IwlThe World Bank NUMBER 4 1 PUBLIC SECTOR Decentralization and the challenge of hard budget constraints Reaping the benefits of decentralization requires mitigating its potential costs. Since the early 1980s fiscal and political decen- ernments to overborrow, overspend, or tralization have spread around the world. But undertax on the assumption that the central do the benefits of decentralization-increased government will cover their liabilities. public sector efficiency and accountability- outweigh the potential costs? Decentraliza- Market discipline takes time Effective tion can encourage dangerous opportunistic to develop behavior by state and local officials. Left unre- Institutions can foster market-based fiscal decentralization stricted, such opportunism can undermine discipline by encouraging voters, creditors, macroeconomic stability and other objectives. and asset owners to monitor local fiscal deci- requires hard The most pressing manifestation of this sions and punish local leaders for making problem is the softening of subnational imprudent fiscal decisions. This role can budget budget constraints. The impact of decen- also be assumed directly by the central gov- tralization on public sector efficiency and ernment, which might enforce local fiscal constraints macroeconomic stability depends on a coun- discipline through rules, regulations, and try's ability to prevent lower-level governments administrative oversight. for local from passing on their liabilities to higher-level Although well-functioning markets allo- governments. Brazil's recent financial crisis cate credit better than hierarchies, and local governments was triggered by state-level defaults on debt oversight is generally preferable to central payments-demonstrating the urgent need oversight, the Bank's client countries gen- for institutional mechanisms that discipline erally require a combination of market and borrowing by state and local governments. central government mechanisms. Fiscal, polit- This note draws on case studies of 11 ical, and financial institutions often under- countries-7 developing and transition mine pure market discipline, especially in economies and 4 OECD countries-to iden- developing and transition economies. Thus tify institutional factors associated with hard strong, centrally imposed fiscal restrictions and soft budget constraints and extract pol- may be needed, especially at the early stages icy lessons for other countries (see Rodden, of decentralization. The most prudent strat- Eskeland, and Litvack forthcoming and egy seeks to strengthen market and rule- http://www.worldbank.org/publicsector/decentraliz based mechanisms at the same time. ationl). Fiscal, political, and financial insti- tutions can facilitate hard budget constraints Local creditors and constituents by strengthening competition at the local can enforce fiscal discipine... level-especially for capital-and by strength- The first and most basic mechanism for ening the central government's ability to reg- enforcing a hard budget constraint is a set ulate local borrowing and other activities. of institutions that clearly conveys that local But such institutions can also promote soft governments will bear the costs and bene- budget constraints, inspiring subnational gov- fits of their fiscal decisions. When this mes- FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY AND POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK sage is also conveyed to creditors, voters, have mandated that subnational govern- and asset owners, three additional mecha- ments provide key public goods but have not nisms come into play. First, capital markets devolved sufficient revenue for them to do will constrain local fiscal decisions, and local so. In addition, local governments are more governments will face limited access to likely to credibly shift blame for local fiscal credit if they do not make sound fiscal deci- crises if the central government controls local sions. Second, profligate local officials will spending decisions. For instance, public be voted out of office. Third, markets for employment regulations in Brazilian states land and other assets will supplement the enable governors to claim that they have market for votes-knowing that local fis- little room to maneuver when facing adverse cal decisions directly affect their property fiscal shocks. If creditors and citizens are to values and rents, land owners will likely perceive local obligations as truly local, cen- By reforming basic lobby against imprudent debt, and owners tral regulations must allow subnational offi- of mobile assets might threaten to move. cials to adjust to adverse shocks on their own. fiscal institutions, . . . but only if institutions Well-designed transfers it may be possible provide incentives to do so Subnationalgovernmentstypicallyrelyonrev- The problem with these market-like mecha- enue raised or regulated by higher levels of to enhance nisins is that theywork well only when subna- government. This setup can weaken local tional governments have considerable fiscal accountability and undermine the credibility accountability autonomy, when voters and creditors have of the central government's commitment to good information about local fiscal perfor- withhold bailouts (Rodden 2000). While aver- and strengthen mance and risk, and when the central gov- tical fiscal imbalance is often unavoidable in ernment is able to make a credible developing countries, local budget constraints incentives for commitment that it will not provide bailouts. can be hardened by strengthening the local In the 1 countries surveyed, only U.S. states tax base, improving local tax administration, market discipline and Canadian provinces meet these conditions. and encouraging local fiscal effort. More important than the amount of inter- Three features are essential governmental transfers is how they are dis- for fiscal institutions tributed. Transfers are often distributed By reforming basic fiscal institutions, it may through highly discretionary, political, and be possible to enhance accountability and unpredictable processes, as in Brazil and strengthen incentives for market discipline. Ukraine. But even rule-based transfers can Three features stand out. create perverse incentives by rewarding poor fiscal performance, as in Germany and India. Clear division of responsibilities The most important objective is to cre- Many of the Bank's client countries could stand ate predictable intergovernmental transfers to clarify revenue, spending, and regulatory that favor rules over discretion, encourage powers. If there is much overlap and confu- local effort, and give local politicians, their sion in the assignment of authority between constituents, and their creditors few reasons central and subnational governments-as in to expect bailouts. Transfers should not be Ukraine-citizens and creditors may not have subject to yearly bargaining among politi- the ability or the incentive to distinguish cians. Expert commissions and indepen- between central and local obligations. dent agencies may be helpful in reducing discretionary bargaining. Powers and revenues that match responsibilities Political institutions are critical Subnational governments must have enough in hardening budget constraints revenue to implement their spending respon- Local politicians and their constituents are sibilities. In many developing countries much more likely to expect bailouts in sys- (South Africa, Ukraine) central governments tems with decentralized, fragmented legis- PREMNOTE 41 JULY 2000 latures and weak party discipline. In such sys- Local credit markets as a source tems legislative coalitions may be hard to of discipline form, and vote trading is common. Such A central government that allocates credit logrolling helps explain why a central gov- by administrative fiat may be unable to cred- ernment would provide bailouts to certain ibly commit to not provide bailouts. Thus states even though bailouts are inefficient for it is important to reduce the central gov- the federation as a whole. Bailout expecta- ernment's role in credit allocation and to tions maybe particularly strong if subnational strengthen local capital markets. Links officials are well represented in the central between credit ratings and fiscal outcomes legislature, as in many federal systems. are growing stronger in several countries, Still, few countries are likely to pursue far- including Germany, India, and South Africa. reaching reform of basic political structures. As borrowing from government interme- More realistically, central governments can diaries is replaced by borrowing from cap- It is important enhance their no-bailout commitments by ital markets, fiscal discipline is expected delegating authority to independent agen- to improve. to reduce the cies, autonomous central banks, and (perhaps But it is not enough to simply set local mostimportant) independent arbitrators and governments free in domestic and inter- central government's courts. Reforms that increase the access of national capital markets and hope for the voters and creditors to information about best. Like asset owners and voters, creditors role in credit local government performance will also will discipline local fiscal decisions only if enhance market discipline. More generally, they are convinced that local borrowing is allocation and reforms should fortify local democracy and not explicitly or implicitly backed by the strengthen links between local politicians' central government. They will take cues to strengthen local performance and their tenure in office. about the likelihood of bailouts from the fiscal and political institutions described capital markets Financial institutions also have above. If these cues suggest that the central an important role to play government will provide bailouts if pressed, Public and private financial institutions can market incentives will do little to constrain undermine or strengthen both market- and local spending and borrowing decisions. rule-based forms of fiscal discipline. In par- ticular, the central government's role in the The role of rule-based mechanisms allocation of credit deserves careful scrutiny. While market mechanisms can and should be strengthened, they are often insufficient- Government transactions that undermine especially in developing countries embark- budget discipline ing on decentralization. In most of the Bank's In some countries the lending activities of client countries, local governments have lit- the central government and its agencies have tle autonomy to set and raise taxes, creditors undermined hard budget constraints. India's and voters have poor information and incen- central government has occasionally for- tives, and the central government cannot given state debts. In Argentina, Brazil, and fully commit to a no-bailout policy. In such Germany states borrow from banks owned cases additional hierarchical mechanisms or controlled by subnational governments, might be needed to achieve hard budget undermining lender independence. constraints. Privatization of such banks in Argentina This does not mean that central govern- and Brazil, and reform of the state-owned ments must prohibit local access to credit max- Landesbanks in Germany, may strengthen kets. Rather, the central government might lender independence. Budget constraints limit local deficits and debts, require that all can also be hardened by privatizing locally or some borrowing be centrally approved, or owned state enterprises, since these can not allow local governments to borrow to also serve as conduits for excessive local cover current spending (see Ter-Minassian borrowing. and Craig 1997 and PREMnote 15). PREMNOTE 41 JULY 2000 Central regulations might also seek to and auditing, implementing and enforcing increase transparency and accountability in limits on borrowing to cover current spend- local budget processes. Following New ing, and clarifying bankruptcy procedures. Zealand's example, Argentina has passed a Above all, reforms can improve the infor- wide-ranging Fiscal Responsibility Law. mation and incentives of voters and Brazil is considering similar legislation. The creditors. proposed Brazilian legislation not only lim- In many developing and transition its debt issues and personnel spending, it economies that are rapidly decentralizing, also introduces new budget rules and hard budget constraints may require rules accounting principles to increase trans- that restrain local borrowing in the short parency at every level of government. term. But in the long term such rules should let local voters and creditors know that local As experience with Who will guard the guardians? obligations are indeed local. As experience One problem with central controls on local with decentralization evolves, subnational decentralization spending and borrowing is that they may governments can gain revenue autonomy make voters and creditors even less likely to and establish credible track records of no evolves, subnational view local governments as responsible for bailouts-allowing them to move from rule- their obligations. Nor are such restrictions based to market-based enforcement governments can necessarily compatible with most of the effi- mechanisms. ciency and accountability advantages of move from decentralization. Moreover, central restric- Further reading tions are only as strong as central enforce- Rodden,Jonathan. 2000. "The Dilemma of rule-based to ment. Fiscal Federalism: Hard and Soft Budget Some of the case studies, however, show Constraints around the World." Massa- market-based that it is possible to implement rules that chusetts Institute of Technology, Cam- simultaneously: bridge, Mass. enforcement a Limit local autonomy and discourage Rodden,Jonathan, Gunnar Eskeland, and opportunistic behavior. Jennie Litvack, eds. Forthcoming. Decen- mechanisms a Clearly state that the costs and benefits of tralization and Hard Budget Constraints. local fiscal decisions will be borne locally. Ter-Minassian, Teresa, andJohn Craig. 1997. e Foster market-based discipline. "Control of Subnational Government As noted, enforcement can be made more Borrowing." In Teresa Ter-Minassian, ed., credible by delegating it to autonomous Fiscal Federalism in Theory and Practice. courts and agencies. For example, Hungary Washington, D.C.: International Mone- and South Africa recently implemented tary Fund. local bankruptcy laws that largely depoliti- cize the process, relying on courts and inde- This note was written by jonathan Rodden (Assis- pendent arbitrators. tant Professor, Department of Political Science, Massachusetts Institute of Technology). Conclusion If you are interested in similar topics, consider Central regulations need not undermine joining the Decentralization Thematic Group. market discipline. Indeed, they can facili- ContactJennieLitvack (x80519), send an email tate it by promoting local revenue collec- to decentralization_mail@worldbank.org, orclick tion, improving information, accounting, on Thematic Groups on PREMnet. This note series is intended to summarize good practice and key policy find- I ings on PREM-related topics. The views expressed in these notes are those of the authors and do not necessarily reflect the views of the World Bank. 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