Chapter 4. Taxes or grants: What revenue source for sub-central governments?1

Sub-central governments (SCGs) have two main revenue sources: own taxes and grants from other tiers of government. Both revenue sources help finance sub-central public expenditure, but differ in the way they are generated and distributed. As a result, the sub-central revenue mix is likely to shape decisions at all levels of government about how, when and on what to spend money. This chapter presents the policy issues and trade-offs for both central and sub-central governments as they seek to strike a balance between own taxes and grants. The first section shows how the make-up of sub-central revenues has evolved from country to country. The second section explores the advantages of own sub-central taxation, while the third section makes the case for intergovernmental transfers. As for the fourth section, it puts forward policy options for improving the balance between taxes and grants.

Trends in revenue composition

The composition of sub-central revenue OECD-wide has changed little over time – around half is supplied by own and shared taxes and half by intergovernmental grants.2 The picture is very different when countries are considered individually, though. While in Iceland almost all sub-central government (SCG) revenue consists of own taxation, it comes near-exclusively from grants in the Netherlands, although those proportions should be set against the total share of sub-central revenue in general government revenue (Figure 4.1A). In federal countries, SCGs boast a slightly higher share of taxes than in unitary countries. Since 2005 the share of grants in sub-central revenue rose in most countries (Figure 4.1B). A case in point is Denmark, where own taxation shrank by more than 2 percentage points whereas transfers grew by more than 6 percentage points.

The growth of transfers was prompted by a widespread policy of decentralising expenditure. In the late 1990s and the first half of the 2000s, many countries decentralised spending responsibilities, especially in the areas of education, infrastructure and neighbourhood services, while SCG tax revenues remained largely stable. The resulting rise in the vertical fiscal imbalance – the difference between SCGs’ own revenues and spending obligations – was met by ever-growing grant systems. Transfers were thus mechanisms used in response to higher SCG spending. With the onset of the economic and fiscal crisis in 2008, which affected all tiers of government, the share of SCG spending started to decline again – partly because central government brought selected functions back into its fold, and partly because its consolidation endeavours led to reduced transfers. Over the entire period, year-on-year increases in transfers as a share of SCG revenue were much more frequent and smaller than falls which, though they happened more seldom, were larger (Blöchliger and Petzold, 2009). The inference may be that transfer growth is systemic and creeping, while transfer reductions are the consequence of structural reform. After the up- and downswings of the last 20 years or so, the composition of SCG revenue is today close to where it stood in 1995.

The composition of sub-central revenue will depend on 1) how relative spending needs evolve across all tiers of government and 2) how rising sub-central needs will be met. Pressure will be felt most keenly by the tier of government which is assigned the task of meeting fast-growing needs – e.g. those related to ageing or to combating climate change. Such pressure is thus country-specific. A German study on demographic change and multilevel public finance concludes that spending pressure will be higher at central than sub-central level. The chief reason is that spending on social security, usually a central responsibility, tends to grow faster than overall expenditure. Conversely, primary and secondary education – in most countries a sub-central responsibility – will grow more slowly (Seitz, 2008). By contrast, an Austrian study claims that sub-central needs will be greater since their responsibilities in areas such as education, childcare, elderly care and transport infrastructure are growing faster than general government expenditure (Aiginger et al., 2006). A Canadian study, for its part, sees little change ahead in relative spending needs (Slack and Kitchen, 2006).

As for the second factor affecting revenue composition, tax reforms may increase SCGs’ share of total tax revenue and consequently reduce the need for intergovernmental transfers. This is the topic of the next section.

The balance between taxes and grants

The benefit of having own tax revenues

Relying on own taxes brings a number of benefits. While it could be argued that the amount rather than the composition of sub-central fiscal resources is what matters, overwhelming evidence suggests that the impact of the two fiscal arrangements on public finance and economic outcomes tends to be different. As a general rule, spending and revenues should be aligned along the Wicksellian Connection, suggesting that spending is to be largely covered by own revenue – at least for jurisdictions with GDP above the national average (Bird and Slack, 2013; Ter-Minassian, 2015). The reasons are as follows:

Autonomy. Own tax revenue brings greater autonomy in determining public service levels. With own taxes, voters in a jurisdiction are able to define freely where and how much to spend on their public services. Tax autonomy makes particular sense in countries where tastes, preferences and attitudes towards the public sector vary according to jurisdictions – in other words, where autonomy is likely to make a difference to tax and service levels. Grants do not give SGCs much freedom to decide spending levels – and even less when earmarked for specific purposes.
Accountability. Own taxes make governments accountable to their citizens, particularly through electoral democracy. SCGs which tax their own citizens are under pressure to justify their revenue sources and how and for what purposes they plan to spend. If voters feel that they are not getting what they pay for, they will say so at the ballot box. Civic engagement and political participation tend to be stronger if SCGs are financed through own taxes rather than grants.
Resource mobilisation: Reliance on own tax resources may underpin overall resource mobilisation in a country. SCGs might, for example, seek to tap resources that are otherwise underutilised or overlooked by central government. Property taxes or user fees are a case in point. Income taxes, too, could – at least partially – be mobilised efficiently at the sub-central level. Assigning tax revenues to SCGs can be a means of improving tax effort and generating incentives for greater tax collection.
Sustainability. Own taxes are a hard budget constraint on SCGs, making them accountable for their fiscal policy. Grants, by contrast, tend to ease the budget constraint and leave SGCs prone to overspending. There is considerable evidence to that effect in the link between transfer and spending growth. Central government caving in to sub-central demands for more grants and the so-called “flypaper effect” – a tendency for governments to spend grant money more easily than own-tax money – seems to lie at the core of the link between transfers and spending.
Political economy. Most grant systems contain provisions that are not based on objective criteria. They are, in fact, the consequence of political factors such as the pressure of special interest groups, the sub-central election system, or the alignment of political parties across central and the sub-central tiers of government. Many grant systems favour certain groups or jurisdictions for no objective reason. Although sub-central tax systems are also prone to distortions that stem from special interest group pressure, they tend to be less so than grants.

In sum, SGCs could be assigned more own tax revenue. The challenge is to find the fitting taxes. While optimal tax decentralisation is quite country-specific, a few general rules govern tax assignment. They are discussed in the next section.

The current sub-central tax mix

Income and consumption taxes are central government’s main sources of revenue, while property and income taxes are SCGs’ (Figure 4.2A and B). That summary statement obscures the fact that within a country the sub-central tax mix is less balanced than the central tax mix. In some countries, particularly English-speaking ones, property taxes account for the overwhelming share of local taxes. Elsewhere, though, such as in the Nordic countries or Switzerland, income taxes are almost the sole sub-central tax source. As for own or shared consumption taxes, they are a significant sub-central source of revenue in a few federal countries like Canada, Germany and the United States. The tax mix has changed and fluctuated little since 1995, but a salient feature up to 2007 was the gradual decline of revenue from property tax in some two-thirds of all countries. Of late, it has started growing again for cyclical and policy reasons – the principal ones being that property taxation withstood the crisis better than other taxes and that several countries implemented reforms to bolster property tax revenues. Corporate income taxes yield little revenue, as few countries boast a sub-central corporate income tax. Where there is one, it seems to have weathered cyclical downturns and inter-jurisdictional tax competition well.

Which taxes for sub-central governments?

Taxes can be ranked according to whether they are efficient, fair or redistributive, whether they produce high and stable yields, and whether administrative and compliance costs are low. The OECD studied the relationship between taxation and economic growth to rank taxes from an economic development perspective (OECD, 2010). The results suggest that, measured against per capita GDP growth, taxes on immovable property are the least distortive, followed by consumption taxes, personal income taxes and corporate income taxes. If the tax mix were to be truly revenue neutral, therefore, it would have to shift from personal and corporate income taxation towards immovable property and consumption taxes. The opposition to such reforms would, however, be considerable. Lower income tax would be contested on redistributive grounds and higher property taxes – a resolutely unloved tax – would likely be met with strong resistance from various groups.

There are a number of additional limitations on achieving a “good” sub-central tax mix. Although there is no equivalent to the empirically tested economic growth ranking described above, there is quite a broad consensus on what makes an effective sub-central tax mix. As a basic principle, SCGs should rely on benefit taxation, i.e. taxes where there is a link between the taxes that households and businesses pay and the public services (i.e. benefits) that they receive (Oates and Schwab, 1988). The criteria underlying the benefit principle comprise:

SCG taxes should be non-mobile and non-redistributive (to prevent tax erosion);
they should be non-cyclical (to stop SCGs running pro-cyclical fiscal policy);
they should not be exported to other jurisdictions (to ensure the benefit principle is maintained);
the tax base should be evenly distributed across jurisdictions (to avoid wide disparities and/or the need for large fiscal equalisation systems).

On the strength of these criteria, the property tax would enjoy even greater pride of place in sub-central than central taxation. Other taxes might lose out, particularly sub-central corporate income taxes, as they are mobile, highly cyclical, geographically concentrated and tend to shift the tax burden to non-residents.

The way ahead for countries seeking to increase their sub-central tax shares while reducing intergovernmental grants is rocky, but feasible:

Property taxes’ share of SCG tax revenue is at around 36% and was declining until recently. Hikes are much contested by taxpayers and, if the sub-central tax share were to rise, it is unlikely that property taxes could play a substantial part as a source of SCG tax revenue. And yet recent property tax reforms in Greece or Ireland demonstrate that revenues from land-related taxes can supply a greater share of sub-central revenues.
Consumption taxes will continue to play a limited role as a source of revenue for SCGs. Although there are a number of proposals for sub-central consumption taxes – like destination-based dual central/sub-central VAT or a mix of central VAT/sub-central sales taxes – they are confined to large countries with large regional jurisdictions (Marè, 2007). Most countries would need to incorporate sub-central consumption taxes into tax-sharing systems, leaving SCGs no tax autonomy.
Personal income taxation could supply a larger share of sub-central tax revenues. If central government were to cede some income taxes to SCGs, they, in turn, could introduce a proportional surcharge on the national income tax. Such “piggyback” taxation – practised in several countries, introduced in Belgium and Portugal over the last decade, and under discussion in Germany and the United Kingdom – would maintain benefit taxation at the sub-central level.

With a mix of taxes on immovable property, proportional income taxes and – in selected cases – consumption taxes, a revenue-neutral increase in the sub-central tax share could go hand in hand with a more efficient overall tax system and a reduction in intergovernmental grants.

Central government’s role in shaping the sub-central tax mix

While a higher sub-central tax share might be desirable, central government must set a number of rules on sub-central tax policy and restrict the power of SCGs to raise certain taxes. These would chiefly relate to non-benefit taxes and taxes with externalities, i.e. those that export the tax burden to non-residents. SCGs may attempt to extract revenues from sources for which they are not accountable, thus obviating the basic efficiency argument for sub-central taxation. National government should therefore restrict sub-central access to taxes that fall mainly on non-residents – corporate income taxes, certain consumption taxes, natural resource taxes, etc. If the benefit principle were applied strictly, property taxes on non-residents would also become an issue, although such taxes – plus user fees and charges – may help fund services that extend across jurisdictional borders. In short, central government might wish to establish a uniform set of tax bases for sub-central governments. Another, more lenient, approach is to establish a set of rules under which SCGs are allowed to tax certain items. A number of countries use constitutional provisions to limit SCG taxation if they feel that it harms inter-jurisdictional trade or distorts internal markets.

Intergovernmental transfers have a role to play

While a stronger link between SCGs’ own spending and their own-source revenue is desirable on various grounds, there are both efficiency and distributional arguments in favour of intergovernmental grants. A certain vertical fiscal imbalance – the gap between spending needs and own revenue sources – is probably inevitable. Transfers are thus a core ingredient of most intergovernmental fiscal frameworks and likely to complement most jurisdictions’ own-tax revenues.

Grants help reduce differences in tax raising capacity

A higher sub-central tax share might well be preferable on the grounds of efficiency and accountability. It is, however, likely to raise distributional concerns. Tax-raising capacity is unevenly distributed across jurisdictions and may leave some unable to provide an appropriate level of public services. Consequently, narrowing disparities in tax-raising capacity and public service provision needs between jurisdictions are considered the most important objective of intergovernmental grants (Boadway, 2007).

Most countries have explicit or implicit equalisation systems that use either vertical transfers to financially weak SCGs or horizontal transfers from the financially strong to the financially weak. For a set of 15 countries, equalisation amounts to around 2.3% of GDP, 4.8% of total government expenditure and around half of all intergovernmental grants (Table 4.1).3 Tax revenue equalisation and cost equalisation systems are roughly the same size, despite tax revenue disparities being four to five times greater than disparities in the cost of providing public services (not shown in Table 4.1). On average, fiscal equalisation diminishes disparities in revenue-raising capacity – as measured by the Gini coefficient or variation coefficient – by almost two thirds, from 29% to 10% and virtually zero in some countries. After equalisation, fiscal disparities are clearly narrower than economic disparities, as measured by regional GDP. In other words, the ability to provide public services is more evenly distributed than economic output.

Table 4.1. A snapshot of fiscal equalisation
Equalising grants and their fiscal disparity-reducing effect, 2012
Country	Gini coefficient of differences in tax raising-capacity				Ratio of highest to lowest tax-raising capacity
	Before equalisation		After equalisation		Before equalisation		After equalisation
	2005	2012	2005	2012	2005	2012	2005	2012
Federal/regional countries
Australia	0.05	0.07	0.00	0.00	4.8	7.5	1.0	1
Austria			0.02	0.05			1.1	1.5
Canada	0.10	0.11	0.07	0.08	2.4	2.4	1.7	1.8
China	0.33	0.31	0.25	0.18	14.4	10.3	9.5	5.3
Germany	0.06	0.06	0.02	0.02	1.7	1.7	1.2	1.1
Italy	0.21	0.19	0.10	0.04	6.1	4.5	1.3	1.3
Spain	0.15	0.13	0.04	0.05	2.1	3.0	1.4	1.4
Switzerland	0.15	0.17	0.11	0.11	3.8	4.3	2.5	2.6
Unitary countries
Chile (2010)		0.49		0.14		20.6		2.3
Denmark	0.08	0.06	0.04	0.03	2.2	1.4	2.0	1.2
Finland	0.11	0.12	0.03	0.05	1.8	1.8	1.1	1.4
Japan	0.20				3.2
Norway	0.13	0.13	0.05	0.04	2.2	2.1	1.3	1.2
Portugal	0.34		0.14		12.7		2.1
Sweden	0.06	0.07	0.01	0.01	1.4	1.5	1.1	1.1
Turkey	0.22		0.06		65.0		1.7
Average	0.16	0.16	0.07	0.06	8.8	5.1	2.1	1.8
Source: OECD (2014), Fiscal Federalism 2014: Making Decentralisation Work, OECD Publishing, Paris. https://doi.org/10.1787/9789264204577-en.

Empirical evidence suggests that a larger sub-central tax share or more sub-central tax autonomy are associated with larger fiscal equalisation systems, although the relationship is not always significant (OECD, 2007). For reasons of political economy, countries wishing to increase SCGs’ share of taxes or their tax autonomy might have to think about strengthening fiscal equalisation. Be it vertical (from central government to poorer jurisdictions) or horizontal (from rich to poor jurisdictions), a well-functioning transfer and equalisation system plays a crucial role in decentralised systems. Given that around half of all transfers are currently equalising, there is ample room for improving equalisation (Blöchliger and Petzold, 2009).

Grants could help reduce inter-jurisdictional externalities

Horizontal and vertical fiscal externalities, or “spillovers”, may justify intergovernmental grants on the grounds of the effectiveness of overall fiscal policy. They arise if the fiscal policy of one jurisdiction or government level affects fiscal outcomes elsewhere. Intergovernmental grants can compensate jurisdictions that are affected by such externalities, which may originate on both the spending and revenue sides of decentralised budgets.

Spending externalities. Spending externalities arise when an SCG’s spending policy affects the residents of other jurisdictions. Examples include public services funded by one jurisdiction– e.g. infrastructure – which benefit the residents of neighbouring jurisdictions. Externalities may also arise if the spending decisions of an upper tier of government on, for example, tertiary education depends on the expenditure of a lower-level government on primary and secondary education. Jurisdictions may undersupply externality-prone services.
Tax externalities. Tax externalities arise when an SCG’s tax policy affects the residents of other jurisdictions. Examples include tax exporting – local and regional taxes borne by non-residents – or strategic tax rate setting (or tax competition) that affect revenues in other jurisdictions, although rate setting is not always considered an “externality”. Tax externalities may also arise if different government levels tax the same tax base. Persistent tax externalities may distort the tax mix and the spatial allocation decisions of firms and residents, or they may lead to excessively high or low tax rates.

Intergovernmental grants – particularly matching grants which are determined as a percentage of sub-central spending – can offset such externalities and encourage SCGs to provide adequate levels of public services. Or they compensate them for the tax policies of other jurisdictions. However, the rationale for grants as an anti-externality device is not always clear-cut and seems to be relevant only in a limited number of countries with a specific institutional and fiscal background.

Horizontal tax externalities can play a role if SCGs enjoy strong powers of taxation and rely significantly on sales taxes – which is very much the case in the United States, where autonomous sales taxes account for 50% of state and 20% of local tax revenue. Studies estimate those externalities at between 0.5 and 5% of total tax revenue (OECD, 2005). However, rather than use grants to correct such externalities, policy should reform the tax system by replacing SCG sales taxes with a sub-central value added tax or by incorporating SCG indirect taxes in a tax-sharing system. Australia, in 2000, and Mexico, in the 1980s, reformed their consumption tax systems accordingly, although they also reduced sub-central fiscal autonomy at the same time.
Horizontal spending externalities are relevant in countries where SCGs boast considerable spending power. In tertiary education, for instance, the geographical mobility of students could deter SCGs from investing in universities. Another example is transport infrastructure where inter-jurisdictional externalities (or spillovers) could lead to underinvestment by sub-central governments (Sutherland et al., 2009). A number of Swiss studies estimate spillovers for various municipal services at between 8% and 5% of total municipal expenditure (OECD, 2002). Since Switzerland is a benchmark for both jurisdictional smallness and spending decentralisation, those percentages could hold as an upper limit for OECD countries. In Canada, spending externalities appear to be negligible (Smart, 2005). Moreover, some spillovers tend to cancel each other out, which gives affected jurisdictions an incentive to negotiate horizontal compensation agreements.4
Vertical spending externalities arise when the policy outcomes of one government level relies on those of another. Tertiary education – often a higher-tier government provision – relies on the performance of primary and secondary education, mostly provided by lower-level governments. Central government may subsidise SGCs’ spending on primary and secondary education when it assumes that they do not invest sufficiently in preparing students for higher education. Other services where vertical spending externalities might occur include healthcare and infrastructure. However, the few existing empirical studies suggest that SCGs do supply adequate levels of core services and, in some cases, even tend to overspend (OECD, 2005).5
Vertical tax externalities arise if central and sub-central governments tap the same tax base. Concurrent taxation is pervasive in many OECD countries, resulting in externalities where one government level fails to factor in the impact of its tax policy on another government level. Tax externalities are particularly relevant if all tiers of government tax mobile bases like those of personal or corporate income (Keen and Kotsogiannis, 2002). However, since it is not clear which government level is actually responsible for vertical externalities, the question of who has to compensate whom remains moot, and grants could just as easily flow from the sub-central to the central level. If governments feel that concurrent taxation creates externalities, intergovernmental consultation and changes to the tax framework rather than compensating grants are the appropriate solution.

Actually, the extent of fiscal externalities is much smaller than the transfers supposed to address them. Earmarked matching grants plus discretionary earmarked grants (often of a matching nature, too) account for around 54% of intergovernmental grants and around 18% of total sub-central spending for both SCG levels taken together (see Figure 1.10 in Chapter 1). These percentages are well above almost any externality identified in an OECD country. Moreover, matching rates – the percentage at which a specific sub-central spending item is subsidised – are typically much higher than can be justified by plausible externality levels in most countries. If intergovernmental grants are going to be implemented or reformed on the basis of intergovernmental fiscal externalities, the size and nature of the externalities should be thoroughly assessed.

Grants could stabilise sub-central revenue, but often do not

Intergovernmental grants could ensure that SCGs’ total revenues remain stable over the business cycle, thereby compensating for own-resource revenue fluctuations. And they would absorb tax revenue volatility and act as insurance against asymmetric shocks. Seen from the perspective of central government, transfers could, in fact, act as automatic stabilisers. Indeed, properly designed, sub-central tax revenues and grants would be inversely related: abundant tax revenues would combine with lower grant allocations and vice versa, and aggregate sub-central revenues would be less volatile than sub-central tax revenue alone.

In practice, however, many intergovernmental transfer systems do not have those stabilisation properties. In 2013, the Fiscal Network conducted an empirical study whose findings suggested that, in many OECD countries, grants tended to exacerbate fluctuations in SCG revenue or GDP rather than damping them (Figure 4.3). Overall, a 1 percentage point increase in the output gap – a measure of economic slack – reduces transfer growth by between 0.6 and 0.8 percentage points (Blöchliger and Égert, 2013). Although the destabilising effect seems a little stronger in countries with large transfer systems and a relatively stable tax base (like the property tax), no clear pattern has yet emerged. Since consolidation started in 2010, transfers have begun to exert a slightly stabilising effect – in other words, central government has partially compensated SCGs for their falling own-source revenues, especially in unitary countries (Foremny and von Hagen, 2013).

What are the underlying forces that cause many intergovernmental grant systems to exert a destabilising effect?

Some grant formulae contain an element of tax sharing – in other words, total grant spending is partially a function of central or sub-central tax revenue. And since tax revenue tends to move with the cycle, spending on transfers also becomes pro-cyclical. The fact that the nature of some transfers is akin to tax sharing – in Austria, Japan, Korea and Mexico, for example – could explain their destabilising impact on sub-central revenue.
Matching grants, which account for 40% of all grants, make grant allocation a function of sub-central spending. The more a SCG spends, the more transfer revenue it gets. So, if SCG spending varies positively with the cycle, then matching grants become pro-cyclical. The matching character of transfers might go some way towards explaining pro-cyclicality in Ireland and the United Kingdom.
Equalising transfers usually rely on a fiscal capacity indicator, where grant allocation is determined by the difference between an individual SCG’s fiscal capacity and the national average. This average tends to move with the cycle. If recipient SCGs have, on average, weaker cycles than the country, the difference between the national average and an individual SCG’s fiscal capacity tends to become destabilising – which could explain pro‐cyclical equalisation in Canada and Germany even though pro-cyclicality is weak.
Finally, pro-cyclical transfers can be politically driven. Revenue buoyancy tends to be associated with higher spending, including spending on intergovernmental transfers (Joumard and André, 2008). Since roughly 20% of all transfers are not formula-based but can be increased or cut at the discretion of central government, grants can be adapted to changing budget conditions and become pro-cyclical.

If central government transfers exacerbate fluctuations in the revenue of SCGs, their budgets become more difficult to manage over the cycle. And sub-central fiscal policy becomes even more pro-cyclical if fiscal rules cap SCG spending or borrowing – a common practice in most countries, at least for current spending. SCGs could also react asymmetrically to excessive revenue fluctuations by raising expenditure when times are good and increasing tax rates or borrowing when they are bad, thereby inflating the size of government and the public sector in the long run (Rattso and Tovmo, 1998).

There are a number of ways to reduce pro-cyclical fluctuations in intergovernmental grants and strengthen their automatic stabiliser properties.

Grants should be needs-based. To avoid excessive sub-central revenue volatility, transfers should, as a general rule, be linked to SCGs’ effective needs, measured by tax raising capacity or the standard cost of providing services.
Grants should be decoupled from central government tax revenue collection. Decoupling grants from central government tax revenue collection prevents the tax system’s pro-cyclicality from being transmitted to grants.
Matching grants should be limited. Limiting the percentage of matching grants would be an effective way of breaking the link between central and sub-central spending, which could help ease pro-cyclical pressures on central government transfer spending.
Horizontal equalisation. Horizontal equalisation schemes tend to be less prone to cyclical fluctuations than vertical ones, so switching to them could improve the stabilisation properties of transfers.
Grant entitlements could be lagged. The use of lagged variables in determining SCGs’ grant entitlements may reduce excessive revenue volatility, although the resulting grant systems might not be flexible enough to respond to rapidly changing sub-central needs.

Grants can have unintended consequences

Intergovernmental grants constitute a “common pool” resource for an individual jurisdiction. A SCG that receives a grant or increased grant allocation enjoys its full benefits, yet bears only a fraction of the cost of the additional tax revenue or borrowing required by central government to finance the grants or grant increase. Moral hazard can work through several channels, affecting not only fiscal outcomes such as SCGs’ own-tax revenue, expenditure, deficits and debt, but the size of the transfer system itself.

Grants may reduce the sub-central tax effort. In most countries, grants provide a minimal fiscal endowment for low-income jurisdictions in inverse relation to their fiscal capacity. While such equalising grants are justified on the grounds of equity, they might discourage SCGs from raising their own tax revenue since, if they do, their grants are reduced. This “equalisation tax”, “compensation rate” or “tax on tax revenue” accounts for as much 80% or 90% of additional sub-central tax revenue in some countries. Because the more a jurisdiction lags behind the national average, the higher the equalisation tax usually is, the reluctance to raise own-tax revenue can be particularly pronounced in the poorest jurisdictions.
Grants may put pressure on spending. In most countries, the cost of a jurisdiction’s services provision explains a share of the grant it receives. Grant formulas usually factor in specific unit cost and the number of service units produced or consumed in a jurisdiction. SCGs therefore have an incentive to manipulate those figures to obtain more grants. Moreover, many grants are matching, so an allocation increases if a SCG spends more on the matched service. Since cost-based grant systems often rely on a multitude of indicators, and so tend to be complex, they are prone to rent seeking and pressure from special interests. Country studies suggest that political economy forces exert considerable influence on the size and structure of grant allocation (Blöchliger and Charbit, 2008).
Grants may increase deficits and debt. The grant system may negatively affect sub-central fiscal balance and trigger the self-perpetuating growth of deficit and debt. Empirical evidence suggests that central government’s commitment to a certain level of transfers is not always credible, prompting SCGs to overspend or under-tax in the hope that they will receive additional transfers (Aldasoro and Seiferling, 2014). In that event, the growth of transfers becomes endogenous – higher deficits bring about more grants, and more grants bring about higher deficits (de Mello, 2007). What’s more, the grant-debt relationship might be asymmetric: cuts in grants might be associated with higher debt issuance, but grant increases are not necessarily associated with debt repayment (see Martell and Smith [2004] on the United States).

A skilfully designed transfer system (Box 4.1) can reduce fiscal slippage across levels of government. However, with grants still a common-pool resource for the individual SCG, disincentives cannot be avoided, even if they can be limited.

Box 4.1. Well-designed grants at a glance

Countries have developed several approaches to containing the negative side-effects of their intergovernmental transfer systems (Bergvall et al., 2006; Blöchliger and Charbit, 2008). They can be divided into three groups of measures that sometimes overlap.

Measures on the tax revenue side. It is possible to step up the tax effort if the potential tax base, rather than actual tax revenue, is used to assess SCG tax capacity. Many countries use a representative tax system (RTS), where potential revenue from each sub-central tax is determined by multiplying a standard tax base by a standard tax rate. Some may also use revenue from a central tax to assess sub-central tax capacity. A RTS should cover the major sub-central taxes. Alternative indicators for assessing potential tax capacity include sub-central GDP or household income (a macroeconomic approach). RTS can help curb strategic behaviour and prevent SCGs from manipulating tax capacity indicators in order to obtain more grants.
Measures on the grant side. Spending pressure can be reduced if grant allocation is based on a few broad-based indicators that measure geographic, demographic or socio-economic needs. The use of fewer indicators to determine principal sub-central needs tends to be more transparent and to make the allocation of entitlements less of a statistical headache. Indicators should be outside sub-central control to prevent any manipulation. Most countries today use standard or norm cost approaches whereby grant allocation is independent of a SGC’s incurred expenditure. And it is possible to improve spending performance by disentangling grants that serve several purposes at once – e.g. subsidising SCG services and equalising SCG disparities – and developing separate ones.
Institutional measures. Finally, institutional reform can help contain grant-related budget drift. Some countries set transfer caps irrespective of sub-central financial needs. Having independent agencies and other arms’ length bodies manage grant distribution can help channel transfer increases and ease pressure from special interests. An adequate set of budget management rules can also improve fiscal discipline. A number of countries show intergovernmental grants as a single, separate budget item, thereby increasing transparency. A two-stage budget procedure, in which negotiation of the overall grant budget is separate from the distribution formula, can also offset pressure from special interests.

Summary and conclusions

Across the OECD, own-tax revenue covers some 50% of sub-central government spending and intergovernmental grants the other half. Transfers have slightly increased their share over the last two decades with a peak in 2005. In several countries, own-tax revenue’s contribution to sub-central spending is small, which binds the fiscal policy of central and sub-central governments closely together. A higher own-tax share would make SCGs more efficient and accountable and help mobilise resources at the state/region and local level.

Intergovernmental grants still have a role to play. They help reduce disparities between jurisdictions in tax revenue per capita and costs of service provision and they address fiscal externalities, particularly the under-provision of certain collective goods. Yet, for that dual purpose, they would have to be only around half their current size. And not only are they larger than they have to be, they are often pro-cyclical, too, exacerbating rather than easing SCG revenue fluctuations. Hence the need to reform both taxes and grants if intergovernmental fiscal frameworks are to be more effective.

To make sub-central funding more effective, countries can go in three main policy directions:

Increase the share of own taxes in the overall funding of sub-central governments. Countries, particularly those where the share of own-tax revenue (or else user fees) in overall sub‐central revenue is low, should seek to increase it. A few countries could increase the sub-central own-tax share by as much as 15 percentage points. In order to address distributional concerns arising from stronger sub-central taxation, more effective fiscal equalisation might have to be put in place.
Assigning the right taxes to the right sub-central jurisdiction. Not all taxes are equally suitable for SCGs. While tax reform would help increase the share of immovable property taxes in the total tax take, they would probably not cover all sub-central spending needs. Personal income tax would likely have to complement them. The most common form of sub-central income taxation is a flat rate added to a reduced central government income tax (so-called “piggyback” taxation). Countries with large SCGs might be able to assign some indirect taxes to them.
Reforming the grant system. Regardless of the issue of increased own-source revenue, the grant system itself might warrant reform. As a rule, grants should be linked to SCG needs, measured against the yardsticks of tax-raising capacity or objective spending obligations, and can be disbursed subject to performance (conditionality). Grant allocation indicators should be immune to sub-central manipulation and non-equalising grants reduced. And institutional measures should ensure that the overall size of the grant system reflects voters’ preferences.

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Notes

← 1. The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

← 2. Other revenue sources – user fees, property income – are not taken into account.

← 3. Since some equalisation systems work via tax sharing not reported as intergovernmental grants, the share of equalising transfers in total transfers is likely to be lower than 55%. Moreover, many grants reported in Table 4.1 as “equalising” consist of both an equalising and a neutral part, with the neutral part often larger than the equalising part.

← 4. Around 3% of SCG spending is covered by grants from other jurisdictions of the same government level. This type of grants usually reflects horizontal compensation agreements.

← 5. Swiss cantons seem to provide excessive hospital care compared to what the federal level would do if it was responsible for this service (Steinmann et al., 2003). Some regions in Spain appear to overspend on transport infrastructure to lure economic activity (e.g. Delgado and Alvarez, 2007).