Fiscal Federalism policy in OECD member countries
Jon Blondal

I would now like to turn to some of the general fiscal federalism issues faced by OECD Member countries. There are five fiscal federalism issues that I would like to highlight specifically:

• Aggregate fiscal discipline;
• Economic stabilization measures;
• Allocative efficiency;
• Regional equity considerations; and
• Operating effectiveness and efficiency.

These are wide-ranging issues, but they are complementary in many ways, and essential elements for successful fiscal federalism outcomes.

1.2.1. Aggregate fiscal discipline
I would first like to turn to the issue of aggregate fiscal discipline.
The overriding goal of any fiscal system is, or at least should be, to maintain aggregate fiscal discipline, i.e. to control the totals. The fear of national governments is generally that some sub-national governments will be less than responsible in this regard and accumulate excessive and unsustainable levels of debt.

There are three approaches that Member countries have adopted to impose fiscal discipline on sub-national governments.

The first approach is simply to have the national government impose no restrictions on the borrowing activity of sub-national governments and leave it to the market to impose the necessary discipline. The United States and Canada employ this approach.

The second approach can be termed “administrative controls.” This consists of sub-national governments consulting with the national government on their borrowing plans, in aggregate or for individual loans. (These consultations commonly incorporate a discussion of other aspects of sub national governments finances. i.e overall levels of revenue and expenditure.) These are generally labeled “consultations,” but if disagreements between national and sub-national governments take place, it is generally the national government's point of view that prevails. This is the most common approach adopted in OECD Member countries. Prime examples include the Nordic countries, Germany with its Financial Planning Council, and Australia with its National Loans Council.

The third approach consists of national governments prescribing general rules for the allowed level of borrowing by sub-national governments. A common feature of rules-based systems is to distinguish between capital expenditure and operating expenditure, and permit borrowing only for capital expenditure. The rules-based systems are, however, often combined with administrative control systems. The clearest example of a stand-alone rules-based system, albeit different in nature, is the Maastrich criteria for European Monetary Union with its benchmark budget deficits and government debts of 3% and 60% of GDP, respectively.

In looking at the three approaches, it is striking that only two Member countries –the United States and Canada– rely on the market to impose fiscal discipline on sub-national governments. OECD Member countries have advanced financial markets and high-quality fiscal reporting. This would seem to suggest that the market discipline approach should be effective. Indeed, it has worked very well in the United States and Canada. Sub-national governments in the United States have relatively low levels of debt. Sub-national governments in Canada accumulated heavy debts in the early 1990s. But as the result of downgradings by credit rating agencies and higher interest rate differentials, provincial governments in Canada have adopted strong fiscal consolidation programs. (See Appendix B).

So, why don't more Member countries adopt this approach if it works so well in the United States and Canada? The reason lies in the fact that in the United States and Canada, it is not assumed that the national government would bail out sub-national governments if they got into financial trouble. In other Member countries, there is generally the belief that the national government would come to their assistance.

Of course, national governments could try to change this belief over time –primarily by not coming to the rescue of sub-national governments in financial trouble. But failing that, there is a need for more direct involvement by the national government in the borrowing operations of sub-national governments in these countries, either through rules-based approaches or administrative control approaches.

Rules-based systems have the advantage of being transparent and expeditious. They have, however, generally been regarded unfavorably. They are said to be inflexible; they are said to lose all credibility if the rules are ever breached; they are said to lend themselves to all sorts of perverse behavioral incentives in order for participants to get around the rules. There are of course elements of truth in this. But the Maastrich criteria for European Monetary Union and the impact it is having on fiscal consolidation efforts in Europe highlights the powerful role that such rules-based approaches can have. I believe that Member countries will increasingly move to such systems and away from administrative control systems which, although flexible, can often be cumbersome and tedious.

1.2.2. Economic stabilization measures
I will now look at fiscal federalism as it relates to economic stabilization measures.

Fiscal policy is an important tool for economic stabilization measures in Member countries and only the national government is in a position to effectively run the automatic stabilizers. This is acknowledged in all Member countries.

The reason I raise it here is that the Maastrich criteria for European Monetary Union is making this an emerging issue for European Union Member countries, which we can view as sub national governments in this context. This is because countries are locking themselves into a maximum permitted fiscal deficit. This maximum does not differentiate between Member countries that are enjoying robust economic growth and those suffering from economic recessions. As each country operates its own automatic stabilizers with no central European Union funds, this can lead to significant adjustment problems in individual Member countries. This has been recognized with the Growth and Stability Pact, which offers some flexibility for Member countries to operate with higher deficits during economic downturns; whether this flexibility is sufficient is open to debate.

We see a huge difference if we contrast this with the situation in the United States where the Federal government is largely responsible for the operation of the automatic stabilizers. For example, when a severe recession hit California, the financial streams to the state from the Federal government increased significantly (unemployment and other welfare benefits) and financial streams from the state to the Federal government decreased greatly (less economic activity resulting in less taxation). This eased the adjustment process in California.

I use this to highlight the fact that the automatic stabilizers should be located at the national government level and not at the sub-national government level. It will be interesting to see if the automatic stabilizers in European Union Member countries will not evolve towards a more centralized basis.

1.2.3. Allocative efficiency and regional equity considerations
I would next like to turn to the subject of allocative efficiency and regional equity considerations. I discuss these two issues together because they are closely linked.

Allocative efficiency refers to the distribution of resources in an optimal manner, i.e. spending public money where it is most needed. The key benefit of strengthening sub-national governments in this respect is that they are closer to the population and thus in a better position to reflect the wishes and specific needs of each community. They can be more innovative and flexible in how they meet these wishes and needs. There is no longer a “one-size-fits-all” standard. Almost by definition, therefore, stronger sub-national governments equal greater allocative efficiency.

However, we also need to recognize regional equity considerations. This refers to the disparities among individual sub-national governments, either in terms of the financial resources at their disposal or the costs of providing services. For example, should people in more affluent areas enjoy premium services while people in poorer areas struggle for basic services? Similarly, should people in urban areas enjoy better services than people in less densely populated areas? A recognition of these disparities would argue for a strong national government in order to ensure equity.

Fiscal federalism is therefore a balancing act between these poles: strong sub-national governments to achieve allocative efficiency versus strong national governments to achieve equity. One school of thought would be that regional inequity is the price you have to pay for strong sub-national governments. Another school is that regional inequity should preclude strong sub-national governments. We have no Member countries that illustrate these extreme poles. You could, however, say that the United States leans towards the former and countries such as the United Kingdom to the latter. The middle ground is typically that the national government fills the gap between the revenue-raising capacities and the expenditure requirements of individual sub-national governments through transfers.

There are many types of transfer arrangements. They form a continuum in terms of the degree of discretion available to sub-national governments. Some are relatively simple while others involve complex formulas; many incorporate detailed conditions for the use of the transfers.

From the national government point of view, these conditions are necessary to ensure that the money is spent on improving the services that form the rationale for having the transfers in the first place. For example, if the national government decides to improve educational standards and supports this policy with transfers to the sub-national governments that operate the schools, it will want to ensure that the money is used for that purpose. They may go further and insist that the money is spent on improving a specific aspect of the schools, for example improving science education. They may go further still and insist that the money is spent on buying laboratory equipment. Now, multiply this by the hundreds, or thousands, of individual transfer programs in operation. From the national government's point of view, these conditions for individual transfer programs are necessary in order to ensure that national initiatives are implemented in a uniform manner throughout the country.

We are, however, witnessing fundamental reforms in this area in Member countries. The broad outlines of these reforms are the same across most countries: the pendulum is swinging the other direction. Individual transfer programs are being consolidated and the conditions attached to the transfers are being relaxed substantially. The primary motivation for this is generally to reduce national government expenditures as these reforms are usually accompanied by cuts in the total amount of transfers. This is justified in terms of the allocative efficiency argument: sub-national governments will be able to make better uses of the funds if they have increased freedom in how they are used, and will therefore require less funds.

It is too early to evaluate the impact of these reforms. Member country experiences, however, seem to suggest that this may be a win-win situation. National governments win because they are reducing expenditures. Sub-national governments win because they can use the funds transferred from the national government in more appropriate ways.

Other reforms being undertaken in Member countries to promote allocative efficiency include measures to clarify the roles of each level of government in specific sectors in order to avoid duplication of effort.

Similarly, efforts are being made to clarify responsibility for financing expenditure programs in order to avoid situations where the national government is responsible for, either fully or on a cost-sharing basis, the financing of expenditure programs operated by sub-national governments. This should increase the incentive for sub-national governments to limit expenditures.

Canada has for example embarked on a major programme of change in the system of federal transfers to provinces. A complex system of separate transfers for social assistance, post-secondary education and health care, partly on a cost-sharing basis, are being combined into a single Canada Health and Social Transfer. This transfer will be a block grant, i.e. not an open-ended, cost-sharing transfer. This reform is being accompanied by a decline in total transfers to provinces, as a percentage of GDP, of one-fifth over a three year time period.

1.2.4. Operating effectiveness and efficiency
The last issue I would like to discuss is operating effectiveness and efficiency. There are two aspects to this issue. The first is whether sub-national governments have the managerial and technical capacity to carry out the functions assigned to them. The second refers to “value for money” efficiency —Are sub-national governments carrying out their functions at least cost?

The question of managerial and technical capacity is generally related to the size of sub national governments. There is a size threshold below which the necessary economies of scale cannot be achieved in operation. The problem of insufficiently large sub-national governments is an issue for most Member countries. Member countries have tended to alleviate the problem in one of two ways. First, by merging sub-national governments to form larger units. Second, by creating special-purpose organizations operated by several sub-national governments. For example, a secondary school may be operated jointly by several small jurisdictions. Member countries' experience would suggest that, although the second option is easier in political terms, the first option should be preferred in terms of operating effectiveness and efficiency. This is because a plethora of specific-purpose organizations can obscure accountability and, as a result, operating effectiveness and efficiency can suffer.

Second, there is concern in Member countries to ensure that public services are being operated at lowest cost by sub-national governments. In most cases, this is said to be a problem for the electorate in each jurisdiction. This highlights the importance I stressed above of clear lines of accountability. There is, however, a notable exception to this “hands-off” approach, and that is the United Kingdom. They have set up an Audit Commission for Local Governments, established a Citizen's Charter which sets performance standards for various public services, and instituted a program of Compulsory Competitive Tendering by local governments. I would like to touch briefly upon each of these.

The Audit Commission is responsible for auditing the finances and performance of each local authority. The Audit Commission's primary influence is due to the respect it enjoys and that it provides the electorate with information by which to hold local authorities accountable. For example, it has established “league tables” where it compares how effectively and efficiently different local governments perform the same service. For example, why does it cost more for local government “A” to perform a certain services than it does for local government “B”?

The Citizen's Charter established a framework for “setting, monitoring and publication of explicit standards for the services that individual users can reasonably expect (and) publication of actual performance against these standards.” Citizen's Charters have been established for a variety of local government services, including education and public housing. A key benefit of these Charters is that they are at the level of the individual user and they provide benchmarks for them to judge the performance of public services.

It is also interesting to note that the UK Conservative Party proposed in its last manifesto to have the national government take over activities from individual local governments if their performance of an activity did not meet certain minimum national service standards.

The Compulsory Competitive Tendering program is a requirement for local governments to market-test specific activities. Conceptually, market-testing is essentially contracting out with the exception that in-house personnel can compete against an outside contractor in the bidding process. There is thus not a presumption that activities that are being market-tested will be contracted out to private suppliers. The objective is to expose in-house personnel to the discipline of the market and thereby foster efficiency. This program was first started for blue-collar activities, such as trash removal and janitorial services, but is now being expanded to include white-collar activities, such as legal and financial services.

All these UK initiatives, the Audit Commission, the Citizen's Charter, and the Compulsory Competitive Tendering program, appear to have been highly effective in promoting effectiveness and efficiency in the delivery of service by sub-national governments.