POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise NOVEMBER 2010 · Number 38 57657 Taxation and Decentralization Richard Bird Strengthening subnational governments is high on the policy agenda of many developing countries. From an economics perspective, the most important potential benefit from decentralization is the increased efficiency (and consequent welfare gain) that comes from moving governance closer to the people. To achieve this benefit, however, close attention must be paid to the design and implementation of subnational tax systems. Some people have argued that fiscal decentralization may reluctant to release taxing powers to subnational govern- improve welfare not only directly, but also indirectly by ments. On average, the subnational tax share of total taxes helping alleviate such other problems as economic develop- in developing countries is only about 10 percent, or less than ment, revenue mobilization (see box 1), innovation in public half of that in industrial countries. These figures have service delivery, accountability of elected officials, capacity changed little in the last 30 years (Bahl and Bird 2008). The development at the local government level, and grassroots result is that most subnational government expenditures in participation in governance. What more can one ask? developing countries are financed through transfers (includ- However, to be successful in attaining the potential ben- ing shares of national taxes, usually distributed on a formula efits from decentralization, subnational governments must basis). As a rule, even the few taxes that subnational govern- have the power to control their employees, and local resi- ments have are costly and difficult to administer. This note dents must have the power to control their governments discusses the case for improving the design and increasing (normally through elections). Moreover, there must be suf- the role of such taxes. ficiently accurate information available for voters to evaluate the fiscal decisions of local governments, and sufficient in- Assigning Subnational Taxes centive and interest for them to exercise their power respon- sibly. Unfortunately, in many developing countries, few if The traditional theory of fiscal federalism prescribes a very any of these conditions may be satisfied. limited tax base for subnational governments. The only good Significant tax assignment to subnational governments is local taxes are said to be those that are easy to administer lo- common in developed countries: in Sweden and other Scan- cally, are imposed solely (or mainly) on local residents, and dinavian countries, for example, local income taxes are im- do not raise problems of harmonization or competition be- portant, whereas state and local governments in the United tween subnational--local or regional--governments or be- States often impose both sales and income taxes. In most de- tween subnational and national governments. The only ma- veloping countries, however, central governments have been jor revenue source that passes these stringent tests is usually 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise ly, fiscal decentralization may shift the composition of public Box 1. Decentralization and Increased Revenue Mobilization capital investments away from national priorities. Moreover, if fiscal decentralization takes the path of increasing reliance In principle, fiscal decentralization may increase revenue mo- on own-source revenues, then local governments with bilization by involving subnational governments more directly greater fiscal capacity (such as large cities in which there is in taxation. Typically, central governments rely on a combina- both a larger tax base that is easier to reach and a better tion of company income tax, individual income tax, value chance of developing the administrative capacity to collect added tax, and excises and customs duties. In many de- taxes) have an advantage; and regional inequality is likely to veloping countries, however, small firms, most individuals, increase. Finally, revenue decentralization may result in high- and owners of immovable property are all underrepresented er administrative and compliance costs. in the tax base as the result of the combination of high entry Counterarguments may be made to support increasing lo- levels (thresholds) and widespread evasion. cal tax autonomy. For instance, local residents are likely to Subnational governments may have the potential and--if hold officials more accountable if local public services are fi- the intergovernmental transfer system is properly designed so nanced to a significant extent from locally imposed taxes as not to penalize success in revenue raising--the incentive and charges that local residents must pay, rather than from to reach this tax base. In that case, increases in subnational central government transfers. Local taxes should be both vis- government tax revenues will not be offset by reductions in ible to local voters and large enough to impose a noticeable central government tax revenues; instead, they will reduce the burden that cannot be easily exported to nonresidents. Re- need for intergovernmental transfers from central revenues. liance on own-source taxes has the important advantage of To an extent in some countries, local governments do seem imposing fiscal discipline on subnational governments. Re- to have broadened the tax base by employing a variety of tax quiring local governments to finance a greater share of ex- instruments and by taking such administrative measures as penditures from their own revenue sources drives up the tax placing levies on the sales of firms' assets, requiring licenses price of public services and, hence, tends to reduce upward to operate, establishing betterment charges, and creating var- pressure on subnational government expenditures. In con- ious forms of property taxation. trast, heavy reliance on intergovernmental transfers--the Such taxes and charges often are unpopular with those common situation in most developing countries--has pre- who pay them, and some may constitute an unduly costly and cisely the opposite effect of expanding local demand for in- undesirable burden on new businesses. However, they do il- creased public services (financed largely by others), unless lustrate that--at least in some instances--decentralized gov- unusually great care is devoted to ensuring that transfers ernments may have a comparative advantage in raising rev- have no effects at the spending margin (Bird and Smart enue because they have ample opportunity to identify 2002). businesses in the community and to gain some knowledge about those firms' assets and the scale of their operations. Principles of Revenue Assignment Who should levy what taxes and how effectively they can do so have been major issues in some countries. This is not the property tax, with perhaps a secondary role for taxes on surprising because the correct revenue assignment in a mul- vehicles and user charges and fees. Because central govern- tilevel government structure is not at all clear in principle ments generally are reluctant to provide subnational govern- and often is controversial in practice. There are two funda- ments with access to more lucrative sales or income taxes, it mental problems: is not surprising that, to some extent, property tax­driven 1. The central government inherently can collect most decentralization has become both conventional wisdom and taxes more efficiently than can subnational govern- common practice in many developing countries. ments (vertical imbalance). There may be good reasons why central governments of- 2. The potential tax bases available to the subnational ten are reluctant to give much tax discretion to local govern- governments vary widely from jurisdiction to jurisdic- ments. For instance, they may fear losing some degree of tion (horizontal imbalance). macroeconomic control. In addition, fiscal decentralization To some extent, vertical imbalance may be solved if sub- may shift resources from central governments that have national governments are permitted to impose variable sur- higher rates of capital spending to regional and local govern- charges (perhaps within a set range) on central taxes. How- ments that spend relatively more on consumption goods and ever, even if the vertical imbalance issue can be resolved by services. If the result is a lower overall rate of useful spending adjusting revenue assignments, the degree of horizontal im- on infrastructure, national growth could be harmed. Similar- balance is invariably worsened by decentralizing taxing pow- 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise ers because those who have more to tax are obviously better · To strengthen local accountability, it should not be pos- off under this system than are those who are less favored. sible to export much, if any, of the tax burden to non- Consequently, in countries where interjurisdictional dispar- residents. ities are a concern, more decentralized taxes imply a need · The tax base should be visible, again to ensure account- for more equalizing transfers to poorer regions. ability. Four basic principles for assigning revenues to subnational · To be acceptable, the tax should be perceived by tax- governments may be suggested: payers as reasonably fair. 1. Efficiency--Subnational taxes should not unduly dis- · The tax should be relatively easy to administer effi- tort the allocation of resources. ciently and effectively so that the cost of administra- 2. Accountability--Governments at all levels should bear tion is a "reasonable" proportion of revenue collections significant responsibility at the margin for financing and that compliance costs (those incurred by taxpay- the expenditures for which they are politically respon- ers) are relatively low (see box 2). sible. Not everyone may agree that all these characteristics are 3. Sufficiency--Ideally, own-source revenues should be necessarily or equally desirable. For example, is it unequivo- sufficient to enable at least the richest subnational gov- cally good that subnational governments be insulated either ernments to finance from their own resources all local- from the tax base consequences of their tax rate choices or ly provided services that primarily benefit local resi- from inflation? Moreover, the characteristics that may be dents. sought in a local tax that is ideal from the point of view of 4. Localization--Subnational taxes should burden only local governments may not be compatible with the charac- local residents (and businesses), preferably in relation to the perceived benefits they receive from local serv- ices. Economists often emphasize the first of those criteria, ef- Box 2. Administering Local Taxes ficiency. The importance of the second criterion, accounta- bility, has already been noted briefly. Sufficiency, the third The key characteristic of a "local" tax in terms of accounta- criterion, focuses on fiscal imbalances: it is motivated by the bility is that the local (or regional) government should be po- argument that the lighter the load put on intergovernmental litically responsible for the tax imposed. That usually requires fiscal transfers, the more likely it is that they will be able to the local government to be able (perhaps within limits) to set do their job adequately. Finally, although the last criterion the tax rate. However, neither this nor any other assignment listed, localization, is related both to reducing distortion (cri- principle requires that local taxes be administered by the local terion 1) and increasing accountability (criterion 2), it also government. reflects a common assumption with respect to subnational The issue of administration thus can be considered apart from finance--namely, that the principal task of subnational gov- the revenue assignment issue. Many ways of organizing sub- ernments cannot and should not be income redistribution. national tax administration exist in different countries. In the Although local governments often are critical deliverers of United States, at one extreme, each local government may be services to the poor, they are seldom well suited to play any responsible for administering its own taxes. At the other ex- substantial redistributive role in terms of financing such treme, there may be only one tax authority responsible for ad- services. ministering the taxes at all levels of government. Although no country appears to go quite that far, Canada has moved a long What Is a Good Subnational Tax? way down the path with respect to provincial taxes, and coun- tries such as Denmark have both an integrated information Among the characteristics that might be sought in a good system and strong operational synergies between levels of subnational tax are the following: government. In some cases, the "national" tax authority may · The tax base should be relatively immobile so local au- be directed by a board that includes significant representation thorities have some leeway in varying rates without from subnational governments. There are countries in which risking the loss of too much tax base. subnational governments may even be responsible for much · The tax yield should be adequate to meet local needs of the administrative work involved in administering some na- and sufficiently buoyant over time to cover expected tional taxes. In others (often regarding the property tax, for ex- increases in the local expenditures being financed. ample), one level of government may establish the tax base · The tax yield should be relatively stable and predictable (the cadastre) while another level (or levels) sets rates and over time to facilitate development and implementa- both collects and enforces the tax. tion of sound local fiscal practices. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise teristics that are ideal from the central government's per- have both problems in managing decentralization and less- spective. Both levels might agree that the tax base should be than-satisfactory policy outcomes. immobile, and perhaps that tax yields should be stable and Another danger is that subnational governments may at- adequate to meet local needs. But central governments tempt to extract revenues from sources for which they are should be concerned also about ensuring that little, if any, of not accountable, thus obviating the basic efficiency argu- the tax burden is exported to nonresidents and that the local ment for their existence. To avoid this problem, it may be tax base is visible to provide accountability. Subnational gov- desirable to take two steps: ernments are likely to view such attributes quite differently. 1. Limit the access of subnational governments to taxes Finally, because not all subnational governments are the that fall mainly on nonresidents--such as most natural same, the appropriate tax mix in most countries is likely to resource levies, preretail-stage sales taxes, and, to some differ not only between regional and local governments, but extent, even nonresidential real property taxes. also among governments of different sizes and complexities 2. Establish a uniform set of tax bases for local govern- at each level. ments (perhaps differing for such categories as big cities, small towns, and rural areas), with a limited Decentralization and Fiscal Autonomy amount of rate flexibility providing room for local ef- fort while restraining unproductive competition and Unless local governments have a significant degree of free- unwarranted exploitation. dom to alter the level and composition of their revenues, If inappropriate tax bases are assigned to subnational gov- neither local autonomy nor its essential partner, local ac- ernments, wasteful competition and undesirable tax export- countability, can be achieved. In particular, some degree of ing may result. Moreover, when inadequate tax bases are as- rate flexibility with respect to a significant component of lo- signed, the result may be the imposition of a variety of cal revenues seems essential if local taxes are to be both ad- undesirable and distortionary fees, levies, and informal equately responsive to local needs and decisions and instru- charges--often outside the normal budgetary process. In mental in making local leaders more accountable to their such instances, it is common for central governments to citizens. blame incompetent or corrupt local governments for such A potential danger in permitting local governments even undesirable outcomes. In reality, however, the fault may lie limited freedom to tax is that they may not use fully all the less with subnational politicians and officials (who, for the revenue sources open to them for fear of fiscal competition most part, are simply responding to an implicit incentive or adverse political consequences, thus allowing the level structure that allows them to shift tax burdens to others, to and quality of public services to deteriorate--the infamous impose taxes and charges irresponsibly, or perhaps to de- "race to the bottom." Of course, if the service in question is mand and receive increased transfers or borrow irresponsi- one of national importance or one in which there is a strong bly) than with the central government that established such national interest in maintaining standards, it presumably a dysfunctional structure. should be funded and the extent to which it is achieved should be monitored by the central government. Even with Smarter Subnational Taxation respect to strictly local services, if intergovernmental fiscal transfers are properly designed, this monitoring should not However subnational tax systems develop in the future in be a problem (Bird and Smart 2002). developing countries, it is clear that much can and should be In the ideal world envisaged in the fiscal federalism litera- done to strengthen the deficient property taxes already in ture, if local residents do not like what their local government place in most countries. For example, the property tax does or does not do, they may (try to) "throw the rascals out" should be simplified and applied uniformly. Cadastral maps at the next election. To put this another way, the freedom to should be updated and valuations made more consistently make mistakes and to bear the consequences is an important and currently. Improved use should be made of information component of local autonomy in any country. Indeed, unless flows from property registries, local building license author- subnational governments are given some degree of freedom ities, public utilities, and so forth. In addition, close attention with respect to local revenues, including the freedom to make generally should be paid to improving the "sharp end"--col- mistakes (for which they are accountable to their citizens), re- lection and enforcement--and the technically more costly sponsible and responsive subnational government is unlikely (and less immediately productive in terms of revenue) map- to develop. If, as in many developing countries, there are inad- ping and surveying of the traditional cadastral approach. equate mechanisms for local accountability, or if those who Although the property tax is a useful, even necessary fail to collect local taxes or to spend revenues efficiently are source of local revenue, it seldom can provide sufficient re- bailed out by discretionary transfers, countries are likely to sources to finance a significant expansion of local public 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise services in most countries. Indeed, many countries have been often are financed largely through central government trans- hard-pressed even to maintain the present low relative im- fers. However, when regional governments are also expected portance of property tax revenues. Although the assessment to contribute to financing such services, they often need ac- and collection of property taxes certainly can be improved cess to some broader revenue source--perhaps income or in most developing countries, it is difficult to administer consumption taxes. Because these tax bases also are the main these taxes equitably in a rapidly changing environment; and revenue sources for central government, maintaining an ef- it is always difficult to greatly or quickly increase revenues ficient, effective, and accountable public sector can be a from this source. Nonetheless, a low-rate, uniform property tricky problem. Although detailed discussion of this issue is tax has an important role to play in financing local govern- beyond the scope of this note, the key to resolving these ments, whether urban or rural; indeed, such a tax is probably complex problems is to keep in mind the close interdepend- the only general tax source available in most rural areas. ence between the assignment of expenditures and revenues Apart from user charges (including those related to motor between levels and units of government and the design and vehicles), which are not discussed here, the other main role of intergovernmental transfers (Bird 2010). source of own revenue found in many countries is some form of local business tax or license system. Whether or not Acknowledgment there is an economic case for such taxes, the political reality is that practically any subnational government permitted to This version has been considerably improved by comments from impose such levies does so. Given the restrictions on (and Raúl Junquera-Varela and Eduardo Ley. unpopularity of) residential property taxes and the unrelia- bility of central transfers in many developing countries, most About the Author property taxes are imposed on businesses. In addition, other business taxes often provide almost the only way in which Richard Bird, a longtime World Bank consultant, is professor subnational governments have been able to expand revenues emeritus of economics at the University of Toronto; associate of in response to perceived local needs. the International Institute of Business, Rotman School of Man- To an extent, there is an economic case for some local agement; and adjunct professor at the Munk School of Global business taxation. Where it is not feasible to recoup the mar- Affairs, University of Toronto, Canada. ginal cost of cost-reducing public sector outlays through user References charges, a form of broad-based general levy on business ac- tivity may be warranted. If this is the rationale, from an eco- Bahl, R. W., and R. M. Bird. 2008. "Subnational Taxes in Developing Coun- nomic perspective, it may be argued that the best form of tries: The Way Forward." Public Budgeting and Finance 28 (4): 1­25. tax on business might be a nondistorting low-rate, broad- Bird, R. M. 2005. "A Look at Local Business Taxes." State Tax Notes 36 (9): based tax similar to those imposed by subnational govern- 685­98. ments in Italy (the IRAP); and, more recently, in both Japan ------. 2010. "Subnational Taxation in Developing Countries: A Review of the Literature." Policy Research Working Paper 5450. World Bank, (the modified enterprise tax) and France (the new uniform Washington, DC. business tax). For further discussion, see Bird (2005). Bird, R. M., and M. Smart. 2002. "Intergovernmental Fiscal Transfers: Les- Finally, intermediate regional governments in some coun- sons from International Experience." World Development 30 (6): 899­ tries are responsible for important and expensive services, 912. such as health, education, and welfare. These expenditures The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. It is produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at www.worldbank.org/economicpremise.