_______________ /PS182 POLIC'Y RESEARCH WORKING PAPER 1822 Intergovernmental Fiscal How rune ;o . . ,.,-., ^, X.~~~~~Autrafl$, cnda, ,0,^,Germ.rn.,y',. - Transfers in Nine Countries hdiabnones5 Jap n, the - Repubc of Korea. the Unjted Lessons for Developing Countries -- the Unitd- intergovernmentI FiscalJ Jun Ma transfer5 wth 8P4n emphasis on aezi~atfontransfers and: ..-a speciT Took at.I nsctrats- - . if G ina.: The World Bank Economic ]Development Institute Macroeconomic Management and Policy Division September 1997 I POLICY RESEARCH WORKING PAPER 1822 Summary findings Jun Ma presents an overview of intergovernmental fiscal Ma concludes that the formula-based equalization transfer systems used in nine developing and industrial transfer system has at least three advantages over the countries and draws implications for other developing discretionary system prevailing in many countries: countries. * It provides the single most important means to On the basis of a comparison of these countries, Ma address regional disparities. classifies equalization transfer formulas into four * It bases the evaluation of a subnational government's categories, analyzes the data requirements of each type of entitlement on objective variables, thus minimizing formula, discusses the applicability of these formulas in bargaining and lobbying and keeping distribution fair. developing countries, and uses illustrative examples to * If properly designed, the formula-based system show how the calculations should be carried out. The eliminates the disincentive inherent in many author also discusses implementation issues, including discretionary systems that encourages overspending and the transition from an old to a new transfer system. weak tax collection efforts. Finally, he presents an illustrative equalization transfer model for China. This paper - a product of the Macroeconomic Management and Policy Division, Economic Development Institute - is part of a larger effort in the department to study and disseminate international experience in fiscal management. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Chiharu Ima, room G8-004, telephone 202-473-5856, fax 202-676-9879, Internetaddress cima@worldbank.org. September 1997. (78 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should he cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center Intergovernmental Fiscal Transfer in Nine Countries: Lessons for Developing Countries Jun Ma Prepared for Macroeconomic Management and Policy Division Economic Development Institute The World Bank* *: This paper was prepared by the author when he served as a public policy specialist at the Economic Developiment Institute of the World Bank. The author's current address is: Dr. Jun Ma, International Monetary Fund, 700 19th St., NW, Washington, D.C. 20431, USA. Tel:202-623-8432, Fax:202-623- 4010, enail: jmanimf.org. The views expressed in this paper are those of the author and should not be attributed to any organizations that he has been associated with. The author would like to thank Kenji Yamauchi, Malcolm Nicholas, Richard Bird, Anwar Shah, Ehtisham Ahmad, William McCarten, Ching-Hsiou Chen, Kee-sik Lee, Nobuki Mochida, Toshihiro Fujiwara, Shunsuke Mutai, Jhungsoo Park, Robert Brightwell, Paul Bemd Spahn, Wolfgang Fottinger, Bob Searle, Jon Craig, Madras S. Guhan, Colin Bruce, Burkhard Drees, Xiaoping Yu, Jinfa Jiang, and Rui Coutinho for helpful discussions and comments. He also appreciates the excellent research assistance of Chiharu Irna. .. TABLE OF CONTENTS PART L INTRODUCTION 1.1. Economic Rationales for Intergovernmental Transfer 1.2. Criteria for an Effective Transfer System 1.3. Types of Intergovernmental Transfer PART II INTERGOVERNMENTAL TRANSFERS IN NINE COUNTRIES 2.1. The lnited States 2.2. Canada 2.3. Australia 2.4. Gernany 2.5. The ]Jnited Kingdom 2.6. India 2.7. Japan 2.8. Korea 2.9. Indonesia PART IIL LESSONS FOR OTHER COUNTRIES 3.1. Foriulas for Equalization Transfers 3.2. Measuring Fiscal Capacities and Fiscal Needs 3.3. Does Fiscal Equalization Reduce Local Tax Effort? 3.4. Sources of Data Required for Calculation 3.5. Institutional Requirement for Introducing a Formula-Based Transfer System 3.6. Transitional Arrangements 3.7. Concluding Remarks PART IV. A FORMULA-BASED EQUALIZATION TRANSFER SYSTEM FOR CHINA: MODEL AND SIMULATIONS 4.1. Estimating Fiscal Capacities 4.2. Estimating Fiscal Needs 4.3. Transfers to the Provinces 4.4. Does the Transfer System Equalize? Appendix: State-Local Fiscal Transfer: the Cases of the United States, Canada and Brazil References Intergovernmental Fiscal Transfer in Nine Countries: Lessons for Developing Countries Jun Ma PART L INTRODUCTION This paper provides an overview of the intergovernmental fiscal transfer mechanisms in nine major industrial and developing countries, with special reference to the design of equalization transfers. The countries selected are the United States, Canada, the United Kingdom, Australia, Germany, Japan, Korea, India, ancl Indonesia. Most of these countries have relatively developed formula-based transfer systems, and represent the major varieties of transfer systems adopted in the world. The three sections in Part I present a brief review of the economic rationales and basic criteria for designing an intergovernmental transfer system. The following nine sections in Part II discuss the mechanisms adopted by these nine countries, respectively. Part Im compares and contrasts the nine countries' transfer systems and, based on the comparison, attempts to draw implications for developing countries that are considering or are in the process of reforming their intergovernmental transfer systems. It classifies the transfer formulas into four categories, analyzes the data requirements of each type of formula, and uses illustrative examples to show how the calculations should be implemented. A few implementation issues, including the transitional arrangement from an old to a new system, are also considered in this part. Part IV presents an illustrative equalization transfer model for China and the simulatiom results using 1994 data. The appendix of this paper discusses a number of country cases on fiscal transfers from state (provincial) level governments to lower level governments. In this paper, we use "grant" and "transfer" interchangeably to refer to paynent of funds from one level of the government to another. 1.1. Economic Rationales for Intergovernmental Transfer The literature of fiscal federalism suggests several economic rationales for intergovernmental transfers: 1 A. Addressing vertical fiscal imbalances. In most countries, the national government retains the major tax bases, leaving insufficient fiscal resources to the subnational See Broadway et al (1993), Shah (1994), and Rosen (1995). 1 governments for covering their expenditure needs. Intergovernmental transfer is therefore needed to balance the budget at the subnational levels. B. Addressing horizontal fiscal imbalances. On one hand, some jurisdictions may have better access to natural resources or other tax bases that are not available in others. They may also have higher income levels than those in other jurisdictions. These are refereed to as differences in fiscal capacities. On the other hand, some jurisdictions may have extraordinary expenditure needs, because they have high proportions of poor, old, and young population, or because they need to maintain national airports and harbors. The net fiscal benefits, measured by the gap between fiscal capacity and fiscal need, is often caused by such uncontrollable factors and therefore should be addressed by central government transfer.2 A weaker version of this argument states that the central government has the obligation maintain a minimum standard of public service in all the subnational units. Regions without sufficient resources to reach this minimum level should be subsidized. C. Addressing inter-jurisdictional spill-over effects. Some public services have spill-over effects (or externalities) on other jurisdictions. Examples are pollution control (water or air), inter-regional highway, higher education (graduates may leave for other regions to work), fire departments (may be used by neighboring areas), etc. Without reaping all the benefits of these projects, a local government tends to underinvest in such projects. Therefore, the center government needs to provide incentives or financial resources to address such problems of under-provision. 1.2. Criteria for an Effective Transfer System An effective transfer system should satisfy several criteria3: 2 Some scholars have argued that the market itself will perforn the function of equalization, and there is no need for the government to be involved. This argument is based on the assumption that population and other resources have a high degree of mobility. If a country's population is perfectly mobile across regions, then the differenials of public service will not exist, because people can always move to jurisdictions that provide better services. With an increasing population in such a jurisdiction, the benefits each person can receive will decline, and equalization of fiscal benefits takes place. However, in no country is the population perfectly mobile, due to factors such as moving costs and employment constraints, and people may not have the perfect information about levels and qualities of public services in all regions. The lack of mobility among the population tends to create a high level, or even increasing levels, of uneven development pattems across regions, as financially strong regions tend to save and invest more and develop faster than financially weak regions. 3 Shah (1995). 2 Revenue adequacy: the subnational authorities should have sufficient resources, with the transfers, to undertake the designated responsibilities. Local tax effort and expenditure control: ensuring sufficient tax efforts by local authorities. Formulas should not encourage fiscal deficits. Equity: transfer should vary directly with local fiscal needs and inversely with local fiscal capacity. Transparency and stability: the formulas should be announced and each locality should be able to forecast its own total revenue (including transfers) in order to prepare its budget. knd the formulas should be stable for at least a few years (3-5 years) to allow long-term planning at the local level. 1.3. Types of Intergovernmental Transfer There are basically two types of grants, conditional and unconditional. iA. Conditional grants. These are sometimes called specific purpose grants or categorical grants. The central government specifies the purposes for which the recipient government can use the funds. Such a grant is often used to address concerns that are highly important to the center but are considered less so by the subnational governments. Examples are projects with inter-regional spill-over effects. Within conditiornal grants, there are several types: L. Matching Open-Ended Grants. For a unit of money given by the donor to support a particular activity, a certain sum must be expended by the recipient. For example, a grant might indicate that whenever a local governnent spends a dollar on education, the central government will contribute a dollar (or fifty cents) as well. With an open-ended matching grant, the cost to the donor ultimately depends upon the recipient's behavior. If the local government's expenditure is vigorously stimulated by the program, then the central government's contributions will be quite large and vice versa. 2. Matching Closed-Ended Grants. To put a ceiling on the cost borne by the central government, the center may specify some maximum amount that it will contribute. This is called a closed-ended matching grant. This mechanism is used by most countries due to concerns of budget control. In some countries, the total sum of matching grants is limited by the government selection mechanism. :3. Non-matching Grants. In this case, the central government offers a fixed sum of money with the stipulation that it be spent on a specified public good. The recipient government is not required to match the contribution of the central government. 3 B. Unconditional grants. An unconditional grant places no restrictions on the use of funds. In effect, it is a lump sum grant to the recipient government. The main justification for the central government to give unconditional grants to states/provinces and localities is that such grants can be used to equalize fiscal capacities of different local governments to ensure the provision of a minimum (or reasonable) level of public services. In most countries, the equalization grants are transfers made from the central govenmment to the subnational govemments (e.g., Canada, Australia, the United Kingdom, Japan, Korea, etc.), while in Germany, the equalization transfer is made from states with above-average fiscal capacities to states with below-average fiscal capacities. In other countries, unconditional equalization grants take the form of a general revenue-sharing. The formulas used to allocate the equalization transfers to subnational govemment are the central element of this grant system, and are subject to intense debate both academically and in practice. And this is the main focus of this paper. PART II. INTERGOVERNMENTAL TRANSFERS IN NINE COUNTRIES 2.1. The United States Over the past four decades, grants from the federal govenmment have increased both in dollar arnount and as a proportion of total federal outlays (Table 2.1). Grants as a percentage of state and local expenditures have also increased over the long run. In 1993, grants from federal and state govemment were about one third of the total amount that localities spend (Rosen 1995, p.536). Table 2.1. Relation of Federal Grant-in-Aid Outlays to Federal, State, and Local Expenditures (Selected fiscal years) Total Grants as % Grants as % Grants of Total of State & Local Fiscal Year (Bn 1990$) Federal Outlays Expenditures 1950 12.7 5.3 10.4 1960 30.0 7.7 14.7 1970 75.7 12.3 20.0 1980 141.5 15.9 28.0 1990 135.4 10.9 20.0 1993 176.7 14.0 22.0 Source: Rosen (1995), p.536. Unlike most other developed countries, the United States emphasizes the use of conditional grants rather than unconditional grants. In the early 1990s, conditional, or categorical grants accounted for more than 90 percent of federal intergovernmental transfers (Rosen 1995, p.537). About two-thirds of this aid were granted to state governments, while the remainder was given directly to local governments. The four most important categories of federal aid to states are for health, income security, education and training, and transportation. Health and income security accounted for 55 percent of federal grant outlays in 1988. 4 The major functions for which federal transfers are made directly to local governments include education, housing and community redevelopment, waste treatment facilities, and airport construction (Hyman 1993). While all three fonns of conditional grants (closed-ended matching, open-ended matching, and non- matching) are used, the most common form is closed ended matching grant. The intervention of the federal government into state and local affairs through conditional grants is pervasive. In 1991, a law was passed to discourage drunken driving and voted to give money to states that established anti-drunk driving programs. The House specified everything from the percent of blood-alcohol concentration that would be the criterion for intoxication to the length of time the drive's license would be suspended for a first offense. This is not atypical. According to one count, the federal government imposed more than one thousand spending mandates upon states and localities (Rosen 1995, p.537). Since the early 1980s, a new form of transfer, block grants, became popular under the Reagan administration. Many categorical grants were consolidated into a few broad block grants, which are essentially non-matching conditional grants. Within a given "block" of programs, the recipient state and local governments have more flexibility in spending funds than with categorical grants. One example of a block grant program is the Job Training Partnership Act of 1982. This act provided funds from federal revenue to finance human resource training programs administered by state and local governments designed to be tailored to the particular needs of workers and employees in local labor markets (Hyman 1993). Despite the efforts of the Reagan administration, the categorical grant still remains the dominant means of transferring funds from the federal government to state and local governments. The fact the United States has a marked preference for conditional grants--and its corresponding bias against unconditional grants--has aroused the interests of many scholars. One reason that has been offered to explain the marked U.S preference for conditional grants is the peculia US problems of fiscally fragmented metropolitan areas, with concentrations of low-income people (often ethnically distinct) clustered in the decaying urban core as a result of the flight to the suburbs by the white middle class. It is argued that conditional grants are a better response to U.S. needs than are unconditional grants, because the major interregional disparities are not in taxes but in service levels. "Congress wants to focus on particular services rather than on the general level of service or tax capacity, a substantial portion of the remaining grant syslem is focused on very narrow purposes." (Davis and Lucker 1982, p.355) This view presupposes that the federal interest is in actually providing certain service levels, rather than merely the possibility of attaining such levels at average tax rate, as in the equalization systems of Canada and Australia (Bird, 1986, p.159). 2.2. Canada4 Canada is a federation of ten provinces (British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, Quebec, New Brunswick, Nova Scotia, Prince Edward Island, and Newfoundland) and two 4 This section is based on Broadway and Hubson (1993) and Shah (1995a). 5 territories (Northwest Territories and Yukon). The specific purpose transfers from the federal government to the territories are similar to those from the federal government to the provinces. But for equalization transfers, the territories receive more than the provinces on per capita basis as the equalization scheme reflects the greater needs and costs that arise as a result of the territories' remoteness and sparse populations. The transfer of funds from higher to lower levels of govemment has been an important aspect of the Canadian federal system since Confederation. At the time of Confederation, customs and excise duties constituted the principal revenue sources of government. Because the Constitution Act 1867 restricted fte provinces to direct taxation, a system of grants and statutory subsidies was established to compensate for lost revenues. In addition to cash payments, close-ended per capita grants were instituted. The federal government also assumed the provinces' existing debts and made special grants to New Brunswick and Nova Scotia. These special grants were subsequently enhanced and also extended to the ew prairie provinces. Both the magnitude and the nature of federal-provincial transfers have changed dramatically since World War II. The scope of Canada's equalization program has increased, and transfers under the program have assumed a major role as a revenue source for the "have-not" provinces. In the 1980s, major changes in the equalization program took place, both in the formula and in the growth rate of payments. Currently, there are three major programs of federal transfers to the provinces: (1) the Canadian Equalization Program: a constitutionally mandated unconditional block transfer program to support reasonably comparable levels of services at reasonably comparable levels of taxation in all provinces; (2) the Established Programs Financing (EPF): conditional block (per capita) transfers for health and education with federal conditions on accessibility and standards of service; and (3) the Canadian Assistance Plan (CAP): conditional matching transfers for welfare assistance; and In 1994/95 fiscal year, the total federal transfers amounted to $41.9 billion, among which EPF accounted for $21.3 billion, equalization program accounted for $7.7 billion, and CAP accounted for $8.2 billion (Shah 1995a, p.244). The Equalization Program. The Canadian equalization program uses a notional average standard as the basis for equalization. The basic calculation for the equalization formula is that of a province's tax capacity. Tax capacity is calculated as the amount of per capita revenue that a province could raise by applying the national average tax rates to its tax bases. The tax capacity of each province is then compared with the amount of per capita revenue that could be raised if the province has a standard (five province average) per capita tax base. A province whose per capita tax base is below the standard receives an equalization payment equal to the difference between the province's tax capacity and the standard tax capacity, multiplied by the province's population. The actual formula is: Eij = tj [ Bj/P, - Bij/P1 ] Pi where E1j is entitlement under revenue source j in province i, B,j is the base in five provinces (standard) for revenue source j, 6 P. is the population of five provinces, B1j is province i's base for revenue sources j, t, is the: national average tax rate for revenue source j, or: = 1jTRij/X1Bij where TRj; is actual revenues under revenue source j in province i. The total entitlement of province i, TE1, equals the sum of all the entitlement under different revenue sources: 'FE, = EjEij. This program equalizes have-not provinces up to the national average--only those provinces that were beJlow the national average are affected by the program--and is paid for out of general federal revenues. Provinces whose tax capacities are above the national average--the have provinces---are not equalized down. Thus, the system does not fully equalize tax capacities across all provinces. 'Currently, there are 30 revenue sources for this program. The main sources include personal income taxes, corporate income tax, secession duties, general sales taxes, gasoline taxes, motor vehicle license fees, alcoholic beverage taxes, forestry taxes, oil royalties, natural gas royalties, sales of Crown leases and reservations on oil and gas lands, other oil and gas revenues, metallic and non-metallic mineral revenues, water power rentals, other provincial taxes, and miscellaneous provincial revenues. Table 2.2. Erovincial Per Capita Notional Revenues Before and After Equalization, 1990-91 Notional Equalization Index of Index of Provinces revenue yield' Tax capacityb fiscal capacity' Newfoundland 2,898 1,686 0.63 0.93 Prince Edward Island 2,988 1,595 0.65 0.93 Nova Scotia 3,517 1,066 0.76 0.93 New Brunswick 3,295 1,288 0.71 0.93 Quebec 3,973 610 0.86 0.93 Ontario 5,085 ... 1.10 1.03 Manitoba 3,737 847 0.81 0.93 Saskatchewan 4,058 525 0.88 0.93 Alberta 6,306 ... 1.36 1.2S British Columbia 4,808 ... 1.04 0.97 a/ Per capita yield of tax bases at national average tax rates. b/ Notional revenue before equalization relative to the national average. c/ Notional revenue yield after equalization relative to the national average. Source: Broadway and Hubson (1993), p.59. In most cases the determination of tax bases is relatively straight forward, based on provincial data. The most complex calculation involves the determination of the property tax base. Because assessment practices vary markedly from province to province, a standardized base cannot be inferred from provincial data. Instead, the value of land and capital in residential property, commercial, industrial and federal property, and farm property must be calculated by province. In the case of residential property, the value of buildings in residential use is calculated as a percentage of the value of the total residential capital stock. T1he value of land in residential use is calculated as a percentage of personal disposable income (net 7 of indirect taxes) weighted according to the degree of urbanization and the share of residential capital in determining the remaining components of the property tax base. Established Programs Financing (EPF). EPF transfers are made on an equal per capita basis to all provinces. This program is based on the terms of the Federal-Provincial Fiscal Arrangements and Federal Post-Secondary Education and Health Contributions Act of 1977. The federal government has provided each province with a total tax abatement of equalized under the terms of the equalization prograrn. Specifically, the procedure involves three steps: Step 1. Calculate each province's total per capita entitlement, which is the same for all provinces. It equals the national average per capita federal contribution to shared-cost programs in 1975 plus $20 per capita for Extended Health Care Services (starting in 1977), escalated to the current year by the growth in the Canadian economy, as measured by GNP per capita. Beginning in 1986, the rate of escalation was reduced to two percentage points below the GNP escalator. The 1989 federal budget reduced the rate of escalation to three percentage points below the GNP escalator. However, this was suppressed by the Expenditure Control Plan. As part of the Expenditure Control Plan, from 1990-91 to 1994-95, the per capita entitlement is frozen at its 1989-90 level. In 1994-95, the total per capita entitlement is $735. Step 2. Calculate the per capita values of tax transfer to provinces (13.5 percentage points of personal income tax revenue and 1 percentage point of corporate income tax revenue) and the equalization associated with it. This amount is paid to provinces under the equalization program. Step 3. Subtract the equalized tax transfer (amount calculated from step 2) from the total entitlement per capita (calculated in step 1), and the remainder is paid to each province in cash (Shah 1995, p.245). Thus, although total per capita transfers will be the same for all provinces, the per capita cash transfer may differ depending on the per capita equalized value of the tax abatements to provinces. In addition, the cash transfer to Quebec is reduced by the calculated value of the special abatements in lieu of EPF cash. Provinces are given complete flexibility in the allocation of block transfers under EPF across the areas covered--health care and post-secondary education. Provinces must, however, adhere to federal standards in health care and technically demonstrate that federal funds have indeed been spent within the designed areas. In fact, the latter requirement is virtually meaningless since the amount of the transfers themselves has been less than the amount of provincially funded expenditures in these areas. It is practically impossible to determine the extent to which funds meant to be used for health care and post- secondary education have actually contributed to expenditures in these areas rather than being diverted to other uses. Canada Assistance Plan (CAP). Canada Assistance Plan (CAP) evolved from the federal- provincial shared-cost programs that existed in the areas of old age assistance, blind persons allowance, disabled persons allowance, and unemployment assistance. Currently, the CAP encompasses not only those four categories of assistance but also assistance to any other persons who require public support, 8 such as needy mothers, dependent children, homes for special care, nursing homes, homes for unmarried mothers, hostels for transients, child-care institutions, work activity programs, and welfare programs for native people. The costs of direct financial assistance, welfare services, and administrative costs are eligible for subsidy. Capital costs and the operating costs of plant and equipment, however, are not. The primary advantage of the CAP is that it leaves wide discretion to the provinces in the allocation of expenditares to particular areas of social assistance in accordance with provincial circumstances. Grants under the CAP are matching and open-ended. The federal government pays 50 percent of all provincial expenditures for assistance to persons in need and for welfare services. Provincial welfare expenditLres must meet only a few requirements to be eligible for federal grants. The provinces must agree to meet adequately the basic requirements of the recipients, including food, shelter, clothing, fuel, utilities, househo]d supplies, and personal requirements. The only "eligibility" requirement is that of the individual recipient (as opposed to the income or means test). In addition, no residence requirement may be imposed as a condition of receiving aid. Provinces are free to choose their own rates and categories of assistance, since federal support is completely open-ended. 2.3. Australia .In Australia, the tax bases of the federal and lower level governments (state and local governments) are divicled in such a way that the federal government receives about two thirds of the total government revenues. In tenns of expenditure, however, the federal government spends only one third of the total government revenues. This means half of the federal govenmment revenues are distributed through various fomis of transfers to the state and local govemments. As in other westem countries, the Australian federal government grants to lower level governments include general purpose grants and specific purpose grants. In 1994-95, about 47 percent of the total federal transfers are general purpose grants and the rest are specific purpose grants (Rye and Searle, 1996). This section focuses on the mechanism of the general purpose transfer. The federal grants to lower level governments are administered by the Commonwealth Grants Commission established in 1933. This commission consists of three federal appointees. Mainly due to its long history, it has received substantial attention by scholarly studies worldwide. The Commission has been commented by foreign observers as, for example, "a model in the intemational context for the objective appraisal of spending needs."(Bird, 1986). Many countries that developed their formula-based transfer systems later has adopted methods substantially similar to those used in Australia. Currently, the Grants Commission distributes general purpose grants using a system that measures the states' fiscal capacities and fiscal needs.5 The objective of this system is to make it possible for any state with reasonable tax efforts to provide the level of public services not substantially below other states. The formula used for calculation the distribution has several alternative presentations, which are 5The idea to base grant distribution on fiscal needs was developed in as early as 1936. 9 mathematically equivalent. According to one presentation, the entitlement to state i can be written as fonows:6 entitlementi standard financial assistance + special revenue needsi + special expenditure needs3 - assessed needs met by specific purpose transfersi where standard financial assistance = an equal per capita grant The amount of standard financial assistance is determined based on the difference between the total expenditures and revenues of the states, and adjusted for the center's resource availability for transfer. The objective of the standard financial assistance is to close the vertical fiscal imbalance (the fact that the states' total expenditure is higher than their total revenue) for the states as a whole, without adjusting for the specific needs arising from individual states' revenue and expenditure situations. special revenue needsi = Pi (R/Ys)(YfPs - Yi/Pi) = Pi (RJP.)[l - (Yi/Pi)/(Y3/Ps)] where Pi is the population of state i, Rs is the total revenue of all the states, Y, is the total tax bases of all the states, RJYS is the national average effective tax rate (standard tax effort), P. is the country's population, Y)P, is national average per capita tax base (standard tax capacity), Y, is the tax base in state i, and Pi is the population of state i, and YI/P3 is per capita tax base of state i (own tax capacity). If (YiIPi)f(YRJP) < 1, that is, state i's tax capacity is lower than the national average, then the state will receive a positive entitlement as special revenue needs, and vice versa. Special expenditure needs of state i is the sum of the needs of many expenditure categories of that state. In each category, the need is calculated using the following formula: Pi (Ef/P.) (yi-l) where Pi is the population of state i, Es is the total expenditure of all the states, Es/P. is per capita standard expenditure. y, is the category disability ratio of state i, which measures the extend to which state i's need differs from the standard. Generally, a state's category disability ratio is calculated by combining (usually by multiplying but sometimes by adding) individual disability factors which express relevant cost influences as a ratio of the Australian average. The general formula for most individual disability factors can be written as: Yi = disability factor of state i = (xf/Pi)/(x)PJ) 6 See Comnmonwealh Grants Commission (1996), pp.65-66. 10 where xi amd xY are measures of a cost influence for state i and the total of the cost influence for all states. There are some exceptional cases where category disability ratios are expressed in the equal per capita method or actual per capita method.7 T he 11 expenditure categories and the factors that used to determine the disability ratio in each category are as follows: NVelfare: relevant population, administration scale, age/sex, dispersion, input cost, social- economic composition Cultural and recreation: administration scale, cross-boarder, dispersion, input cost, land rights, national capital, sacred sites, social-economic composition, transient population, combined urbanization and physical environment Community development: administration scale, input cost, land rights, national capital, social-economic composition, stage of development, urbanization (General public services: administration scale, dispersion, expenditure relativities, input cost, land rights Services to industry: administration scale, dispersion, expenditure relativities, input cost, land rights, physical environment 1Eduction: relevant population, administration scale, age/sex, cross-boarder, dispersion, economic environment, grade cost, input cost, physical environment, service delivery scale, social-economic composition, urbanization, vandalism and security Hlealth: administration scale, cross-boarder, dispersion, inpatient services, input cost, non- inpatient services, combined age/sex and social economic composition Law, order and public safety: relevant population, administration scale, age/sex, commonwealth offenders, cross-boarder, dispersion, input cost, land rights, national capital, physical environment, service delivery scale, social-economic composition, transient population, urbanization, vandalism and security, combined age/sex and social economic composition Transport: administration scale, dispersion, input cost, land rights, road length, road usage, social economic composition Economic affairs and other purposes: administration scale, dispersion, expenditure r elativities, input cost, physical environment, social-economic composition 7 See IRye and Searle (1996) for details. 11 Trading enterprises: relevant population, administrative scale, expenditure relativities, input cost, interest, land rights, physical environment, service delivery scale, social economic composition, urbanization, vandalism and security The main difference between the Australia model and that used in Canada is that the Australian model takes both expenditure needs and fiscal capacities into account, while the Canadian model considers revenues only. It was decided in 1988 that every five years the Grants Comrnission would conduct a major review of the existing grant distribution method. The first such review took place in 1993. Between two major reviews, the Grants Commission updates the coefficients used in the formula based on most recent data. These data are often calculated as moving averages of the last three years. 2.4. Germany Compared with other countries, a unique feature of the German tax assignment is that all major taxes are shared by the federal and state governments. These shared taxes include the personal income tax, corporate income tax, and VAT. Altogether these shared taxes amount to about two thirds of tax revenues in the country. The main federal taxes are the excises on mineral oil, tobacco, and alcohol (except beer). The states only have minor taxes such as the motor vehicle tax and net wealth tax. The local governments levy property taxes and receive income from user charges. In 1990, about 64 percent of the state revenues came from shared taxes and 15 percent from federal grants. For the local governments, 30 percent of their revenues came from shared taxes and 22 percent from federal grants.8 If revenue sharing is included, Gennany has three schemes of intergovernmental transfer: revenue- sharing, the interstate equalization payments, and the supplementary grants. All these transfer schemes are administered by the Ministry of Finance. Revenue sharing. VAT sharing is the most important tax sharing arrangement in Germany and is primarily an equalization scheme. Currently, 44 percent of VAT is assigned to the states. Among this, 75 percent of the state share of VAT is distributed to states on an equal per capita basis--a measure that is of course equalizing. The remaining 25 percent are distributed to states with below-average tax capacity (per capita revenues) to enable them to achieve 92 percent of the national average. In addition to the VAT sharing, 42.5 percent of the personal income tax and 50 percent of the corporate income tax are distributed to the states. But these two taxes are shared on the basis of derivation, thus having no equalization effect. Interstate equalization payments. The direct transfer scheme, named interstate equalization payments, were first introduced in Germany in 1951 as a form of compensation for the "special burdens" bome by certain states with respect to refugees, harbor maintenance, and so on. In 1955, these payments 8See Spahn (1995), p. 14 1. 12 were given a constitutional basis in Article 107, which provided that the revenue received by the states should be adjusted to offset differences in their tax capacity, although still with some allowance for the special burdens facing particular states. The federal law currently regulating these interstate transfers --the Financial Settlement Act--was passed in 1969 and revised in 1977 (Bird, 1986). Currently, the interstate equalization formula is as follows (Shah, 1994a): Ei = ATCi - NEEDi where AlTCi is the adjusted taxable capacity of state i, and NEEDi is the fiscal need of state i.9 If Ei>0 then state i contributes to the equalization pool; if E10) receive transfers from the central government, and regions with above-average capacities (TR,>O) receive no transfer but are not required to contribute to the pool for transfers. In Germany, however, the interstate equalization transfers are made directly across states--states with above-average capacities contribute funds to a pool that is distributed to below-average states. A variation of this formula uses a different "average" per capita tax base as the bench-mark level for comparison. Namely, the national average B/P is replaced by the average of a group of regions. The selection of this group can be used as an instrument by the central government to adjust the intensity of the equalization effort. If the central government selects a group that yields a group average lower than the national average, the transfer scheme becomes less than "funl" equalization and requires a smaller pool of fiscal resources. An equalization transfer scheme based on this type of formula assumes that per capita fiscal needs of all the regions are the same. This is an over-simplification and may create a new source of regional disparity if the costs of providing public services differ vastly across regions. However, if a country has relatively insignificant regional cost differentials or data on such cost differentials are not available, this formula imay be a convenient option to consider. ]Formula C. Formulas that distribute equalization transfers based on some "needs" indicators. Fiscal capacity is not considered in these formulas often because such data are difficult to obtain. India, Italy, and Spain use this type of formula. There are varieties of indicators that can reflect the fiscal needs of regions, and the choices are very much dependent on the government's objectives as well as other historical and political factors. Typical indicators (often used in combination with weights) used to determine regions' fiscal needs include: Per capita income level; 35 Poverty incidence; Unemployment rate; Population density; Area; Infant mortality; Life expectancy; School enrollment rate; Infrastructure (e.g., length of roads and railways); Other indicators of development level (e.g, electricity consumption and number of telephone lines). What indicators should be chosen and how much weight each indicator should be given are highly sensitive questions and need to be answered with careful simulations and consultations with regional authorities. Formula D. Formulas that distribute equalization transfers on an equal per capita basis. Such formulas are used in Germany's VAT sharing, Canada's EPF, England's NDR, and in a number of Indonesia's general purpose grants. Compared to the above three types of transfers, equal per capita transfer is least demanding for data, but has relatively weak equalization effects. The simplest equal per capita transfer formula is as follows: TR, = Pi (TT/P) (6) where TT is total amount of transfer and P is total population eligible for the transfer program. Equal per capita transfer cannot fully equalize but can mitigate regional disparity in fiscal capacity. To see this, suppose there are only two regions, region A and region B, with per capita tax revenues of $1000 and $2000 respectively. An equal per capita transfer of $1000 reduces the ratio of region B's per capita tax revenue to that of region A from 2 to 3/2. But unless the per capita transfer is infinity, the ratio is always less than one (full equalization). Comments: Type A formula provides the potential for full equalization. It is the most complex and perhaps most accurate one in measuring horizontal fiscal gaps, but is also most demanding for data. Types B and C each ignore a major aspect (capacity or need) of the horizontal equalization, and thus are less effective in addressing regional disparity issues. However, they require less data and may be appealing for countries that intend to start an equalization transfer system on an experimental basis. Type D is probably least effective in terms of equalization, but is also least demanding for data. 3.2. Measuring Fiscal Capacities and Fiscal Needs The above subsection mentioned several times the fiscal capacity (Ci) and fiscal need (Ni) of a subnational government. This subsection discuss the details on how to estimate these variables. 36 Measuring fiscal capacity. Fiscal capacity is defined as the ability of a govermnent to raise revenues from its own sources. There are several ways to measure the fiscal capacity of a subnational government. In many developed countries, fiscal capacity is measured using figures of major tax bases and standard 'average) tax rates. This method measures the fiscal capacity of a region by the revenue that could be r aised in that region if the regional government taxes all the standard tax bases with the standard tax effort. The formula is as follows: Ci = Z:jBij*tj (7) where Ci is the ith region's tax capacity, Bij is the ith region's jth tax base, and tj, is the standard (e.g., national average effective) tax rate on the jth tax base. It is important to apply the standard tax rate to the region's tax base rather than the region's own effective tax rate, in order to ensure that the regions with high tax efforts are not penalized and regions with low tax efforts are not encouraged. In other words, if the region's effective tax rates are higher than the national averages, the transfer it receives does not decrease as a resu]lt; if the region's effective tax rates are lower than the national averages, the transfer it receives does not increase as a result. Applying this method involves several steps: Step 1: Select the tax bases. In practice, information on some tax bases (e.g., numerous small tax bases) may not be available or is costly to obtain. Therefore, instead of exhausting all the tax bases, fiscal capacity is often measured using several major tax bases as a proxy. Personal income tax, corporate income tax, sales tax or VAT, property tax, and resource tax are the ones that are often used in assessing local fiscal capacities. Step 2: Collect data on the selected tax bases. One can use the previous year's figures on tax bases. There are also cases where tax bases (e.g., property tax) are assessed every few years (say, three years) since an annual assessment may be too costly. Some of these data may be readily available from various departments of the central or subnational governments. If the data are provided by the subnational governments, it is important to have well established rules on the reporting and auditing procedures as well as penalties on false reporting. Step 3: Select the standard tax rates. There are many different ways to calculate the standard tax rate on a particular tax base. Several examples are: (1) the effective tax rate of the whole country; (2) the arithmetic mean of all regions' effective tax rates; (3) the arithmetic mean of selected regions' effective tax rates. Step 4: Calculate the fiscal capacities using equation (7). The method described above requires detailed and accurate information on major tax bases, which may not be available in many countries. In such a case, fiscal capacity may be measured indirectly by employing some income or output indicators. The most frequently used indicators are: 37 (a) Gross Domestic Product (GDP) of the region. The region's fiscal capacity is measured by the product of its GDP and a standard revenue/GDP ratio, where this standard ratio can be the national average or an average of a group of regions. The main weakness of using the GDP indicator is that it ignores the fact that different structures of the regional economies may have important impact on the regions' abilities to generate revenues. For example, with the same level of per capita GDP, a region with a high percentage of agricultural production may have a lower revenue capacity than a region with a high percentage of high value-added manufacturing sectors. To mitigate this effect, one can conduct an estimation to determine to what extend other factors (such as the structure of the economy, degree of urbanization, etc.) affect the regions' fiscal capacities, and develop an adjusted model for fiscal capacity by incorporating a few more variables in addition to GDP. (b) Personal income (sum of all incomes received by the residents) or disposable personal income of the region. The region's fiscal capacity is measured by the product of its total personal income and a standard revenue/personal income ratio. This is an imperfect measure of fiscal capacity since personal income is only one revenue source and may not be proportional to the sum of all tax bases. (c) Total retail sales of the region. If consumption based taxes are important revenue sources of the region, it may be a good proxy of its total tax base. The region's fiscal capacity is measured by the product of its total retail sales and a standard revenue to total retail sales ratio. It is important not to use the regions' actual revenue figures to measure their fiscal capacities. If the actual figures are used, the transfer a region receives from the center becomes largely a variable controlled by its own tax effort. The regions would thus have the incentive to under-collect their own revenues in order to attract more transfers from the center. The reason is straightforward: the more a region collects from its own sources, the high the measured fiscal capacity, and the less transfer it will receive. In some countries, this system has encouraged subnational governments to shift budgetary revenues to incomes outside of the budgetary system. Measuring fiscal need. Broadly speaking, there are two methods used to determine fiscal needs of subnational governments. The first method, used by the United Kingdom, Australia, Japan, and Korea, divides the expenditures of a subnational government into many different categories and for each category estimates the need of this government. The total fiscal need of a subnational government is the sum of the estimated needs for all these categories. This approach involves the following steps: Step 1: Divide the region's expenditures into several categories. The most commonly used categories include: Education Health Transportation Teleconmmunications Social welfare Police and fire 38 Environmental protection Other Services Of course, depending on the country's existing budgeting rules and data availability, the division of expenditure categories can have many variations. One can combine transportation with telecommunications, separate police from fire, divide social welfare further into many smaller items, divide education into primnary, secondary, and post-secondary educations, etc. Most countries' equalization transfer formulas take into account the needs for current expenditures (include maintenance of capital projects) but exclude those for new capital projects. The reasons are threefold: (1) capital projects are typically lumpy in size, and their expenditure needs may vary significanitly from year to year; (2) it is difficult to find appropriate indicators that reflect the needs for new capital projects; and (3) most capital projects benefit users for many years and even generations. Requiring current tax payers to fully finance projects (as in the case of fiscal transfer) that mainly benefit future users is inconsistent with the "benefits principle" of taxation. In some countries (e.g., in Japan), however, local debt burden is considered part of the local expenditure needs. Since the limit on local borrowing imposed by Japan's Ministry of Home Affairs is proportional to local own revenue, its transfer formula effectively assumes that a locality's expenditure need for new capital projects is proportional to its fiscal capacity. Step 2. Calculate the expenditure need for each category and then sum up these needs to get the region's aggregate fiscal need. An illustrative example is discussed below. The general formula for calculating expenditure need in category i can be written as: Ni = Measurement Unit * Average Per Unit Cost * Adjustment Index where i standards for the ith expenditure category, such as education, health, transportation, etc. Measurement unit refers to the number of units that receive services from the regional government. Average per unit cost is defined as total local expenditure on category i divided by the measurement unit (e.g., the average per unit cost of primary and secondary eduction is the ratio of the total expenditure on primary and secondary eduction to the total number of students in the country). One can use the previous year's data in this calculation. Adjustment index is a combination of factors that differentiate the per unit cost of the service in the region from the national average. (1) Primary and Secondary Education Measurement unit = population of school ages (e.g, age 7-18) Average per unit cost = the country's per capita public expenditure on primary and secondary education Adjustment index = a1WI + a2RCI + a3SDI + a4PFI where WI (wage index) = the ratio of teachers' wage level in this region to the national average; 39 RCI (rental cost index) = the ratio of per square rental cost in this region to the national average; SDI (student disability index) = the ratio of the percentage of students with physical disabilities in this region to the national average; PFI (poor family index) = the ratio of the percentage of students from low-income families in this region to the national average. The weights attached to the four factors should add up to one, i.e., a, + a2 + a3 + a4 = 1. These weights can be derived from an econometric estimation using cross-region or penal data (cross region and time series) from the past years. Shah (1994a) provides an example of such an estimation. Many countries try arbitrary values of weights based on the designers' intuition about the importance of different factors in affecting the costs of services. Assigning these weights can also be a method for the designers to emphasize certain factors in grant distribution. Figures used to calculate the indices (WI, RCI, SDI, and PFI) are those of the previous year or past few years' averages. (2) Health Measurement unit = total population in this region Average per unit cost = the country's per capita public expenditure on health care Adjustment index = a1HPI + a2IMI + a3ILEI + a4IPDI where HPI (health price index) = the ratio of health care cost in this region to the national average; IMI (ifant mortality index) = the ratio of infant mortality rate in this region to the national average; ILEI (inverse life expectancy index) = the ratio of national average life expectancy to life expectancy in this region; IPDI (inverse population density index) = the ratio of national average population density to that in this region; a, +a2+a3+a4= 1. (3) Transportation Measurement unit = total length of roads in this region Average per unit cost = the country's per capita public expenditure on transportation Adjustment index = a,WI + a2GRI + a3SNI + a4IPDI where WI (wage index) = the ratio of wage level in this region to the national average; GRI (grade index) = the ratio of average road grade in this region to the national average; SNI (snow index) = the ratio of annual snowfall in this region to the national average; 40 IPDI (inverse population density index) = the ratio of national average population density to that in this region; a, +a2+a3+a4= 1. (4) Police and Fire Measurement unit total population in this region Average per unit cost = the country's per capita public expenditure on police and fire protection Adjustment index = a1WI + a2CRI + a3FI + a4UBI where WI (wage index) = the ratio of wage level in this region to the national average; CRI (crime index) = the ratio of per capita crime rate in this region to the national average; FI (fire index) = the ratio of per capita number of fires in this region to the national average; UBI (urbanization index) = the ratio of proportion of population in urban areas in this region to the national average; a, + a2 + a3 + a4= 1. (5) Social Welfare Measurement unit = total population in this region Average per unit cost = the country's per capita public expenditure on social welfare Adjustment index = aiMWI + a2PVI + a3OAI + a4UEI + a5DI where WI (minimum wage index) = the ratio of minimum wage level in this region to the national average; PVI (poverty index) = the ratio of percentage of low-income population in this region to the national average; OAI (old age index) = the ratio of percentage of old population (e.g., age 60 or above) in this region to the national average; UEI (unemployment index) = the ratio of unemployment rate in this region to the national average; DI (disability index) = the ratio of percentage of physically disabled people in this region to the national average; a, + a2 + a3 + a4 + a5=1 (6) Other Services Measurement unit = total population in this region Average per unit cost = the country's per capita public expenditure on other services 41 Adjustment index = a,WI + a2RCI + a3UBI where WI (wage index) = the ratio of wage level in this region to the national average; RCI (rental cost index) = the ratio of per square rental cost in this region to the national average; UBI (urbanization index) = the ratio of proportion of population in urban areas in this region to the national average; a, + a2+ a3 = 1. The above method to calculate regions' fiscal needs require substantial information on a large number of factors that affect the costs of providing public services. Much of these information may not be available in some countries. This being the case, a feasible solution is to use fewer variables to estimate directly a region's aggregate fiscal need. There can be many different forms of this type of formula. Below we discuss a few examples: (1) Estimate a region's fiscal need on the basis on population, income level, and area: N1 = TE[wp(P/I,jPj) + wI(IDPi/IJIDiPj) + wA(A,/YAi) ] where N1 is the fiscal need of the ith region; TE is the total expenditure made by regions; Pi is the population in the ith region; wp is the weight assigned to population; ID; is the per capita income distance from the richest region; w, is the weight assigned to income disparity; Ai is the area of ith region; wA is the weight assigned to area; Wp+W +WA= 1 Area is included in the formnula because it accounts for differences in the cost of providing many public services. Services such as roads, telecommunications, schools, and libraries face higher per capita production costs in sparsely populated regions than those in densely populated regions. The income distance factor in the formula reflects the govenmment's explicit objective to address regional disparity.'6 Other variables that can be considered for this formula include population density, tax effort (revenue/GDP ratio), etc. (2) Estimate a region's fiscal need using only education and health indicators:17 The distribution based on income distances are scaled by population, because otherwise a region with a large population and a region with a small population would get the same amount of entidement as long as their per capita incomes are the same. The same logic applies to the treatment of weather condition. A variation of this formula is prsented in Gupta et al (1996). 42 Ni = SIi*fIi*Pi*c where N1 is the fiscal need of the ith region; SI; is the student index; HI; is the health index; pi is the population of the ith region; c is the per capita public expenditure of the country; SIi = (S/P)/(Si/P,); 1Hi = (FP)/(H,/P,); and where Si is the number of students in the ith region, Hi is the number of health care workers in the ith region, P is the total population of the country, S is the total number of students in the country, H is the total number of health care workers in the country. SIi roughly measures the enrollment rate of the ith region relative to the national average. HI, measures the number of health care workers per capita in this region relative to the national average. (:3) Estimate a region's fiscal need using indicators that reflect "wealth":18 Ni = EI,*TIi*Pi*c where Ni is the fiscal need of the ith region; ElI, is the electricity index; Tli is the telecommunications index; P;, is the population of the ith region; c is the per capita public expenditure of the country; EIi = (E/P)/(E,IPi); 'li = (T/P)I(E,/Pi); and where Ei is the level of electricity consumption in the ith region, Ti is the number of telephone lines in the ith regiont P is the total population of the country, E is the total electricity consumption in the country, T is the total number of telephone lines in the country. EI, and TI, measure the levels of consumption of electricity and telecommunications relative to the national averages. 3.3. Does Fiscal Equalization Reduce Local Tax Effort? A, frequently heard criticism of equalization transfer schemes is that equalization may adversely affect localities' effort to collect revenue. The rationale is that because an equalization scheme redistributes revenue fiom revenue rich regions to revenue poor regions, the former may purposely reduce their tax effort 1S Ibid. 43 in order not to be penalized by the transfer scheme. This reasoning is, in most cases, a false impression of fiscal equalization. Consider the formula described by equations (1) and (7). In this formula, local fiscal capacities are calculated using the previous year's tax bases and standard tax rates set by the central government. Therefore, fiscal capacities are independent from tax effort (the actual tax rates). If a locality increases its tax effort by raising its tax rates above the standard rates, the transfer that it will receive does not decrease. If the locality reduces its tax rates to levels below standards, it will not receive more transfer as a result. In other words, such a formula does not encourage low tax effort, and does not discourage high tax effort. The additional revenue collected due to a locality's higher effort will be kept by itself. In this sense, this formula encourages local tax effort. Of course, if a locality's tax base increases, its transfer will decrease. However, it is important to note that, if the formula is appropriately designed, the magnitude of the decline in transfer can be rather small relative to the benefits a locality can gain from the increase in tax base. As a result, localities do not have the incentive to reduce tax bases simply for the purpose of attracting more transfers. This point can be illustrated by the following example. Consider a country with only two regions, A and B, each having a population of 1 million and one local tax base-income. Region A has a high per capita income of $1000, and region B has a low per capita income of $500. Suppose that the per capita expenditure needs are the same in the two regions, and local tax rates in both regions are 10 percent. In per capita terms, an equalization formula will redistribute $25 from Region A to Region B. This reduces the net per capita income in Region A to $975, and increases the net per capita income in Region B to $525. Obviously Region A does not have the incentive to reduce its tax base to Region B's level: this will avoid the -$25 transfer, but it will reduce its net per capita income from $975 to $500.19 Moreover, Region A does not even have the incentive to reduce its tax base by a small margin. A comparison of the following two hypothetical cases shows that if Region A reduces its tax base from $1000 to $900, its transfer will fall from -$25 to -$20, but its net per capita income will fall from $975 to $880. Case 1: Region A's Per Capita Tax Base is $1000 Region A Region B ($) ($) Per capita income 1000 500 Per capita local tax revenue 100 50 Per capita transfer -25 25 19 When the two regions' tax bases are both $500, no transfer will take place. 44 Per capita revenue after transfer 75 75 Per capita net income 975 525 (income + transfer) Case 2: Region A Reduces Its Per Capita Tax Base to $900 Region A Region B ($) ($) Per capita income 900 500 Per capila local tax revenue 90 50 Per capila transfer -20 20 Per capita revenue after transfer 70 70 Per capita net income 880 520 (income + transfer) 3.4. Sources of Data Required for Calculation ][n selecting formulas for equalization transfer, a major consideration is the availability of data. In many developing countries, data constraints force the central government to adopt relatively simple models with fewr variables. This section briefly discusses the possible channels through which data could be collected for the purpose of calculating equalization transfers. 'The central government agency in charge equalization transfer can use a variety of data sources. In most countries, the easiest source is the statistics provided by the central government's statistical agency. In addition to the central statistical agency, line ministries can often provide more detailed statistics on need indicators such as demographic composition, land areas, student enrolment rates, health indicators, length and quality of roads, electricity consumption, number of policemen, etc. Data on local tax bases are often supplied by local tax authorities.20 In cases where the central and local governments share the same tax bases and the center is responsible for tax collection, tax base data can be easily obtained from the central tax authorities. In cases where local tax bases differ from central tax bases, local tax authorities should be required to provide annual tax base figures to the central government agency in charge of 20 Hen: "local governments" refers to subnational governments in general. 45 transfer. It is necessary to enact a law or issue a central government ordinance on fiscal transfer that obliges local authorities to submit accurate data on a timely manner. Naturally, incentives exist for local governments to under-report their tax bases in order to receive more transfers. To prevent such practices, it is necessary to include penalty clauses on fraud in the law or ordinance. Equally important is that the central government audits the statistical reports submitted by local governments (either by directly sending officials to local governments or hiring independent auditors). A general principle for the application of formulas is that the most recent data should be used to calculate fiscal transfers. In other words, the previous year's data on tax bases and expenditure needs should be used, whenever available. In calculating fiscal capacities, a possible approach is to use forecasted tax bases to calculate the preliminary amounts of transfer, and base the current year's (e.g., 1996) initial disbursements on these forecasts. When the actual tax base figures of 1996 become available in 1997, the final amounts of 1996 transfer are recalculated with the actual figures. If the 1996 initial disbursement to a locality is lower/higher than the final amount, then the difference is added/subtracted to/from the 1997 disbursement. 3.5. Institutional Requirement for Introducing a Formula-Based Transfer System For a country that has no experience with a formula-based transfer system and is interested in adopting one, the first step is to set up a team to work out the methodology and to conduct the detailed calculations. The staff needed for such a tearn will include: (1) officials from the Ministry of Finance who understand the basic concerns of the Ministry on the overall budgetary impact of transfers; (2) technical experts who understand the models used by other countries and the applicability of these models to the country in question, and who have the ability to revise/design their own models that will be appropriate under local conditions; (3) statisticians who are familiar with the data availability and who are able to conduct simulations with alternative models. The whole team should be able to interpret the simulation results to the Finance Minister and the concerned provincial leaders in an accurate yet non-technical manner. In terms of administrative affiliation of the team, a possible arrangement is that the team be part of the Ministry of Finance at least in the initial stage of designing the transfer system. In the long run, the desirability of creating an independent grants commission (such as those in Australia, India, and Pakistan) can be considered. The main advantages of an independent grants commission include: (1) reduced political influence from both the central and the regional governments and, as a result, (2) the possibility of exercising fair judgements over disputes among different subnational governments and between levels of governments; and (3) that the recommendations made by the independent commission are easier to be accepted by the parties involved. The disadvantage of an independent grants commission mainly has to do with its limited authority in obtaining data and other supports from the subnational governments. 21 See Searle (1994) for a detailed discussion on Australia's Grants Commission. 46 During the design stage, the team should conduct hearings preferably in all states/provinces to collect information about fiscal capacities, extraordinary expenditure needs, and possible impact of alternativ(e arrangements. Once the system starts operating, the grants commission or another agency that runs the transfer system should publish its calculation method and results annually, so that each state/province can prepare its budget according to the expected amount of transfers. 3.6. Transitional Arrangements Fiscal expenditures are the materials that politics is made of. This point is especially apparent when the, vested interests of particular groups (e.g., regions) are threatened by a proposed reform of the distribut]ion formula of transfers. It is difficult to imagine that a major change in the distribution method causes no opposition from the subnational governments that are worse off because of such changes. Of course, countries with different political structures may encounter different levels of difficulty in implementing changes in the transfer system. Countries where subnational governments have substantial political bargaining powers must be very careful in assessing the impact of the reform proposal on and the possible reactions from the subnational governments. One way to maximize the political support from the subnational governments is to phase in the new system in an incremental way. Using this method, the number of worse-off regions can be reduced to a minimum and even to zero from the beginning of the reform. With fewer regions suffering from the reform, its political feasibility is increased. Two examples of the such arrangements are as follows: (1) Increase the weight of the new system (and to reduce the weight of the old system ) in grant allocation over an extended period of time (say, three to five years). That is, over time, an increasing share of the toltal transfers are distributed using the new formula, and a decreasing share of the total transfers are distributed using the old method. This method ensures that, in each of the first few years of the reform, there is nio or very few net losers because the distribution of grants changes marginally every year. i(2) For an extended period of time, keep the old system running and the size of the grants distributed by the old method constant in nominal terms. As the economy grows, additional central fiscal resources made available for transfers will be distributed using the new formula. The old system will be abolishol when its impact on overall grant allocation is no longer significant. This method has the same effect the first one does. 3.7. Concluding Remarks A formula-based equalization transfer system as discussed in this paper has at least three advantages over the discretionary system currently prevailing in many countries. (1) It bases the evaluation of each r egion's entitlement largely on objective variables, thus avoiding excessive bargaining and lobbying by the subnational governments. As a result, it increases the fairness of the distribution outcome. (2) A formula-based system, if properly designed, can eliminate the disincentive inherent in many discretionary systems that encourage low tax efforts and over-spending of the subnational governments. (3) Most 47 important, a formula-based equalization system provides an effective means to address regional disparity issues. Nevertheless, the design and implementation of a new transfer system is never an easy task. A careful study of the relevant international experience and a careful assessment of the country's own situation are required if the new system is to be both economically rational and politically feasible. 48 Table 3.'. Comparison of .he Grant System.s n Nne Coasr.trie US Canada UK Germany Australia India Japan Korea Indonesia Equalizing fiscal capacities No Yes Yes Yes Yes Weakly Yes Yes Weakly Adjusting for Expenditure needs No No Yes Weakly Yes Yes Yes Yes Yes Sources of equalization fund Central Central Central VAT sharing Central fixed portions fixed fixed Central government government govemment inter-regional government of income tax percentages of percentage of government revenue revenue revenues transfers (from revenue and value 5 central taxes total national revenue rich to poor added tax tax revenues _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ states) Data requirement Ad hoc Data on Data on Data on local Data on Data on Data on local Data on local Main scheme is subnational properties tax bases and local tax population, tax bases and tax bases and an equal per tax bases (provided by expenditure bases and income, land detailed detailed capita transfer. localities) factors detailed area, and tax expenditure expenditure only need data and detailed expenditure effort. factors factors on population expenditure factors factors (provided by various agencies) Grant administration Functional Dept. of Dept. of Ministry of Grants Finance Ministry of Ministry of Ministry of Depts. ofthe Finance Eniron. Finance Commnission Commission Autonomy Home Affairs Finance. Federal and Planning Ministry of Govt Commission Home Affairs 49 PART IV. A FORMULA-BASED EQUALIZATION TRANSFER SYSTEM FOR CHINA: MODEL AND SIMULATIONS The current Chinese central-provincial fiscal transfer system mainly consists of three mechanisms.22 The first mechanism is based on the old contract system prevailing during 1988-1993. That is, after 1994, the localities (provinces and cities with independent planning status) continue to remit revenues to or receive transfers from the center according to their fiscal contracts in effect in 1993. The second type of transfer is "returned revenue" from the center according to a calculation that ensures each locality retains no less than what it did in 1993. These two types of transfers are general purpose transfers, or unconditional transfers. The third type of transfer includes various specific purpose grants, such as those for price subsidies, educational projects, environmental projects, disaster relief, and the development of poor regions. The general purpose transfers from the center to the localities account for the major part of the total transfers. In 1994, the central government's net transfer to the local governments amounted to about 181 billion Yuan, of which two-thirds were general purpose grants. However, these general purpose transfers suffer from at least two major flaws. First, they were not designed to address the increasingly significant regional disparity issue; rather, they were largely designed to recognize the vested interests of the localities.23 Second, the criteria by which these transfers are allocated are rather ad hoc, that is, the transfer system lacks scientific measurements of fiscal capacities and fiscal needs. This can easily lead to an unjustified distribution and encourage the localities' bargaining activities. T'his part presents an illustrative equalization transfer model and the simulation result using 1994 data on China. It provides the estirnates of fiscal capacities and fiscal needs of 30 Chinese provinces using the methods discussed in the paper. Based on a formula that aims to ensure that provinces with similar levels of tax effort be able to provide similar levels of public services, the calculation results in a set of hypothetical transfers from the center to the provinces in 1994. These results are then compared with the actual transfers made to the provinces in 1994. The method used to calculate the provincial fiscal capacities and fiscal needs may be considered overly simplified and the quality of data can certainly be improved. Nevertheless, the estimation carried out here is simply intended to provide an illustrative example of how an equalization transfer formula with a minimum data requirement can be constructed. The following sections discuss the methodology and the results. 4.1. Estimating Fiscal Capacities 22 In 1996, a formula-based equalization transfer system was introduced on an experimental basis. This system applies a formula that uses objective variables to calculate local fiscal capacities and needs. However, the size of this transfer program was only $2 billion Yuan, or 0.5 percent of the central governnent revenue. 2 According to some studies, China's regional disparity is among the highest in the world. 50 Two methods were tried to determine the fiscal capacities of the provinces, that is, the revexnue each province vould be able to collect with an average level of tax effort. The most important element in this calculation is the estimation of the provinces' tax bases. The first method uses provinces' GDP levels as proxies o1f the tax bases. To see how well GDP can forecast revenue, an OLS regression of a linear equation with no intercept is conducted. The result is: Regression I: REVi = 0.0 186GDPi (1) R-square = 0.75, No. of observations = 30, Degrees of freedom =28 where REV, represents revenue collected province i in 1994, and GDPi is the value of province i's gross domestic product in 1994. The result suggests that the differences in GDP can explain 75 percent of the variations in revenue across provinces.24 Instead of using an output measure such as GDP as a proxy of the tax base, the second method attempts to estimate the local tax base using two variables: the total retail sales and the before-tax profits of industrial enterprises. This is based on the assumption that business tax and personal income tax--the two major local taxes--are positively correlated with total retail sales, and another major local tax--corporate 25 income tax--is positively correlated with profits of industrial enterprises. Using these two variables as explanatory variables, the second regression yields a better fit: Regression II: REVi = 0.0896 SALES3 + 0.1679 PROFi (2) (4.90) (2.84) R-square = 0.88, No. of observations = 30, Degrees of freedom =28 where SALESi is province i's total retail sales in 1994, and PROFi is the profits of the province's state owned industrial enterprises in 1994. Roughly speaking, the regression results suggest that if all local taxes are levied on these two bases, the national average effective tax rate on total sales is 8.96 percent, and the national average effective tax rate on corporate profits is 16.8 percent. The R-square of 0.88 suggests that 88 percent of the variations in revenue collection can be explained by variations in these two variables.26 24 When the structure of the economy (percentage of agriculture in GDP) is added to the regression as the second explanatory variable, R-square improves only slightly to 0.77, and its coefficient is not statistically significantd. 25 25 percent of VAT assigned to provinces is not considered as local tax in this exercise, as it is included in the transfer cadculated from the acual local revenue and expenditure figures. 26 To find out whether individual disposable income (the tax base for personal income tax) is important in determinirg revenue, this variable is added to the regression but yields no improvement in the R-square. When tax effort i(revenue/GDP ratio) is added to the above regression, the R-square further increases to 0.94. However, 51 Because the second method represents a better forecast of actual revenues, it is used to estimate the provinces' fiscal capacities. That is, the following equation is employed to estimate the fiscal capacities of the provinces: Ci = 0.0896 SALESi + 0.,1679 PROFi (3) where C, is the fiscal capacity of province i. The estimated fiscal capacities are reported in Table A-2. 4.2. Estimating Fiscal Needs The fiscal need of each province is broken down into seven categories: education, health, social welfare, police and law enforcement, infiastructure, government administration, and other services. For each category, I construct a formula to determine the expenditure needs of the province. The variables used in these formulas are the most important determinants of the expenditure and are those for which data are readily available. The variables used to determine the needs under the seven categories are: Education: population, average number of years of education Health: population, average life expectancy Social welfare: population, percentage of population over age 65, urban unemployment rate Police and law enforcement: population, percentage of urban population Infrastructure: length of roads, area Government administration: population Other services: population Determining the fiscal need of each province involves three steps: Step 1: determining the share of each spending category in total spending. The share of each expenditure category in total expenditure is calculated using the actual spending figures in 1994: Table 1. Local Expenditures by Category, 1994 (100 Mil Y) to forecast the provinces' fiscal capacities, one should eliminate the impact of tax efforts by leaving out this variable. 52 1994 Actual Amount Share a Educaticn, Culture, and Related Expenses 83858 0.276 Health, Family Planning, and Sports 27467 0.090 Social Welfare 9416 0.031 Government Administration 66539 0.219 Police and Law Enforcement 22000 0.072 Infrastructure Maintenance 23416 0.077 Other services (including subsidies) 71211 0.234 Subtotal 303907 1 Note: capital expenditures, except for urban maintenance, are excluded. Infrastructure maintenance is named "urban maintenance" in China Almanac of Finance 1995. Data Souirce: China Almanac of Finance 1995. Trhe total fiscal need of 30 provinces in category k (k = education, health, etc.) is the weight (ak) multiplied by the total fiscal need of all categories. Denoting total local need of all categories by TN, the total fiscal need in category k is rNk = ak*TN Step 2: determining the fiscal need of each province in category k. For education (k=E), the fiscal need of province i is calculated using the following formula: NiE = TNE(PiEi/XjPjEj) = aE*TN(PiEi/£jPjEj) (4) where NiE is province i's fiscal need for education, aE=0.276 is the weight assigned to education, TNE is the 30 provinces' total fiscal need for education, Pi is the population of province i, Ei is the ratio of the national average niumber of years of education to that in province i, and P,E/jPjFj is the share of province i's fiscal need in tie 30 provinces' total need for education. For health (k=H), the fiscal need of province i is calculated using the following formula: NiH = TNH(PiL,/EjPjLj) = alH*TN(PiLi/EjPjLj) (5) where NiH is province i's fiscal need for health, cti=O.090 is the weight assigned to health, TNH is the 30 provinces' total fiscal need for health, L, is the ratio of the national average life expectancy to that in province i, P,Li£jPjl; is the share of province i's fiscal need in the 30 provinces' total need for health. 53 For social welfare (k=S), the fiscal need of province i is calculated using the following formula: Nis = TNs(0.5*PiOLDi/jPjOLDj + 0.5*PiUMP./zjPjUMPj) = as*TN(O.5*PiOLDi/ZjPjOLDj + 0.5*PiUMP,/zjPjUMPj) (6) where Nis is province i's fiscal need for social welfare, as=0.03 1 is the weight assigned to social welfare, TNs is the 30 provinces' total fiscal need for social welfare, OLDi is the ratio of the percentage of elderly population (over age 65) in province i to the national average, UMPi is the ratio of the urban unemployment rate in province i to the national average, and 0.5*PiOLDi/EjPjOLDj + 0.5*PiUMPi/EjPjUMPj is the share of province i's fiscal need in the 30 provinces' total need for social welfare. For government administration (k=G), the fiscal need of province i is calculated using the following formula: N;G= TNG(Pi/7jPj) = aH*TN(Pi/EjPj) (7) where NiG is province i's fiscal need for government administration, acL0.219 is the weight assigned to government administration, TNo is the 30 provinces' total fiscal need for government administration, and P,/I:jPj is the share of province i's fiscal need in the 30 provinces' total need for government administration. For police and law enforcement (k=P), the fiscal need of province i is calculated using the following formula: Nip = TNp(PiL1/ZjPjLj) = ap*TN(PiUBi/YjPjUBj) (8) where Nip is province i's fiscal need for police and law enforcement, ap=0.072 is the weight assigned to police and law enforcement, TNp is the 30 provinces' total fiscal need for police and law enforcement, UBi is the ratio of percentage of urban population in this province to the national average, and PjUB2/;jPjUBj is the share of province i's fiscal need in the 30 provinces' total need for police and law enforcement. For infratructure (k=I), the fiscal need of province i is calculated using the following formula: Nil = TN1(0.5*LR1/ZLRj + 0.5*Ai/ljAj) = aI*TN(0.5*LR,/ELRj + 0.5*A,/£jAj) (9) where Nil is province i's fiscal need for infrastructure, a0=0.077 is the weight assigned to infrastructure, and TN, is the 30 provinces' total fiscal need for infrastructure. LR, is the total length of roads in province i, and Ai is the area of province i. The former reflects the need for maintenance, and the latter reflects the cost due to sparsity of population. 0.5*LRi/ZLRj + 0.5*Ai/:jA; is the share of province i's fiscal need in the 30 provinces' total need for infrastructure. For other services (k=O), the fiscal need of province i is calculated using the following formula: N1o = TNo(P,/YjPj) = x*TN(P/YjPj) (10) 54 where Nic) is province i's fiscal need for other services, a070.234 is the weight assigned to other services, TNo is the 30 provinces' total fiscal need for other services, and Pi/EjPj is the share of province i's fiscal need in the 30 provinces' total need for other services. Step 3. summing up province i's needs in the seven categories to get the total fiscal need of the province: Nj = aE(PiE,/;jPjEJ) + au(PiL/ZjPjL1) + as(O.5*PiOLDi/£jPjOLDj + 0 5*PiUMPi/TjPjUMPK) + ao(Pi/YjPj) + ap(PiUBi/ZPjUB;) + a1(O.5*LRi/TLRj + 0.5*A./1jA) + uo(P,/i;Pj) (11) where Ni is the total fiscal need of province i. Equation (11) can be rewritten as follows by combining some terms: N, = ccE(PiEi/EjPjE) + aH(PiL,/1jPLj) + as(0.5*PiOLD/FjPjOLDj + 0.5*PiUMPi/zJPJUMPi) + ap(PiUBi/1PjUB) + ai(0.5*LRi/ELRj + 0.5*A,/ZjAj) + (ao+aO)(PI£1Pj) = 0.276(PiE1/YjPjEj) + 0.090(P,L-J/PALj) + 0.31(0.5*PiOLD /13PjOLD; + 0.5*PjUMP./.P.jUMPp) + 0.072(P1UB,/ZPjUBj) + 0.077(0.5*LRi/1LRj + 0.5*Ai/1jAj) + 0.453(Pi/1jPi) (12) Step 4. adjusting for cost differentials across provinces. The above calculation has not considered the cost differentials across provinces in providing the same level of public services. With limited data, I constructed a wage-and-cost index, using prices of food and construction materials and wage levels. Each of the first two commodities is given a weight of 0.25, and the wage level is given a weight of 0.5. There is obviously much room for improvement, but the present data are sufficient to serve as an illustrative example. The wage-and-cost index is fixed at 1 for the national average. If a province's index is higher than 1, it means the unit cost of providing public services there is higher than the national average, and vice versa. The index figures are shown in Table A-l(b). The cost adjusted fiscal need of province i is: AN; = WCIiN; (13) where AN, is the cost adjusted fiscal need of province i, WCIi is the wage-and-cost index of province i, and Ni is the fiscal need calculated using equation (12). 55 4.3. Transfers to the Provinces Using two different definitions of "needs," the transfers to the provinces are different. If the fiscal need figures (unadjusted for cost differentials) are used, the transfer from the center to province i is: Ti = Ni - Ci where Ni is given by equation (12). If the cost adjusted fiscal need figures are used, the transfer from the center to province i is: Ti =ANi -Ci where AN, is given by equation (13). Transfers calculated using these formula are presented in Table A-3. For comparison, the actual transfers in 1994 are also presented in Table A-3. The above calculations assume that 100 percent of the central government transfers made in 1994 be allocated according to the proposed equalization formula. In other words, the proposed system is a "fill" equalization system. However, the distribution of transfers under this system is distinctly different from the actual allocation in 1994: the standard deviation (the average difference between the proposed per capita transfer and the actual per capita transfer) is 263 Yuan, or 198 percent of the average per capita transfer in 1994 (See Table A-4). Obviously, such a drastic reallocation of resources is politically infeasible. I thus tried two alternative "partial" equalization schemes: (1) 50 percent equalization. 50 percent equalization means that 50 percent of the actual central governnent transfers (net) made to the localities in 1994 are allocated in proportion to the original allocation and the other 50 percent are allocated by the proposed equalization formula using cost adjusted figures. From Table A-4, one can see that under this system the standard deviation from the actual allocation now becomes 132 Yuan or 98 percent of the average per capital transfer in 1994. (2) 20 percent equalization. 20 percent equalization means that 80 percent of the actual central government transfers (net) made to the localities in 1994 are allocated in proportion to the original allocation and the other 20 percent are allocated by the proposed equalization formula using cost adjusted figures. From Table A4, one can see that under this system the standard deviation from the actual allocation now becomes 53 Yuan or 39 percent of the average per capital transfer in 1994. 4.4. Does the Transfer System Equalize? The transfer system designed above aims to equalize the provinces' abilities to provide public services at similar levels of tax effort. While equalizing per capita income is not the direct objective, due to 56 a high correlation between income and fiscal capacity, a transfer system like the one suggested above should also have strong redistributive effects on per capita income. T he following regression is conducted to test the hypothesis that a transfer system equalizes per capita income across provinces: PFCTi = ao + a, PCGDPi where PC'Ti is the per capita transfer to province i, and PCGDPi is the per capita GDP of province i. If a, is negative and statistically significant, it means that the system has a significant equalization effect. When per capita transfers are calculated using need figures unadjusted for cost differentials, a, is significantly negative. At the same time, the R-square is 0.55, implying that 55 percent of the variations of the transfers across provinces serves the purpose of "equalization." From Figure 1, one can see a strong negative correlation between the two indices, indicating a significant redistributive effect of the proposed transfer slystem. The regression results are as follows: Regression lll: PCTi = 544.26 - 91.26 PCGDP, (2.55) (-14.51) R.-square = 0.59, No. of observations = 30, Degrees of freedom =28. When per capita transfers are calculated using needs figures adjusted for cost differentials, a, is also significantly negative. The R-square is 0.42. The two variables are plotted in Figure 2, which shows a slightly weaker correlation between the two indices than that in Figure 1. The regression results are as follows: Regression IV: PCTi = 518.77 - 83.93 PCGDP (1.93) (-4.54) R-square = 0.42, No. of observations = 30, Degrees of freedom =28. For comparison purposes, I used the actual transfer figures in 1994 to run the same regression. The resulting a, is statistically insignificant and the R-square is only 0.0002, showing not even a slight correlation between per capita transfers and per capita GDP levels. This suggests that the current transfer system has not effectively achieved any redistributive goal. The regression results are as follows: Regression V: PCTi = 206.46 - 0.97 PCGDPi (1.10) (-0.075) R-square = 0.0002, No. of observations = 30, Degrees of freedom =28. The same regression is also conducted using the per capita transfer figures generated by the "partial equalization" transfer schemes proposed in the previous section. Table 2 compares the regression results of four systems: actual transfers in 1994, 20% equalization, 50% equalization, and full equalization. The results show that the full equalization and 50% equalization schemes have statistically significant equalization effect (the slope coefficients are significantly negative). The 20% equalization schemes do 57 have some equalization effect (the slope coefficient is negative), but it is not statistically significant. The actual transfer scheme has the least equalization effect (the slope coefficient is almost zero). Table 2. Regression Results under Four Transfer Schemes: PCTi = ao + a, PCGDPi 1994 Actual 20% 50% 100% Transfer Equalization Equalization Equalization ao 206.46 268.92 362.62 518.77 (1.10) (1.36) (1.66)* (1.93)* a, -0.97 -17.4 41.95 -83.93 (0.075) (-1.30) (-2.81)* (-4.54)* R2 0.00 0.06 0.22 0.42 DF 28 28 28 28 Note: the calculations use cost adjusted figures on fiscal needs. Numbers in parentheses are t ratios. A "*" indicates that the t ratio is statistically significant. 4.5. Conclusions Statistical evidence suggests that China's current fiscal transfer system performs almost no redistributive function. The illustrative example of a formula-based equalization transfer model presented in this appendix shows that an important improvement in redistribution can be made by introducing appropriate measures of fiscal capacities and needs with appropriate variables. One should notice that shifting from the current transfer system to a "full equalization" system may not be feasible in the short- or medium run. A pragmatic approach is to increase the magnitude of the new transfer scheme gradually over time in order to minimize political difficulties. The purpose of this illustrative example is not to provide the exact model that China is to use; the intent is to offer an alternative methodology to the ones that are being considered. 58 Table A-l(a). China: Basic Indicators by Province Popu. GDP Area Aged Urban per cap popu. unemplmt. 1994 1994 (%) rate (Mil.) (Th. Y) (Th. Mu) 1987 1994 All China 1198.50 3.76 9590.09 6.23 2.8 Beijing 11.25 9.64 16.80 7.66 0.4 Tianjini 9.35 7.76 11.31 7.79 1.2 Hebei 63.88 3.36 187.95 6.34 2.8 Shanxi 30.45 2.80 156.30 5.98 1.2 Inner Mongolia 22.60 3.02 1192.04 4.26 3.7 Liaoning 40.67 6.35 146.15 6.54 2.5 Jilin 25.74 3.76 186.81 5.56 1.8 Heilongjiang 36.72 4.41 451.47 4.17 2.5 Shanghai 13.56 14.54 6.30 11.52 2.8 Jiangsu 70.21 5.78 102.52 8.23 2.1 Zhejiang 42.94 6.21 101.77 8.20 3.1 Anhui 59.55 2.50 139.06 6.35 3.1 Fujian 31.83 5.29 121.12 6.17 2.4 Jiangxi. 40.15 2.57 166.86 5.39 2 ShandorLg 86.71 4.47 156.57 6.72 3.1 Henan 90.27 2.44 167.01 6.33 2.3 Hubei 57.19 3.29 186.10 6.14 3 Hunan 63.55 2.67 212.10 6.43 3.8 Guangdcing 66.89 6.34 177.99 7.28 2.4 Guangxi 44.93 2.76 237.34 6.20 3.6 Hainan 7.11 4.66 33.98 6.36 3.6 Sichuan, 112.14 2.48 570.31 6.79 3.8 Guizhou 34.58 1.51 176.04 4.95 5.5 Yunnan 39.39 2.47 393.33 5.70 2.7 Tibet 2.36 1.94 1220.01 6.67 5 Shaanxi 34.81 2.43 205.52 5.26 3.5 Gansu 23.78 1.90 456.55 4.62 5.3 Qinghai 4.74 2.92 742.82 3.93 6 Ningxia 5.04 2.66 51.73 3.69 5.3 Xinjiang 16.32 4.13 1683.98 4.62 3.2 --------------------------------------------------------------- Source: State Statistical Bureau (1995). Cost data are from Wu Renhong, 1995, "China's Inflation and Regional Disparity," and World Bank, 1994, China. Tnternal Market and Rpgiulations. Social indicators are from Yasuko Hayase and Seiko ]Kawamata, 1991, Pnpiilat-ion Policiy anci Vital StAtisting in China, Institute of Developing Economies, Tokyo, Japan. Author's own calculation. 59 Table A-1(b). China: Basic Indicators by Province -----------------------------------------------------------------__----------_ Urban Length Average Average Wage& Popu of roads years of life cost (%) (kms) educ. expctncy index 1994 1994 1987 1987 1992 -------------------------------------------------------------------__--------_ All China 23.6 1117821 5.68 70.59 1 Beijing 66.6 11532 8.12 74.93 1.19 Tianjin 57.7 4156 7.42 73.64 1.02 Hebei 16.5 50496 5.90 73.26 0.98 Shanxi 25.8 32693 6.29 69.77 0.81 Inner Mongolia 37.0 44202 6.19 69.24 0.82 Liaoning 45.2 42763 7.00 73.32 0.93 Jilin 43.9 29581 6.69 70.11 0.87 Heilongjiang 49.7 48356 6.55 70.33 0.82 Shanghai 70.5 3721 7.92 75.97 1.29 Jiangsu 23.9 25891 5.91 73.63 1.04 Zhejiang 16.5 33170 5.82 71.82 1.21 Anhui 17.2 30876 4.71 71.21 0.87 Fujian 18.3 44608 5.12 70.90 1.19 Jiangxi 20.9 34556 5.15 68.10 0.86 Shandong 17.4 50225 5.52 72.88 0.90 Henan 14.8 47704 5.43 71.68 0.83 Hubei 29.0 48349 5.92 68.91 0.94 Hunan 16.5 58803 6.00 68.82 1.01 Guangdong 16.1 75716 5.96 73.83 1.57 Guangxi 14.1 39550 5.54 70.81 1.07 Hainan 34.1 13015 5.84 69.76 1.22 Sichuan 16.3 100002 5.40 68.70 0.90 Guizhou 15.4 32398 4.37 70.12 0.95 Yunnan 15.9 65578 4.13 64.25 0.94 Tibet 14.1 21842 1.91 63.50 1.17 Shaanxi 21.3 39058 6.29 69.74 0.91 Gansu 18.8 34984 4.40 70.24 0.97 Qinghai 32.6 17061 3.79 66.40 0.90 Ningxia 28.8 8324 5.15 69.74 0.93 Xinjiang 47.7 28611 6.14 69.25 1.00 -----------------------------------------------------------------__----------_ Source: State Statistical Bureau (1995). Cost data are from Wu Renhong, 1995, "China's Inflation and Regional Disparity," and World Bank, 1994, China- Tnternal Market and Rgilat-ion . Social indicators are from Yasuko Hayase and Seiko Kawamata, 1991, Popiilat-ion Ponliy ani Vital qt-atiJt-iJr. in China, Institute of Developing Economies, Tokyo, Japan. Author's own calculation. 60 Table A-2: Fiscal Revenues, Expenditures, and Estimated Fiscal Capacities Actual Tax Actual Actual Estimated revenue effort expndt. transfer fiscal (Mil. Y) (Rev/GDP) (Mil. Y) (Mil. Y) capacity 1994 1994 1994 1994 1994 All China 231159 5.1 392962 161803 228596 Beijing 4585 4.2 9853 5268 9055 Tianjin 5015 6.9 7232 2217 4563 Hebei 9522 4.4 16084 6562 9396 Shanxi 5382 6.3 8923 3541 4562 Inner Mongolia 3630 5.3 9282 5652 3188 Liaoning 15367 5.9 22358 6991 12657 Jilin 5127 5.3 10459 5332 5213 Heilongjiang 8466 5.2 14240 5774 9368 Shanghai 16962 8.6 19084 2122 14323 Jiangsu 13662 3.4 20017 6355 17909 Zhejiang 9463 3.5 15303 5840 13422 Anhui 5468 3.7 9327 3859 6263 Fujian 9194 5.5 13773 4579 6868 Jiangxi 4929 4.8 9203 4274 4175 Shandong 13466 3.5 21877 8411 16734 Henan 9335 4.2 16962 7627 9989 Hubei 7746 4.1 13720 5974 9679 Hunan 8589 5.1 15149 6560 8103 Guangdong 29870 7.0 41683 11813 24621 Guangxi 6226 5.0 12493 6267 5423 Hainan 2753 8.3 4001 1248 1008 Sichuan 13599 4.9 23739 10140 12181 Guizhou 3124 6.0 7423 4299 2325 Yunnan 7670 7.9 20373 12703 7631 Tibet 554 12.1 3030 2476 196 Shaanxi 4259 5.0 8552 4293 3670 Gansu 2908 6.4 7238 4330 2536 Qinghai 701 5.1 2536 1835 583 Ningxia 717 5.4 1938 1221 603 Xinjiang 2870 4.3 7110 4240 2352 -----_,------------------------------------------------------------__------- Source: Tables A-1 and A-2, and author's own calculations. 61 TabLe A-3: Fiscal Needs and Fiscal Transfers Unadjusted for cost differentials Adjusted for cost differentials Fiscal Formula Per capita Fiscal Formula Per capita Actual need transfer formula need transfer formula per cap transfer transfer transfer (Mil. Y) (Mil. Y) (Y) (Mil. Y) (Mil. Y) (Y) (Y) ALL China 392962 161803 135.0 387677 161803 135.0 135.0 Beijing 3735 -5238 -465.6 4447 -4687 -416.6 468.3 Tianjin 3014 -1525 -163.1 3086 -1502 -160.6 237.1 Hebei 19585 10030 157.0 19315 10089 157.9 102.7 Shanxi 9640 4998 164.2 7833 3327 109.3 116.3 Inner Mongolia 9513 6226 275.5 7809 4700 208.0 250.1 Liaoning 13300 633 15.6 12381 -281 -6.9 171.9 Jilin 8634 3368 130.8 7528 2354 91.5 207.1 Heilongjiang 12982 3557 96.9 10688 1343 36.6 157.2 Shanghai 4513 -9657 -712.2 5825 -8644 -637.5 156.5 Jiangsu 21493 3529 50.3 22367 4535 64.6 90.5 Zhejiang 13285 -135 -3.1 16199 2825 65.8 136.0 Anhui 19400 12933 217.2 16936 10857 182.3 64.8 Fujian 10550 3625 113.9 12613 5843 183.6 143.9 Jiangxi 13114 8799 219.2 11341 7288 181.5 106.5 Shandong 26869 9977 115.1 24199 7593 87.6 97.0 Henan 27687 17421 193.0 23007 13240 146.7 84.5 Hubei 18444 8628 150.9 17340 7792 136.2 104.5 Hunan 19790 11505 181.0 20149 12253 192.8 103.2 Guangdong 20700 -3860 -57.7 32586 8101 121.1 176.6 Guangxi 14243 8683 193.2 15363 10110 225.0 139.5 Hainan 2459 1427 200.8 3021 2047 287.9 175.5 Sichuan 36252 23695 211.3 32657 20826 185.7 90.4 Guizhou 11963 9487 274.3 11436 9267 268.0 124.3 Yunnan 14559 6820 173.1 13794 6269 159.1 322.5 Tibet 3374 3129 1325.7 3961 3830 1622.8 1049.2 Shaanxi 11045 7260 208.6 10129 6569 188.7 123.3 Gansu 8987 6350 267.1 8737 6307 265.2 182.1 Qinghai 3139 2516 530.8 2850 2306 486.5 387.1 Ningxia 1810 1188 235.7 1683 1099 218.0 242.3 Xinjiang 8321 5876 360.1 8396 6148 376.7 259.8 Source: Tables A-1 and A-2, and author's own calculations. .62 Table A-4: Fiscal Transfers under Alternative EquaLization Schemes (Yuan) 100% EquaLization 50% Equalization 20% Equalization ----------------- ----------------- ----------------- ActuaL Per cap Differ. Per cap Differ. Per cap Differ. per cap transfer from transfer from transfer from transfer act. amt. act. amt. act. amt. 1994 All China 135.0 0.0 135.0 0.0 135.0 0.0 135.0 Beijing -416.6 -884.9 25.8 -442.4 291.3 -177.0 468.3 Tianjin -160.6 -397.7 38.2 -198.9 157.6 -79.5 237.1 Hebei 157.9 55.2 130.3 27.6 113.8 11.0 102.7 Shanxi 109.3 -7.0 112.8 -3.5 114.9 -1.4 116.3 Inner Mongolia 208.0 -42.1 229.0 -21.1 241.7 -8.4 250.1 Liaoning -6.9 -178.8 82.5 -89.4 136.1 -35.8 171.9 Jilin 91.5 -115.7 149.3 -57.8 184.0 -23.1 207.1 Heilongjiang 36.6 -120.7 96.9 -60.3 133.1 -24.1 157.2 Shanghai -637.5 -793.9 -240.5 -397.0 -2.3 -158.8 156.5 Jiangsu 64.6 -25.9 77.6 -13.0 85.3 -5.2 90.5 Zhejiang 65.8 -70.2 100.9 -35.1 122.0 -14.0 136.0 Anhui 182.3 117.5 123.6 58.8 88.3 23.5 64.8 Fujian 183.6 39.7 163.7 19.8 151.8 7.9 143.9 Jiangxi 181.5 75.1 144.0 37.5 121.5 15.0 106.5 Shandong 87.6 -9.4 92.3 -4.7 95.1 -1.9 97.0 Henan 146.7 62.2 115.6 31.1 96.9 12.4 84.5 Hubei 136.2 31.8 120.4 15.9 110.8 6.4 104.5 Hunan 192.8 89.6 148.0 44.8 121.1 17.9 103.2 Guangdong 121.1 -55.5 148.9 -27.7 165.5 -11.1 176.6 Guangxi 225.0 85.5 182.3 42.8 156.6 17.1 139.5 Hainan 287.9 112.4 231.7 56.2 198.0 22.5 175.5 Sichuan 185.7 95.3 138.1 47.6 109.5 19.1 90.4 Guizhou 268.0 143.7 196.2 71.8 153.1 28.7 124.3 Yunnan 159.1 -163.4 240.8 -81.7 289.8 -32.7 322.5 Tibet 1622.8 573.7 1336.0 286.8 1163.9 114.7 1049.2 Shaanxi 188.7 65.4 156.0 32.7 136.4 13.1 123.3 Gansu 265.2 83.1 223.6 41.6 198.7 16.6 182.1 Qinghai 486.5 99.4 436.8 49.7 407.0 19.9 387.1 Ningxia 218.0 -24.2 230.1 -12.1 237.4 -4.8 242.3 Xinjiang 376.7 116.9 318.3 58.4 283.2 23.4 259.8 SD 263.5 131.8 52.7 C.O.V. 1.95 0.98 0.39 Note: 100 percent equaLization means that 100 percent of the actuaL centraL government transfers (net) made to the localities in 1994 are allocated by the proposed equalization formuLa using cost adjusted fiscal need measurmenl:s. 50 percenit equalization means that 50 percent of the actual central government transfers (net) made to the localities in 1994 are aLlocated in proportion to the original allocation and the other 50 percent are allocated by the proposed equaLization formuLa using cost adjusted figures. 20 percenit equalization means that 80 percent of the actual centraL government transfers (net) made to the localities in 1994 are allocated in proportion to the originaL allocation and the other 20 percent are aLlocated by the proposed equaLization formuLa using cost adjusted figures. SD: standard deviation; C.O.V.: coefficient of variations. 63 Appendix: State-Local Fiscal Transfer: the Cases of the United States, Canada and Brazil I. State-Local Fiscal Transfer in the State of New York27 The State of New York consists of three levels of government: the state government, 61 county governments, and municipal governments (62 cities and 1400 towns and villages). In addition to counties and municipalities, there are a large number of school districts in the State of New York. Except for those in New York City, school districts are not governed by the cities, towns or villages; rather, they are organized for the sole purpose of running primary and secondary schools. As a result, school districts often overlap with cities, towns and villages. Fiscal transfers from the state governnent to the local governments (counties, municipalities, and school districts), local agencies, and individual welfare recipients account for a large part of state government budget. In fiscal year 1995-6, $22.5 billion, or about two thirds of the State of New York's general fund (general revenue) went to various transfer programs. Among these transfer programs, the school aid program and the revenue- sharing program are intergovernmental transfer programs--they are distributed to local governments. Others are welfare assistance directed to eligible individuals. Below we discuss the two main intergovernmental transfer programs in the State of New York. (1) School aid program In fiscal year 1995-6, the total arnount of the school aid was $7.7 billion, or 34 percent of the total state transfers to localities. This program provides assistance to school districts to finance primary and secondary eduction. The school aid program is the single largest transfer program in the State of New York (this is also the case in most other states in the U.S.). The distribution of the aid is based on a set of more than 20 formulas that measure the fiscal needs and fiscal capacities of localities in providing primary and secondary education. The major components of the school aid program include comprehensive operating aid (including extraordinary needs aid), tax equalization aid, tax effort aid, gifted and talented aid, hmited English proficiency aid, public excess cost aid, declassification support service aid, education related support services aid, reorganization incentive operating aid, transportation aid, building aid, organizational incentive building aid, computer software aid, textbook aid, instructional computer hardware and technology equipment aid, library materials aid, growth aid, the transition adjustment, administrative efficiency incentive aid, special services aid, BOCES aid, employment preparation education aid, and incarcerated youth aid. 27 The author would like to thank Ron Kogelmann, Ed Ingoldsby, Mike Murphy, Lisa Timoney, Rosina Mulligan, and Dennise Norton of the Budget Division, Executive Department, State of New York for providing me with helpful information. 64 T he largest component of the school aid program, the "Comprehensive Operating Aid," accounted for about 56 percent of total educational aids from the state to localities in fiscal year 1995-6. The formula for calculating this aid is as follows: A district's comprehensive operating aid is determined by first calculating its "formula aid" and then comparing it with the minimum "flat grant" guarantee. According to Education Law, Section 3602, Subdivision 12, each district receives the greater of: (i) "Formula Operating Aid" (ii) US$400 X selected TWPU (Flat Grant Provision) wvhere TWPU = Total Aidable Pupil Units Formula Operating Aid = ($3,900 + Ceiling Adjustment ) x Operating Aid Ratio x Selected TAPU for payment Operating Aid Ratio = The highest of the following but not less than zero nor more than 0.90: 1.35 - (combined Wealth Ratio x 1.50) 1.00 - (combined Wealth Ratio x 0.64) 0.80 - (combined Wealth Ratio x 0.39) 0.51 - (combined Wealth Ratio x 0.22) Combined Wealth Ratio = (0.5 x Full Value Wealth Ratio) + (0.5 x Income Wealth Ratio) Full Value Wealth Ratio = 1993 Full Value/ 1994-5 TWPU State Average Full Value/TWPU ($261,300) Income Wealth Ratio = District 1993 Adjusted Gross Income/1994-5 TWPU State Average Adjusted Gross Income/TWPU ($82,800) 65 Generally speaking, the amount of aid a district receives is determined by three factors: (1) the number of students-the higher the number of students is, the higher is the amount of aid; (2) wealth (value real estate properties) of the district relative to the average of the state-the higher the wealth level is in the district, the less the amount of aid; and (3) household income level of the district relative to the average ofthe state--the higher the income level is in the district, the less the amount of aid. The second and third factors reflect the program's objective of equalizing fiscal capacities of districts across the state. One should note that the relationships between these factors and the amounts of aid are generally not linear. (2) Revenue-sharing program (unconditional transfer program) Currendy the size of this program is relatively small. In fiscal year 1995-6, the total amount distributed by this program was $700 million. However, it used to be one of the largest aid programs in the State of New York. When the program was first created by state legislation in 1971, it was stipulated that 18 percent of the state income tax receipts would be distributed to cities, towns, and villages within the State of New York. For fiscal year 1977-8, the State capped the aid program at the 1976-7 level, due to the state's difficult budgetary situation. In 1979, funding was changed to 8 percent of total state tax collection. From 1980 to 1984-5 State fiscal year the funding was capped at $800 million. Since 1984-5, this program became a "Base Year Aid" program consisting of four components: per capita revenue sharing aid; aid to special cities, town, and villages and "excess" aid; and needs-based aid. The total amount of this program was specified by the annual appropriation bills, and the allocation across localities was based on the previous year's figures with a uniform increase or decrease rate. Despite many small ad hoc adjustments, the current distribution is largely determined by the formulas adopted in 1984-5. The 1984-5 formulas consider the population, value of properties, and income level of each locality and were designed to equalize fiscal capacities of the local governments. Among the four components, the largest is the Per Capita Revenue Sharing Aid, which distributed $800,860,900, or 83 percent of the total revenue sharing aid in fiscal year 1984-5. The special city, town, and village aid distributed $96,390,000; "excess" aid distributed $30,400,000; and "Needs Based" aid distributed $38,800,000. The following is a brief description of the Per Capita Revenue Sharing Aid. The per capital revenue sharing aid is distributed according to the following two general formulas: A. Approximately $400,430,450 to counties, cities, towns, town outside village areas, and villages as follows: 1. Towns- a uniform per capita townwide rate of $3.55 is allocated, 2. Counties - $0.65 per capita is allocated when the average of per capita full value and per capita personal income is $8,000 or more. 66 - An additional $0.05 per capita is allocated for each $100 or part thereof by which this average falls below $8,000. 3. Cities, Towns Outside Villages Areas, and Villages - When the per capita full value is $8,000 or more, the per capita amounts are: Cities: $8.60 Villages: $3.60 Town Outside Village Area $22.05 An additional $0.05 per capita is allocated for each $100 or part thereof by which per capita full value falls below $8,000 4. City of New York - There is no special formula. The City is paid per capita amounts under both the city formula and the county formula, as described above. Bt. Approximately $400,430,450 to Cities as follows: Each city's share is based on the ratio of its population to the total population of all cities in the State. Other Transfers hn addition to transfers to local governments, there are a number of important transfers to other local agencies and to individual welfare recipients. These include: (1) Medicaid assistance program. In fiscal year 1995-6, the total amount was $5.3 billion. This program was designed to provide health insurance for the poor, and is co-financed by the federal government and local governments. There are 33 services mandated by federal legislation that this program must provide. The federal government matches 50 percent of the costs of these services. Between the state and local governments, the matchng rate varies depending on the type of services. For hospital expenses, the state covers 25 percent and the localities cover another 2'i percent. For long term care, the state covers 40 percent and the localities cover 10 percent. In fiscal year 1996-7, the budget contribution of the federal government to Medicaid is $12.3 billion, the state contribution is $9.4 billion, and the local contribution is $3.9 billion. (2) Income maintenance program. In fiscal year 1995-6, the total amount of this program was approximaitely $2 billion. This program provides income support to unemployed and disabled people. (3) High education aid. This program provides subsidies to state universities and tuition grants for students enrolled in local community colleges. In academic year 1995-6, the total amount of this aid was $626 million. Tuition grants are provided based on economic needs of the students. In 1995-6, the maximum amount each student could get was the higher of $3900 and 90 percent of tuition. For continuing to receive tuition grants, studerts mnust maintain certain number of credit hours and GPA. 67 II. Province-Local Fiscal Transfer in Ontario, Canada Southern Ontario has a two-tier local government system. The upper-tier municipalities include regions (including Metro Ontario) and counties. The lower-tier municipalities include cities, towns, and townships governed by regions and counties. Northern Ontario has a single-tier local government system (regions and counties). The province is also divided into 10 school boards which are responsible for financing and operating prinary and secondary education. Similar to those in the United States, school boards in Ontario are independent from the regions and counties. The province allocates unconditional and conditional transfers to municipalities (regions, counties, cities, towns, townships, and school districts) for both operating (current) and capital expenses. In 1994, transfers from the province accounted for about 32 percent of total municipal revenues. In the same year, the municipalities raised about 38 percent of their revenues from property taxes and 30 percent from fees and user charges (including 12 percent from user fees, 10 percent from special charges, and 8 percent from sewer and water fees).28 The relative importance of transfer as a source of a municipality's revenue varies significantly depending on several factors.29 The most important factor is the municipalities' responsibilities. For example, although counties and regions are both upper-tier municipalities, their responsibilities differ greatly (regions fund their own police forces and counties get free police protection). In addition to providing their own police forces, regions also tend to provide more comprehensive social services and health care than counties. The second factor is the revenue capacities of the municipalities. Generally, urban municipalities raise more of their own revenues (and therefore receive less transfers) than municipalities with a lower degree of urbanization. In 1988 counties received 37.8 percent of their current revenues from provincial transfers. Metro Toronto (with a high proportion of urban population), on the other hand, received just 23.1 percent of its revenues in the form of transfers. The third factor affecting the distribution of transfers is whether a municipality is located in the north. Different patterns of provincial support are also evident in comparing the north with the south. For example, in 1988, transfers account for 27.4 percent of total current revenue for county cities (those in the south), but 42.6 percent in district cities (those in the north). Expressed in dollars per household, transfers to county cities were about $713 per household, while the corresponding amount to district cities was about $1,390 percent household. Conditional Grants 28 Ernie Eve, Q.C.,"1995 Fiscal and Economic Statement," 1995, Ministry of Finance of Ontario. 29 Based on "Report of the Advisory Committee to the Ontario Minister of Municipal Affairs on the Provincial- Municipal Financial Relationship," 1991. 68 In 1988, about 70 percent of provincial transfers to municipalities were distributed in the form of conditional grants. Since then, as the size of unconditional grants was reduced, the share of conditional grants increased to about 90 percent in the early 1990s. Conditional grants are given to municipal agencies to finance education, roads, health care, environmental protection, public libraries, flood control, and other services. Currently there are more than 100 programs of conditional grants. Most of these provide matching grants, which share certain percentages of the cost of locally delivered services. For example, the province matches 50 percent of the cost of road maintenance. The amounts of transfer (conditional and unconditional) to municipalities in 1991-2 are shown in the following table. Table 1. Major Provincial-Municipal Cost-Sharing Programs, Ontario, 1991-2 ($ million) Provincial Local Total Services share taxes Fees Municipal affairs Uncondiltional grants 947 -- 947 Conditional grants 36 -- -- 36 Other 6 -- 6 Education 5,201 6,992 -- 12,193 Transportation 823 1,811 146 2,780 Community and social services 1,883 526 -- 2,409 Environmental 275 1,455 1,588 3,318 Health 265 183 28 466 Natural resources and conservation 53 52 --- 105 Cultural anid communications 41 353 13 407 Tourism and recreation 57 1,076 298 1,431 Total 10,922 13,308 2,960 27,190 69 Source: Ontario Fair Tax Commission, Fair Taxation in a Changing World: Report of the Ontario Fair Tax Commission, 1993. The largest conditional transfer program is the provincial subsidies to school boards for elementaxy and secondary eduction.30 The funding mechanism is embodied in a set of legal documents known as the General Legislative Grants (GLG) regulations. Through a combination of operating and capital assistance programs, the GLG regulation attempts to mitigate inequalities in financial resources among school boards across the province. These assistance programs can be referred to as "equalization payments" since they attempt to equalize the financial resources among school boards by taking into account the size of the local tax base (i.e., resources available) and the resources required by a school board to provide the base level of education service. The General Legislative Grants are comprised of four components. The first and the most important component, called "Basic Per Pupil Grants," is an equalization payment made by the province to a school board. This provincial grant equals the difference between the amount considered necessary by the province for a school board to provide the base level of education and the amount raised from local property taxes. The calculation of the basic per pupil grant is based on two key variables: (1) Average Daily Enrollment (ADE), which is the measure of the number of pupils enrolled in each school board. The ADE multiplied by the provincially established basic per pupil amount equals the recognized ordinary expenditure of the school board. In 1995, the basic per pupil amounts were $4,184 for each elementary pupil and $5,116 for each secondary pupil. (2) The value of the equalized assessment of all property in each community served by the school board determines the amount of money that can be raised from local property taxes. The second component of the General Legislative Grants is called "Board-Specific Grants." The provincial government recognizes that the cost (teacher wages, rental cost, etc.) of providing the base level of education varies with geographic, demographic, and social-economic conditions across the province. The "Board-Specific Grants" are therefore design to assist localities with additional costs so that they can provide the base level of educational services without placing additional financial burden on local taxpayers. The third component, called "Program-Specific Grants", is provided to school boards to encourage them to extend education programs and services into areas that respond to local needs, and to meet provincial priorities. These grants are grouped into four subcategories which include language grants (e.g., French & English as second languages), initiative grants (e.g., class size reduction in grades I and 2), special grants (e.g., student transportation, education programs in care and treatment facilities), and other grants (e.g., isolated boards). 30 Local Government Finances in the Greater Toronto Area, "Background Report 3: Subsidy and Service Levels", 1996. 70 The fourth component, called "Capital Funding Assistance," is distributed on a cost-sharing basis to school boards. Capital projects undertaken by school boards that qualify for this type of assistance include new schools, site purchases, buses, and replacement and renovation of schools. The provincial share of costs is provided ito school boards as loans, and the amount that a school board receives is dependent on its relative taxing ability. On average, the provincial support rate on growth-related capital projects, including new schools, additions, and sites, is 60 percent. Unconditional Grants3' The unconditional transfer system has five components plus a revenue guarantee. Although they are referred to as "unconditional transfers" by Canadians, some of them are actually block grants with broad conditions attached. The three most important components are: the Police per Household Grant, the Northern Support Grant (NSG), and the Resource Equalization Grant (REG). Below is a brief description of these three programs. (1) Police per Household Grant T-his is an equal per household grant provided to regions. The amount of transfer a region receives is the product of the number of households in the region and the uniforn $50 per household rate. This grant is not meant to be a direct subsidy to cover regional policing costs and, as a result, the level of assistance is often criticized by regions as providing inadequate compensation for policing costs (the average expenditure on policing is $290 per household). (2) Northern Support Grant (NSG) This grant, introduced in the 1973 Ontario budget, had two purposes. First, it was intended to recognize the higher costs of providing services in the north and, therefore, higher living costs; and second, it was to compensate north municipalities for the termination of mining payments. Prior to 1973, the mining profits tax was collected by the province and a portion of it was shared with municipalities in which miners resided. In 1973, these payments to municipalities were replaced by NSG, as well as the General Support Grant and REG. The distribution of this grant is based on the municipalities' own revenue collection. Municipalities in the south receive a transfer equal to 6.15 percent of their levy and municipalities in the north receive 29.65 percent of their levy. (3) Resource Equalization Grant lTis grant intends to close the gap in fiscal capacities across municipalities. Municipalities with higher capacities to finance their services with their own sources are given less subsidies than municipalities with lower capacities. The fiscal capacity of a municipality is measured by the average value of residential properties per 3] Based on Advisory Committee (1991). 71 household. The transfer is then calculated by comparing the assessment of residential property value per household of the municipality against the simple average assessment of residential property value per household for municipalities across the province. Pattern of Distribution On a per household basis, the level of fimding is significantly higher in the north than in the south. While this is largely the result of the NSG, the result is also reinforced by the fact that most northern municipalities receive significant funding under the REG and revenue guarantee. Moreover, northem municipalities tend to receive higher levels of conditional grants. Table 2. Ontario: 1988 Provincial Transfers to Municipalities per Household ($) Unconditional Conditional Total South Metro Toronto 217 936 1,153 Co. Cities 258 581 839 Regions 210 709 919 Counties 169 804 973 North Regions 635 687 1,322 Dis. Cities 590 921 1,511 Districts 400 1,081 1,481 Total 238 784 1,022 Source: Advisory Committee (1991). III. State-Municipality Revenue Sharing in Brazil32 Brazil has a federal system with three levels of government: the federal government, the state governments, and municipalities. The federal government assumes exclusive responsibility for the taxes on income, payroll, wealth, foreign trade, banking, finance and insurance, rural properties, hydroelectricity, and mineral products. The federal government allows states to levy supplementary rates up to 5 percent on the federal bases for personal and corporate incomes. The main state taxes include the general value added tax on goods and services, tax on inheritance and gifts, and tax on motor vehicles registration. These three taxes consist 32 Based on Anwar Shah, 1991, The New Fiscal Federalism in Brazil, World Bank Discussion Paper, No. 124. 72 of 72 percent of the states' revenues. Municipalities are empowered to levy taxes on services, urban properties, retail sales of fuels except diesel, property transfers, and special assessments. Municipalities raise only 18 percent of revenues from their own sources and rely heavily on federal and state transfers. The most important source of transfer is from the federal government, accounting for approximately half of municipal revenues. The second important source of municipal revenues is the constitutionally mandated state-municipal revenue sharing arrangements. State transfers constitute one third of municipad revenues. In many states, municipalities rely almost exclusively on transfers from higher-level governments. Mechanisms for state-municipal revenue sharing arrangements have been specified in the regulations issued by the federal parliament. The regulations provide specifics of the formula as well as timing for the release of funds. The most recent regulations as given in Projeto de lei Complementar no. 177 (1989) specifies that municipal shares of federal and state transfers should be immediately deposited in the joint account of all municipalities. Further, individual municipal accounts should be credited no later than the second working day of each weck for all revenues received in the previous week. T-he formulas for state-municipal transfers are highly transparent and have been instituted by Federal regulations. Distribution of tax transfers for the most part follows the origin principle. ICMS (state value added tax) revenues are distributed by a formula which mandates that at least 75 percent of such revenues to municipal governments be allocated based on value added produced in the municipalities. Since ICMS is a value added tax, this clearly recognizes the origin as the guiding principal in the distribution of these transfers. Following this principle, municipal transfers in per capita terms shows a wide divergence across states. Small weight is given in the formula to other factors which the individual states may consider important in the distribution of these monies in their jurisdictions. For example, the State of Para uses population (7 percent weight), area (2 percent), and fiscal effort (9 percent) as special factors. In addition, the State of Para distributes 7 percent of the fund in equal amounts per municipality. The State of Parana uses proportion of population in rural areas, population, and area as special need factors. The specific formulas of state-municipal revenue sharing are as follows: a. State Value Added Tax (ICMS) The distribution of ICMS to municipalities is determined by the following formula: Mi = 0.25*ICMS{(VAN/VA,)*p + (other factors)* (1-p)} where M = funds allocated to municipality i; VA -= value added (average of past two years) = value of outflow of goods + value of services rendered within municipality value of inflow of goods P = proportion of funds distributed by values added component (the following range for p is specified by law (L.C. no. 177): 0.75<=p<=1. Other factors = each state is given complete discretion over specific other factors to be 73 included in the fornula b. Motor Vehicle Registration Tax 50 percent of the receipts of this tax are returned to municipalities by State Treasury by origin. The funds are immediately disbursed to municipalities upon collection. c. 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