Tax, decentralisation and intergovernmental relations

“A career in politics is no preparation for government”, said one of the characters in the 1970s British TV comedy series, Yes Minister. They had a point. After all, to newly elected politicians, government seems to be set up as a testing and complex route for taking (or stopping) decisions and implementing policy.

Another episode of the series aptly shows the one economist in the entire country who truly understands the system for financing local government, a situation closer to reality than top officials around the world might care to admit. Being effective in government depends on navigating a complex multi-layered edifice, with different hierarchies, committees, and reporting structures within departments and ministries, and between national and local authorities. The French even call it a mille-feuilles (a thousand layers), after one of their delicately assembled–and sometimes messy to handle–cream pastries. 

Explaining exactly how these intergovernmental relations actually work is particularly problematic where taxation and public spending is concerned. The recent shutdown of the “non-essential” US federal government activities demonstrates the arbitrary way in which responsibilities across government can be distributed. School budgets, for instance, may reflect a patchwork of different national and local government funding sources.

The inherent gearing of subnational funding creates issues around transparency and accountability for decisions. Take a situation where only 10% of a subnational government entities budget is provided by local taxation: a cut of nearly 1% in transfers from central government gets translated into a local tax increase of 20% if local budgets are maintained. It is no surprise, then, that the relationship between local and national government can become very acrimonious. New, unfunded, statutory mandates that require extra spending on things such as the provision of further social care, education and health care, or even simply a cut in national budget transfers to subnational government tiers, require an offsetting and relatively large rise in local taxes or unpopular cuts in those local services where statutory provision requirements are less binding. A blame game often ensues.

Policymakers across the OECD and beyond constantly grapple with this maze of intergovernmental relations in their daily lives. And many want to reform it, in some cases to decentralise powers to local authorities, in others to recoup more tax revenue from local authorities for national spending. But would such moves improve or worsen effectiveness, and how can that be measured?

The 2013 International Tax Dialogue (ITD) global conference, which takes place in December, aims to help provide answers. It asks how taxation in the context of intergovernmental relations can be used to contribute to shaping countries’ development and improve the lives of their citizens. Before the Industrial Revolution in the late 18th century, economic structures and services were often primarily local, and not always well resourced. National governments’ primary concerns were skewed towards security, and in particular how to pay for war. Indeed, income tax in its modern form was introduced by the British in 1798 to pay for the Napoleonic wars.

But the Industrial Revolution also brought the rise of new cities. Finance was needed to support growth, targeting the likes of education, power, transport, water, and sewage infrastructure, the legacy of which can still be seen today. However, the responsibility for raising revenue and the decision making for this growing range of public services shifted to national governments, with subnational governments acting as administrative vehicles where government money was increasingly spent rather than raised.

Nowadays, there is a shift towards greater decentralisation of spending responsibilities in many countries. In the UK, for instance, local government now accounts for over a quarter of total government spending, but raises less than 5% of total tax revenue.

Ensuring a link between the beneficiaries of decisions relating to expenditure and a broad willingness to pay the taxes needed to fund them, and holding politicians accountable for the outcomes, are vital for effective democratic government. Yet the disconnect between expenditures and taxation responsibilities has few obvious solutions. Professor Richard Bird summed up traditional economists’ views when he wrote that that the taxes over which control could be best be passed to subnational government are but “slim pickings”. True, some countries such as the Latin American countries shown in our graph have reduced the subnational mismatch between spending and their own tax revenues.

But for many developed countries Professor Bird’s observation remains true. Indeed, the share of local and regional level tax revenue now as a percentage of GDP is a small fraction of national revenues in most countries. The Czech Republic, for instance, raised only 1.2% of total revenues at sub-central level in 2011. A handful of countries demonstrate that the opposite is possible. In Finland for instance, nearly a quarter of total tax revenues are the responsibility of local authorities, and not central government.

In short, real policy choices, such as adding a larger local element to national income taxes, do exist, and these can give subnational government more control over their own revenues. These choices deserve greater scrutiny. And, as Finland shows, they can apply to large and small developed countries, and perhaps to developing countries too. Sub-Saharan African countries typically raise less than 1% of GDP in tax revenue from sub-central levels, for instance, yet they face similar choices. However, they face additional constraints in terms of technical capacity and institutional shortcomings.

Centralised governments are not set up to address the myriad different situations that occur at the local level. Calls for decentralisation are likely to become louder, boosted by the recent global financial crisis, and in part a reaction against the globalisation which many people blame for the crisis. People want government structures to be more responsive to local needs. Different communities in different locations face different problems. These differences may be hard to discern from the centre. Innovative solutions, such as the creation of citizens’ budget committees which rely on more local input from households, businesses, and civil society may provide a way forward.

Decentralisation is a balancing act that must take factors such as the degree of development and urbanisation into account. A new Industrial Revolution is now taking place in many developing countries as existing cities become mega-cities and new ones spring up. This is putting relations between city and national governments to the test, as countries struggle with governance, planning, and tax revenue-raising needs thrown up by recent mass urbanisation, and the need to deliver services to an expanding middle class. The imperative of ensuring greener growth adds another layer of complexity in terms of which levels of government should do what. How much freedom should subnational governments have to determine local pollution taxes?

There is also the question of how far decentralisation can go before encountering diminishing returns. In small towns and villages people may well acquire more tax-raising and decisionmaking power, but fragmentation and weaker economies of scale could ultimately blunt their action. India has more than five times as many local government entities as China, but is this structural difference a consequence or a cause of underlying local conditions affecting the delivery of public services? At what point do any benefits from very localised and probing political accountability come at too high a cost in terms of basic efficiency?

Clear divisions in terms of accountability at all levels are vital if the potential benefits of decentralisation are to be realised. Since constitutional powers are relatively fixed, as is the geographic size of countries-and these are the key factors identified in academic literature as determining the extent of fiscal decentralisation-it is through ideas about the merits of decentralisation that future policy direction will be shaped. The International Tax Dialogue conference will be an important opportunity for ministers and officials at all levels of government to discuss and understand these issues, and help them make better choices and improve their own policymaking.

The views expressed are those of the author and should not be interpreted as a statement of the policy positions of the ITD partner organisations.

The 5th ITD global conference on tax and intergovernmental relations will take place in Marrakech, Morocco, from 3 to 5 December 2013. For further information, please visit the ITD website at www.itdweb.org/Tax-Intergovernmental-Relations/Pages/Home.aspx


Reference

Bird, Richard M. (2010) “Subnational Taxation in Developing Countries, A Review of the Literature”, Policy Research Working Paper 5450,The World Bank, October.

Please visit: www.oecd.org/tax/

© OECD Observer No 296 Q3 2013





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