Fiscal Decentralization: Basic Policy Guidelines for Practitioners
by Kenneth Davey

There is wide diversity across states in terms of the scale of tasks devolved to local government. In most countries, local government is responsible for what are often called communal services: local roads and lighting, water supply and sanitation, waste management, parks and sports facilities, cemeteries, low-income housing. What varies greatly is the extent of local responsibility for the social sector, chiefly comprising education, health, and social assistance. In some cases, these services are funded by the state budget; in some, costs are split between levels of government, and, in others, local budgets meet all costs except central supervision. Cost splitting may be by function (the state pays for secondary education, hospitals, and social benefits, and local government pays for basic education, primary health care, and social services) or by cost factor (the state provides professional salaries, while local government pays all other operating costs).

The degree to which local budget responsibility for the social sector varies has an important effect on the nature and scale of decentralization. Without devolution of such responsibility, local government expenditure is unlikely to exceed 5–6 percent of GDP. Responsibilities for education, health care, or social assistance are likely to increase local expenditures by a factor of two or three, with a major impact on financial self-sufficiency. Major social sector responsibilities are usually combined with substantial dependence on state grants or tax shares, both because of the limited capacity of revenues that can be assigned to local levies and because of the need to equalize financial resources in order to meet expectations of geographical equality in access to these social services.

It is customary to distinguish between current and capital expenditure. Current expenditure covers such operating costs as salaries, repairs, energy and other utilities, travel, materials, and debt service. Capital expenditure covers investment in new construction, major renovations, and purchase of land and durable equipment. It is also customary to distinguish between the financial sources for these two types of expenditure. Operating costs are normally covered by a combination of local taxes, user fees, intergovernmental transfers (either grants or subsidies), or shares of state taxes.

Clearly, the structure of local government responsibilities and resources affects the local government’s discretionary power—its ability to make decisions about the nature and levels of local services. If local government obtains a significant proportion of local taxes and charges, it is in a much better position to determine how it spends the money. Revenue shares and block grants should provide more freedom of allocation than targeted grants.

In practice, local discretion depends on a more complex set of factors. Sharing a well-established national tax may support more budgetary choice than dependence on a politically sensitive and administratively burdensome local tax. Targeted grants may simply release local government funds for other expenditures. Expenditure decisions may be largely determined by national regulations over service requirements.

The classic argument for maximizing local discretion is most associated with U.S. economist Wallace Oates. He argues that the greatest efficiency is achieved when budgetary choices are made by local officials elected by local people who have to meet the full cost of their decisions through local taxes. This view has been challenged by European writers, who consider the link between local government budget choices and popular preference somewhat tenuous. They argue that the efficiencies of local expenditure choice outweigh those of local taxation; many important fields of local expenditure, such as education or environmental services, combine legitimate national and local interests. Moreover, in recent years national macroeconomic policy has sought to restrict fiscal burdens; it has been common for governments in both Eastern and Western Europe to restrict local taxation, particularly on business, to stimulate investment and growth. The extent of local discretion is, therefore, a matter of balance between national and local interests: neither central control nor local autonomy has priority.

Fiscal decentralization determines the framework of expenditures, revenues, and legal discretion within which regional and local governments operate. It does not deal with issues of financial management, budgeting, accounting, delegation, procurement, auditing, or other similar processes through which local governments manage their financial affairs. These are equally important, but the subject of a separate body of law and practice.

Fiscal decentralization is inevitably a dynamic process. Although local governments’ responsibilities and resources may be fixed in law, demands on their services and the value of their revenues respond to social and economic changes over which lower levels of government have little control. It is essential to maintain channels of consultation between national government and local government associations so that adjustments can be made in a timely and equitable way, usually through the equalization formula.