own redistributional policies. Expenditures undertaken for the stabilization and growth of the economy, such as public investment projects or unemployment compensation, are by their scale naturally assigned to the central government. The application of these rules largely facilitates the assignment of expenditure responsibilities to different levels of government. However, the rules are unlikely to yield a unique answer in every situation. Some public services, e.g., primary education and primary health services, may be of a local nature by the size of their benefit areas. But because of their relevance to welfare and income redistribution, they may also be considered a responsibility of the central government. The objectives are not all attainable at the same time. The pursuit of greater efficiency and autonomy may be achieved at the cost of a sacrifice in the equality of service levels. It is for this reason that we cannot speak of a "best expenditure assignment." The government's strategy and priorities would assign different weights to the objectives of efficiency, equity, and stability. In addition, what is considered the best assignment is likely to change over time with changes in costs and technological constraints, as well as changes in preferences. However, there is a need at all times to have a concrete and clear assignment of expenditure responsibilities that could be considered preferable among the alternative assignments. Failure to have a concrete assignment may lead to instability in intergovernmental relations and to the inefficient provision of public services. Without an explicit assignment of expenditure responsibilities it will be much harder to reach consensus and stability in the assignment of tax revenues and to arrive at a workable system of equalization transfers.

Table 1: Fiscal Autonomy in Subcentral Governments Own taxes Base and rate under local control Overlapping taxes Nationwide tax base, but rates under local control Nontax revenues Fees and charges. Generally, the central government specifies where such charges can be levied and the provisions that govern their calculation. Shared taxes Nationwide base and rates, but within a fixed proportion of the tax revenue (on a tax-by-tax basis or on the basis of a "pool" of different tax sources) being allocated to the subcentral government in question, based on (1) the revenue accruing within each jurisdiction (also called the derivation principle) or (2) other criteria, typically population, expenditure needs, and/or tax capacity. General purpose grant Subcentral government share is fixed by central government (usually with a redistributive element), but the former is free to determine how the grant should be spent; the amounts received by individual authorities may depend on their efforts.

Specific grants The absolute amount of the grant may be determined by central government or it may be "open-ended" (that is, depend on the expenditure levels decided by lower levels of government), but in either case central government specifies the expenditure programs for which the funds should be spent. Source: Anwar Shah, The Reform of Intergovernmental Fiscal Relations In Developing & Emerging Market Economies, Policy and Research Series No. 23, World Bank, 1994.

Table 2: Conceptual Basis of Expenditure Assignment

Responsibility for Policy, Standards & Provisional, Expenditure Category Comments Oversight Administration Defense F F Benefits and costs are national in scope Foreign Affairs F F Benefits and costs are national in scope International Trade F F Benefits and costs are national in scope Monetary Policy, F F Benefits and costs are national in scope currency & Banking Interstate Commerce F F Benefits and costs are national in scope Transfer Payments to F F Redistribution Persons Subsidies to Business F F Regional development, industrial policy and Industry Immigration F F Benefits and costs are national in scope Unemployment F F Benefits and costs are national in scope Insurance Airlines and Railways F F Benefits and costs are national in scope Fiscal Policy F, S F,S,L Coordination is possible Regulation F F,S,L Internal common market Natural Resources F F,S,L Promotes common market Environment Benefits and costs may be national, F,S,L S,L regional or local in scope Industry & Agriculture F,S,L S,L Significant interjurisdictional spillovers Education F,S,L S,L Transfers in kind Health F,S,L S,L Transfers in kind Social Welfare F,S,L S,L Transfers in kind Police S,L S,L Primarily local benefits Water, Sewage & Refuse L L Primarily local benefits Fire Protection L L Primarily local benefits Parks and Recreation Primarily local responsibility, but F,S,L F,S,L national and provincial governments may establish own parks Highways Interstate F S,L Internal common market Provincial S S,L Provincial benefits and costs Interregional S S,L Interregional benefits and costs Local L L Local benefits and costs Spending Power Fiscal transfers to advance own F,S F,S objectives Note: F is federal responsibility; S is state or provincial responsibility; and L is local responsibility Source: Anwar Shah, The Reform of Intergovernmental Fiscal Relations In Developing & Emerging Market Economies, Policy and Research Series No. 23, World Bank, 1994.

Table 3.1: Expenditure Assignment to Subnational Authorities

Country Expenditure Category Bulgaria CSFR Hungary Poland Romania Russia Defense No No No local No No Military housing responsibility Justice/Internal Security Security of farming -- Enforcement of rights No Public security is -- estates of national and ethnic provided by local minorities branches of the Ministry of the Interior Foreign Economic No ------Relations Education All expenditures Partial responsibility Primary and Kindergarten and None Several special (capital and current) un the Czech secondary only, pre-elementary vocational schools. of primary and Republic including day care schools only Wages, operation, secondary schools. and high schools construction and Some kindergartens maintenance of all and technical & primary and secondary vocational schools schools. Local enterprises build some facilities Culture and Parks No -- Supporting cultural -- Overlapping Some museums with activities responsibility for oblast significance. All cultural activities recurrent expenditures of all sport and park facilities and all other cultural facilities. Health Tertiary care and No Basic health and No None Paramedics, medicine, psychiatric hospitals. social service primary health clinics. Polyclinics. Some Secondary and tertiary primary care ad drugs hospitals, veteran hospitals, diagnostic centers, and special service hospitals Roads Improve traffic No Maintenance of local Only local or urban Maintenance Maintenance of oblast, safety. Maintenance public roads roads/streets rayon and city and of III and IV class commercial roads roads and urban streets Public Transportation All modes of city Urban transport only Local mass transport Construction and Public transport Most public transportation maintenance of investment transportation facilities, bridges including subway Country Expenditure Category Bulgaria CSFR Hungary Poland Romania Russia Fire protection Most fire protection No Local fire protection -- None Most fire protection services services Libraries Local libraries No -- Partial responsibility No (books purchased Special library services through the budget of at the oblast level and the Ministry of most local library Culture) services at the rayon level Police services Sofia has a signed No ------Road (traffic) police contract with the National Militia. Other municipalities get the service free Sanitation (garbage -- -- Garbage collection Ownership and -- Part of garbage collection) provision of cold collection at both oblast water at all levels and rayon levels Sewage Garbage collection -- Garbage collection Ownership and Sewage collection Most operational and sanitation and settlement provision of sewage expenditures at the cleaning rayon level Public utilities (gas, Water supply -- Water management Supply street lighting District heating and Subsidies to households electricity and water) infrastructure and maintenance of water (not enterprises) at the public cemeteries rayon level Housing Management of -- Housing management Shared responsibility Housing services Maintenance is the common pastures and responsibility of the other municipal level of government or property. Financing, enterprise owning the building and housing. Capital subsidizing for expenditures are residential housing included unless otherwise noted. Price and other Mass transport and Direct subsidies to Rent subsidies Rents Energy subsidies to For fuels, mass transport subsidies drugs. Subsidy to agricultural households and and food such as bread, inter-village bus cooperatives, and public transport milk and medicines at service within subsidies to the rayon level. Also, municipalities. enterprises that are rent subsidies Heating subsidy since not involves in 1992. production of local public goods Country Expenditure Category Bulgaria CSFR Hungary Poland Romania Russia Social Welfare Homeless, disabled -- Social care facilities -- -- Part oblast government and orphans such as old age and responsibility, and the handicapped homes rayon level, management of programs funded by upper level governments New public enterprises Can establish new Can establish new Can establish new Can establish new Can establish new Capacity to invest in (productive sectors) domestic joint domestic joint domestic joint domestic joint domestic joint joint ventures (keeps ventures ventures ventures ventures ventures 50% of privatization proceeds if rayon subordination). At the rayon level this also includes 10% of any other subordination Environment Measures to improve -- Protection of the -- -- Responsible for local and rehabilitate the environment environmental environment problems, e.g. preservation of forests State-owned enterprises -- Major local Major local Local ownership Local ownership “Group C” enterprises, ownership ownership responsibilities responsibilities e.g. local light industry, responsibilities responsibilities housing construction and food industry. Rayon responsibility exists only if the enterprise is transferred to the local level Source: Jorge Martinez-Vazquez, The Assignment of Expenditure Responsibilities, Paper presented in Intergovernmental Fiscal Relations and Local Financial Management Course, Chiang Mai, Thailand, February 2-March 5, 1999 . Table 3.1a: Expenditure Assignment to Subnational Authorities (updated) Country Expenditure Category Estonia Latvia Lithuania Ukraine Primary and secondary schools, Primary and secondary schools, Primary, secondary and vocational Education Primary and secondary schooling except teachers’ wages except teachers’ wages schools Polyclinics, municipal hospitals Tertiary care, polyclinics, Primary health case, ambulance Health clinics, hospitals and Health and primary care medicine and some primary care services paramedics Temporary social benefits , day Care for elderly and other social Responsibility for homeless, Child and family allowances, Social Security care, care for elderly, homeless assistance disabled and orphans other social protection and handicapped Municipal police and FIRE Police and Fire No Municipal police Local police and fire service protection Housing maintenance and Financing, building, maintenance Rental and sale of municipal Maintenance and small scale Housing communal services and subsidies housing stock building Some public transportation Public Transportation Local public transportation City transportation Local public transportation facilities Maintenance of local networks Roads Maintenance and construction Urban and rural roads Maintenance of roads and town streets Garbage collection and street Garbage collection and street Garbage collection, street cleaning Sanitation Garbage collection cleaning cleaning and parks Water, sewage and some district Sewage and subsidies to Public utilities Water and sewage Water, sewage and heating hearing households

Table 4: Allocation of Social Functions to Subnational Government in Selected Countries

United Austria Belgium Denmark France Germany Ireland Italy Luxembourg Netherlands Norway Sweden Switzerland Turkey Kingdom Preschool R,L L L L L R,L L education Primary and R,L R,L L R,L R,L L R,L L L L L R,L L secondary education Vocational and R R,L R,L R,L L L R,L L R,L R L technical training Higher R,L R R,L R L education Adult L L L L R,L R L R,L R,L R,L L education Hospitals R,L R,L R L,D R,L R,P,L L R,L R,L R R,L R,L Personal R,L L R,L L R,L R,P,L L L L R R R health Family welfare R,L R,L L L,D R,L R,L L L L R,L L L services Welfare R,L L L L L R,L L L L L R,L R,L L homes Housing R,L L L R,L L R,L L R,L L L L L L Refuse collection L L L L L L L L L L L R,L L L and disposal District L L L L L L L L R,L R,L L heating Water L L L L L L R,P,L L R,L L R,L R,L L supply Note: R = state, regional government; D = departments in France; L = local government; P = provinces in Italy Source: Jorge Martinez-Vazquez, The Assignment of Expenditure Responsibilities, Paper presented in Intergovernmental Fiscal Relations and Local Financial Management Course, Chiang Mai, Thailand, February 2- March 5, 1999.

Table 5: Assignment of Local Public Services to Municipal and Regional/Metropolitan Governments Allocation criteria for public vs. private Allocation criteria for provision production Public Service Economies Economies Benefit- Political Consumer Economic Composite Efficiency Equity Composite of scale of scope cost proximity sovereignty evaluation spillout of sectoral choices Fire fighting L L L L L M L P G P Police protection L L L L L M L P G G Refuse collection L L L L L M L P P P Neighborhood parks L L L L L M L P G G Street maintenance L L L L L M L P P P Traffic management L M L L L M L P P P Local transit service L M L L L M L P P P Local libraries L L L L L M L G G G Primary education L L M M L M M P G P,G Secondary education L L M M L M M P G P,G Public transport M M M L,M M M M P.G G P.G Water supply M M M L,M M M M P G P.G Sewage disposal M M M M M M M P,G P.G P.G Refuse disposal M M M M M M M P P P Public health M M M M M M M G G G Hospitals M M M M M M M P,G G P,G Electric power M M M M M M M P P P Air/water pollution M M M M M M M G G G Special police M M M M M M M G G G Regional parks M M M L,M M M M G G G Regional planning M M M L,M M M M G G G Note: L = local government; M = regional/metropolitan government; P = private sector; G = public sector Source: Anwar Shah, The Reform of Intergovernmental Fiscal Relations In Developing & Emerging Market Economies, Policy and Research Series No. 23, World Bank, 1994.

Table 6: Magnitude of General Government Expenditures and Portion Administered by Each Level of Government1 (average of latest three years available) Total Government Education Health Social Security and Welfare Expenditures3 Ending Social Security Country Total Education Health Central State Local Central State Local Central State Local Central State Local Year and Welfare (in % of GDP) (in % of general government) Argentina2 1987 33.2 4.0 1.1 9.1 60.3 39.7 33.3 66.7 24.4 75.6 89.4 10.6 Australia 1987 39.1 5.5 5.5 9.6 52.9 40.4 6.8 8.5 91.3 0.2 43.5 55.6 0.9 92.8 6.2 1.0 Austria 1987 70.4 13.7 16.9 Belgium 1987 56.7 85.9 11.9 Bolivia 1986 11.1 85.9 10.6 3.4 Brazil 1987 34.1 65.8 24.5 9.6 Canada 1987 46.0 5.8 6.0 12.3 41.3 40.3 18.4 4.8 34.5 60.7 2.6 89.5 7.9 65.8 31.3 2.9 Chile 1987 32.3 4.9 1.9 8.8 93.8 6.2 81.7 18.3 98.1 1.9 100.0 Colombia 1984 18.0 5.5 1.3 3.2 67.4 23.9 8.7 55.5 39.2 5.3 49.0 40.2 10.8 90.0 7.8 2.2 Denmark 1986 57.6 7.1 5.2 23.1 44.9 52.9 46.8 53.2 7.1 92.9 26.1 73.9 Finland 1987 43.0 54.7 45.3 France 1985 49.3 4.6 8.3 20.9 82.2 16.5 75.3 24.7 97.0 3.0 91.8 8.2 Germany 1983 50.2 4.2 8.0 21.2 58.7 21.5 17.9 1.0 73.8 25.2 74.4 11.2 14.4 79.0 10.9 10.1 Hungary 1988 64.5 5.7 4.2 18.1 77.8 22.2 20.0 80.0 39.2 60.8 95.7 4.3 India2 1986 22.6 3.4 0.9 2.3 47.5 52.5 9.0 90.1 30.2 69.8 0.0 100.0 Indonesia2 1988 22.8 3.1 0.5 0.4 88.7 11.3 65.3 34.7 72.8 27.2 0.0 100.0 Ireland 1987 55.8 72.5 27.5 Israel 1986 62.9 5.3 2.0 10.0 90.8 9.2 67.2 32.8 97.0 3.0 94.9 5.1 Kenya 1984 29.3 5.2 2.1 1.4 94.3 5.7 94.0 6.0 91.9 8.1 75.9 24.1 Luxembourg 1987 39.1 4.4 0.7 21.3 81.3 15.9 74.1 25.9 92.0 8.0 97.4 2.6 Malawi 1984 29.1 3.7 2.2 0.6 93.7 6.3 98.7 1.3 82.9 17.1 100.0 0.0 Mexico 1984 30.2 90.1 7.6 2.3 Netherlands 1988 59.2 70.1 29.9 New Zealand 1981 43.2 86.9 13.1 Norway 1986 47.2 66.4 33.6 Pakistan 1979 26.1 68.2 28.3 3.5 Paraguay 1984 11.3 95.1 4.9 Poland 1988 48.1 71.1 28.9 Romania 1985 32.3 2.1 2.1 8.9 77.0 23.0 28.0 72.0 10.3 89.7 99.3 0.7q South Africa 1986 33.3 74.8 12.5 12.7 Spain 1986 38.2 78.8 9.9 11.3 Sweden 1987 61.6 59.8 40.2 Switzerland 1984 37.4 5.3 5.9 13.9 47.5 28.3 24.2 6.2 57.5 36.3 45.5 32.1 22.4 88.5 5.6 5.9 Thailand 1982 21.2 4.1 1.1 1.2 92.3 7.7 94.8 5.2 93.5 6.5 97.4 2.6 Tunisia 1982 34.0 5.1 2.5 4.7 94.6 5.4 100.0 100.0 100.0 United 1987 44.8 5.1 5.1 14.3 70.9 27.2 12.7 87.3 100.0 84.0 16.0 Kingdom United States 1987 37.1 5.1 4.3 9.0 60.3 17.3 22.4 4.2 24.5 71.3 50.5 33.8 15.7 78.0 14.6 7.4 Yugoslavia 1987 25.3 3.2 4.2 7.8 23.2 31.4 45.4 0.0 0.0 100.0 0.0 0.0 100.0 7.3 75.9 16.8 Zimbabwe 1986 45.0 8.3 2.6 3.0 75.8 24.2 60.2 39.8 86.6 13.4 100.0 0.0 1 Excluding intergovernmental grants. 2 Data for general government do not include local government. 3 Includes supranational authorities share of general government expenditures in Belgium (2.2%), Denmark (2.2%), France (1.4%), Germany (1.8%), Luxembourg (2.7%) and United Kingdom (1.9%). Source: Levin (1990), based on International Monetary Fund, Government Finance Statistics Yearbook, Vol. 13 (Washington, DC: IMF, 1989) Table 6a: Magnitude of General Government Expenditures and Portion Administered by Each Level of Government (average of latest three years available, updated)

Total Government Education Health Social Security and Welfare Expenditure Ending Social Security Country Total Education Health Central State Local Central State Local Central State Local Central State Local Year and Welfare (in % of GDP) (in % of general government) Argentina1 1997 26.3 4.0 1.9 8.8 58.9 41.1 22.1 77.9 20.1 79.9 93.0 7.0 Australia 1998 42.4 5.4 6.8 9.8 59.9 34.8 5.3 35.4 64.4 0.2 52.7 46.7 0.6 90.8 7.7 1.5 Austria 1997 74.0 53.9 33.3 12.8 Belgium 1997 53.5 89.1 10.9 Bolivia 1998 32.2 7.6 1.9 5.6 69.1 18.8 12.1 55.5 41.0 3.5 42.2 49.6 8.2 95.2 4.0 0.8 Canada 1995 60.9 10.5 8.1 17.3 41.8 42.5 15.7 8.1 53.0 38.9 15.0 83.7 1.3 64.2 31.7 4.1 Chile 1998 23.1 91.5 8.5 Denmark 1995 75.1 7.6 5.4 36.5 56.3 43.7 52.2 47.8 7.9 92.1 48.8 51.2 Finland 1997 62.8 62.4 37.6 France 1993 55.0 5.1 8.3 20.9 82.3 17.7 62.2 37.8 97.3 2.7 92.0 8.0 Germany 1996 58.1 4.4 8.8 21.9 59.2 24.1 16.7 2.6 69.1 28.3 71.8 12.8 15.4 78.0 11.1 10.9 Hungary 1998 56.3 7.2 4.6 15.4 76.6 23.4 51.9 48.1 52.0 48.0 90.2 9.8 India1 1996 27.0 3.1 0.8 53.8 46.2 9.5 90.5 26.5 73.5 Indonesia1,2 1993 19.6 2.5 0.6 88.0 12.0 67.1 32.9 78.1 21.9 100 Ireland 1996 49.7 6.4 11.2 11.1 74.9 25.1 77.0 23.0 51.0 49.0 92.3 7.7 Israel 1996 42.9 6.9 3.6 9.5 85.9 14.1 72.8 27.2 98.6 1.4 94.0 6.0 Kenya 1994 30.8 5.5 1.7 96.0 4.0 97.9 2.1 92.2 7.8 61.7 38.3 Luxembourg 1995 49.1 5.0 1.0 22.0 84.3 15.7 75.8 24.2 97.8 2.2 97.7 2.3 Mexico 1997 22.1 71.9 23.8 4.3 Netherlands 1997 63.5 17.9 7.4 21.5 76.6 23.4 85.1 14.9 94.9 5.1 84.4 15.6 New Zealand 1998 36.4 89.4 10.6 Norway 1997 55.2 6.7 7.0 17.2 67.1 32.9 38.8 61.2 22.4 77.6 81.3 18.7 Paraguay 1993 13.2 1.2 0.9 2.0 97.9 2.1 98.5 1.5 94.8 5.2 99.8 0.2 Poland 1998 48.6 5.6 6.7 20.3 79.6 20.4 42.9 57.1 92.5 7.5 95.7 4.3 Romania 1997 36.3 3.5 2.8 9.9 87.5 12.5 86.9 13.1 80.5 19.5 97.7 2.3 South Africa 1996 47.4 63.0 29.2 7.8 Spain 1996 53.3 4.3 5.6 15.2 69.4 18.7 11.9 34.3 59.4 6.3 37.7 59.3 3.0 94.6 3.5 1.9 Sweden 1998 67.7 65.5 34.5 Switzerland 1997 52.5 6.9 9.8 17.0 52.3 27.7 20.0 9.8 54.9 35.3 55.7 25.0 19.3 79.0 12.9 8.1 Thailand 1996 15.8 3.2 1.2 0.5 91.9 8.1 96.0 4.0 92.9 7.1 96.1 3.9 Tunisia 1996 United 1998 50.6 4.7 5.8 18.0 78.0 22.0 33.2 66.8 100.0 79.7 20.3 Kingdom United States 1997 43.2 7.6 7.7 9.1 53.7 25.3 20.9 5.3 43.3 51.4 56.6 32.7 10.7 70.6 21.2 8.2 1 Data for general government do not include local government. 2 Expenditure of Indonesian central government on social security and welfare began in 1994 Source: International Monetary Fund, Government Finance Statistics Yearbook, Vol. 23 (Washington, DC: IMF, 1999)

Table 7: Conceptual Basis of Tax Assignment Determination of Collection and Type of Tax Base Rate Comments administration Customs F F F International trade taxes Corporate income F F F Mobile factor, stabilization tool Resource taxes, resource rent F F F Highly unequally distributed tax bases (profits, income) tax Royalties, fees, charges, Benefit taxes / charges for state-local severance taxes, production, S,L S,L S,L services output and property taxes Conservation charges S,L S,L S,L To preserve local environment Personal income F F,S,L F Redistributive, mobile factor Wealth taxes (taxes on capital wealth, wealth transfers, F F,S F Redistributive inheritances, and bequests) Benefit charge, e.g. social security Payroll F,S F,S F,S coverage Border tax adjustment possible under Multistage sales taxes (VAT) F F F federal assignments, potential stabilization tools Single-stage sales taxes (manufacturer, wholesale, retail) Option A S S,L S,L Higher compliance cost Option B F S F Harmonized, lower compliance cost “Sin” taxes Excises on alcohol and F F F Health care shared responsibility tobacco Betting, gambling S,L S,L S,L State and local responsibility Lotteries S,L S,L S,L State and local responsibility Race tracks S,L S,L S,L State and local responsibility Taxation of “bads” Carbon F F F To combat global/national pollution Pollution impact may be national, BTU taxes F,S,L F,S,L F,S,L regional or local Tolls on federal/provincial or local Motor fuels F,S,L F,S,L F,S,L roads To deal with interstate, intermunicipal Effluent charges F,S,L F,S,L F,S,L or local pollution issues Tolls on federal/provincial or local Congestion tolls F,S,L F,S,L F,S,L roads Parking fees L L L To control local congestion Motor vehicles Registratio, transfer taxes and S S S State responsibility annual fees Driver’s licences and fees S S S State responsibility Business taxes S S S Benefit tax Excises S,L S,L S,L Residence-based taxes Completely immobile factor, benefit Property S L L tax Completely immobile factor, benefit Land S L L tax Frontage, betterment S,L L L Cost recovery Poll F,S,L F,S,L F,S,L Payment for services User charges F,S,L F,S,L F,S,L Payment for services rendered Note: F = federal responsibility; S = state or provincial responsibility; L = local responsibility Source: Anwar Shah, The Reform of Intergovernmental Relations in Developing and Emerging Countries, Policy Research Paper No. 23, World Bank, 1994

Table 8: Tax Revenue Attributable to Each Level of Government (in % of general government) Domestic Taxes on Total Tax Revenue Taxes on Income Taxes on Property Goods and Services Country Year C S L C S L C S L C S L Netherlands 1988 97.8 0.8 100.0 100.0 99.4 Paraguay 1987 97.6 2.4 Indonesia 1988 97.3 2.7 100.0 55.4 44.6 95.4 4.6 Chile 1987 96.5 3.5 100.0 100.0 95.5 4.5 Kenya 1986 96.4 3.6 100.0 1.4 98.6 97.6 2.4 Zimbabwe 1986 96.3 3.7 100.0 12.3 87.7 98.3 1.7 Ireland 1987 96.0 2.3 100.0 42.9 57.1 98.7 Malawi 1984 95.9 4.1 99.7 0.3 1.9 98.1 99.8 0.2 Israel 1986 95.5 4.5 100.0 22.9 77.1 100.0 Thailand 1988 95.0 5.0 100.0 58.8 41.2 92.8 7.2 South Africa 1986 94.4 1.5 4.1 100.0 27.7 72.3 95.6 4.4 Belgium 1987 93.5 5.0 90.0 10.0 100.0 95.9 3.3 New Zealand 1981 93.5 6.5 100.0 17.9 82.1 98.8 1.2 Luxembourg 1987 93.3 6.2 87.6 12.4 92.0 8.0 99.2 0.7 Hungary 1988 91.7 8.8 73.6 26.8 55.5 45.5 99.2 0.8 France 1988 90.0 9.2 United 1987 88.1 10.7 100.0 17.0 83.0 99.8 Kingdom Spain 1986 87.7 3.3 9.0 84.3 1.2 14.4 56.7 23.9 19.4 76.1 7.4 16.5 Mexico 1984 84.6 12.7 2.7 98.2 1.6 0.2 8.7 52.4 38.9 99.4 0.3 0.3 Australia 1987 81.1 15.3 3.6 100.0 4.9 4.9 49.2 46.0 75.6 24.4 Norway 1986 80.9 19.1 57.1 42.9 40.6 59.4 99.8 0.2 Poland 1988 80.9 19.1 79.6 20.4 50.8 49.2 89.2 10.8 Columbia 1984 80.3 13.3 6.3 100.0 9.5 90.5 70.0 30.0 Bolivia 1986 78.6 18.4 3.0 99.2 0.8 60.1 36.2 3.7 Sweden 1987 77.7 32.6 33.2 66.8 100.0 100.0 Pakistan 1979 76.9 18.5 4.6 Finland 1987 76.0 25.3 Austria 1987 75.8 11.5 12.7 58.0 22.6 19.4 52.1 4.3 43.6 71.3 13.1 15.6 Brazil 1987 71.4 26.6 1.9 100.0 2.8 51.9 45.3 43.7 53.4 2.8 Denmark 1987 71.2 28.8 54.0 43.0 57.0 43.0 99.4 0.1 Germany 1988 69.8 21.7 7.6 39.4 40.5 20.1 5.2 54.5 40.3 69.9 29.4 0.1 India 1986 67.2 32.8 100.0 39.0 67.0 51.9 48.1 United States 1987 66.7 20.6 12.8 81.6 16.8 1.7 5.6 7.2 87.1 17.1 68.0 14.9 Switzerland 1987 60.5 22.8 16.7 22.8 42.2 35.0 32.6 42.2 25.2 87.7 11.8 0.5 Canada 1988 50.8 40.0 9.2 63.5 36.5 16.1 83.9 38.7 60.8 0.5 Note: C = central government; S = state government; L = local government. Figures are the average of the last three years available. Source: Levin (1991)

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