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Box: Closing the Budget Gap with Transfers
The revenue capacity and
expenditure needs of subnational governments rarely match perfectly, so fiscal transfers
help close the resulting gap. In the transition economies, subnational governments are
particularly transfer-dependent—far more so than developing or OECD countries (table
2).
The aggregate volume of transfers is typically
determined ad hoc by the central government and is subject to intense negotiations that
lead to unpredictable outcomes from year to year, and across localities. As a result,
neither the incentives with respect to tax effort, nor the equity impacts of transfers are
clear.
Once the aggregate volume of transfers is determined,
the next step is fixing its distribution across subnational governments. Typically, the
objective is to equalize spending levels, based on fiscal capacities and expenditure
needs. Empirical work undertaken as part of the seven-country study could not establish a
relationship between "fiscal needs" indicators and transfers in the transition
economies, suggesting that they were not equalizing. This is not surprising since formula-based
allocation is not yet common in the transition economies. Rather, norms are
currently used for regional budget allocations in a number of transition countries,
relating to the existing installed capacity for particular services, such as the
number of hospital beds. Such norms clearly reward jurisdictions that had high rates of
capacity (or expenditure) in past periods, and often distribute funds regardless of
whether or not funds (i.e., the beds) are needed.
Given the importance of subnational
spending in the transition economies, especially in socially sensitive areas as health,
education and social welfare, much more work is needed on the design of transfers,
including their equalization properties and conditionality, and their role vis- a-vis
shared own taxes. In reforming transfer systems, transition economies should aim for
simplicity, as accurate economic and social indicators proxying expenditure needs are hard
to come by and revenue capacity estimates are hard to make. Compressed wages, distorted
prices, and regional inflation differentials complicate the calculation of even the most
basic indicator of needs—per capita income—in some countries.
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